Collateral Damage

It seemed like a slam-dunk. When a developer approached the seven-member board of 270 Fifth Street, a 35-unit Brooklyn cooperative, about buying the building’s air rights, it was a no-brainer. A million dollars for something the co-op never valued, never even thought about? Sure, why not? Images of capital improvements and new reserve funding danced in the directors’ heads.

But not for long.

Faster than you could say, “Sign here,” the holder of the four-story Park Slope co-op’s underlying mortgage, J.P. Morgan/Chase, put the kibosh on the agreement.

“We were stunned,” recalls Jason Wagenheim, the president at the time. “We thought it was a simple matter of getting them to sign a document.” The board didn’t realize that the air rights are considered an “asset of the corporation, so if we were going to sell an asset, we had to get the approval of Chase. This was totally new territory to us.”

In these belt-tightening times, when boards are looking for any number of ways to raise extra cash, be warned: if you don’t check with your lender, selling air rights, roof space, or other such building “collateral” can cause you to run afoul of the holder of your underlying mortgage.

The story of 270 Fifth Street is an extreme but not surprising example, as the board learned the hard way that the best offers in life are rarely free. In the spring of ’07, a developer offered a million dollars for 13,500 of the 37,500 square feet of unused rights.

“We approved the architecture and engineering plans, and were all set to pop a cork, when we learned that Chase needed to approve it,” says Wagenheim. Chase essentially said, if you go ahead with this deal, we’ll call your mortgage. The bank’s stance puzzled the board. The corporation’s original 20-year mortgage with Chase was for $1.1 million and expired in 2018, and “our building, as a co-op, is probably worth only five to eight million dollars,” Wagenheim notes. “We didn’t understand why Chase was putting up roadblocks. We had never considered the air rights as collateral and, in fact, felt they had a diminishing value because if we didn’t sell them to [the developer] now, we would have no other opportunity to sell them” (because the developer would put up some sort of building, even without 270’s air rights).

After further negotiation, Chase said the co-op could go ahead with the transaction – if it placed the million dollars in an escrow account until 2018. The board rejected that – “What would be the point?” says Wagenheim – and then Chase came back with another idea: it would let the cooperative out of the loan entirely for the price of the prepayment penalty: $250,000.

After a year of – sometimes tempestuous – negotiations, Chase finally allowed the co-op to make the deal, with a discounted prepayment penalty of $141,000. “They allowed us to pay a million dollars immediately,” says Wagenheim, “and the balance, which is $231,000, three months later.” The co-op took out a new underlying mortgage for $500,000 and paid off the Chase loan, minus $6,600 in closing costs. Their net gain on that deal was about $850,000. When you subtract $30,000 in closing costs on the new loan, their final profit on the transaction will be about $820,000. “But it shouldn’t have been so painful,” notes Wagenheim, who stepped down after spending over a year on the bruising negotiations (he was replaced as president by Cynthia Shaw Simonoff). “We paid a penalty because Chase acted in a manner that we thought was unreasonable,” adds Jeffrey Reich, a partner at Wolf Haldenstein Adler Freeman & Herz, the attorney who handled the 270 Fifth deal.

Some would disagree. Such steps – prepayment penalties and calling the loan – are not a question of greed or whimsy but simply a matter of business. “Prepayment penalties are almost always based on some form of yield maintenance,” explains Patrick Niland, principal in First Funding, a mortgage broker. “That is, the interest rate on the loan is the yield to the lender or investor. The lender is counting on six percent interest from now till ten years from now. If you prepay in year six, you give them the value of the remaining four years of interest. In essence, you’re maintaining the yield of the investor. You’re making them whole under the contract.”

Getting approval to sell air rights is a way for the lender to protect its investment. From the bank’s point of view, selling such commodities as air rights is getting rid of loan-securing collateral. “Most loan documents have a clause that says that if the borrower sells any significant portion of the collateral of the assets, then the loan becomes due,” explains Niland. “Selling development rights would be looked on as selling a significant portion of the assets. Most lenders charge a fee for changes made in the documents because there is some cost involved.”

“We have to know about air rights in advance,” adds Mindy Goldstein, a senior vice president at NCB, a major lender to cooperatives. “If they want to lease air rights to an antenna company or put up billboards or sign a new commercial lease, they need our consent. Anything that affects income needs our approval.”

Therefore, before signing agreements affecting your property’s value, you should check with the lender’s “investor consent department.”

“In the event the mortgage documents are silent or require release, you will need the consent of the lender,” observes Matthew Wehland, senior vice president at NCB’s investor compliance and credit review department. “When you have a partial release of the collateral, you need permission.”

But why would a lender, like Chase in the 270 Fifth Street deal, turn down a moneymaking opportunity or, at least, put up roadblocks? “Sometimes, a bank may not have as large a portfolio [in this area] as we do and may not be as flexible,” says Wehland. Other times, notes Reich, the lender may simply want to “get out of the business of making loans to cooperatives.”

More significantly, Niland notes, the overall market climate has changed in the last five years, making it more likely that lenders will not be as receptive to such speculative ventures as they once were. “The effect of the subprime mess rippled through the marketplace, like a stone in a pool,” he says. “The way the market has developed is that Wall Street takes every kind of debt – credit cards, home mortgages, and so on – and packages it; they buy these debts and put them all together in a big basket and then they issue a bond to the investing public, which is secured by the payments of the interest on the principal of whatever the assets are in that basket. If the assets are junky, then payments don’t come on a regular basis. Now, bond-holders don’t get paid and their bonds go into the toilet.

“What that has caused is an increase in the risk premium spread of the loan, and the ability of lenders to refinance their own debt at an affordable rate has lessened.” As a result, many lenders are more likely to turn down a deal or else call a loan, taking the short-term money over the long-term uncertainty.

Wehland suggests that a board considering any new money-making opportunities options consult its loan documents, talk to its professionals, and consider ways to simplify matters.

“If the co-op has an idea that they might sell air rights in the future, for example, they might have the air rights placed under a separate tax lot. That way, the building would be in one parcel and the air rights in another. Then the loan is only secured by the real estate portion and there is less difficulty in selling off the air rights.”