Monitoring Shareholder Refinancing

Many co-op shareholders are refinancing their mortgages and using the extra money for repairs. What are the things boards should be concerned about with this “borrow now/pay later” mentality? What are the warning signs that you’re heading into trouble? What happens when the bill comes due?

Most co-op boards have the ability to monitor and approve the financing of a resident’s shares. The board will be required by the shareholder’s lender to execute a Recognition Agreement, and many proprietary leases give the board the explicit right to approve financing. The reason for the board’s concern over shareholders’ financing is that the board wants shareholders to have equity in their apartments. That way, shareholders are more likely to be concerned about the condition of the building and the quality of co-op life. And since paying shareholders have to make up the difference for delinquent shareholders, the board wants to be certain that all shareholders are able to pay their maintenance and assessments.

It’s never easy to determine when a shareholder is carrying too much debt, which is why many cooperatives limit the amount of debt on a unit to a certain percentage of its fair market value. Some exclusive buildings do not allow any financing at all. More common, however, are rules that limit financing to 50 to 75 percent of the apartment’s fair market value. The board then feels protected if there is a sudden downturn in the economy or in the finances of a particular shareholder. The 75 percent borrowing limit is common at many lending institutions, which typically require the shareholder to have 25 percent equity in their apartments. Some lenders are willing to lend against 90 percent or more of the price in newly converted and constructed buildings. They do this in the belief that, after a few years, buyers will pay more for apartments in mature cooperatives.

Corporations also have strict rules that cover refinancing. These include forbidding a shareholder from refinancing if he or she has been in default in paying maintenance or assessments during the previous two or more years; or forbidding a new shareholder from refinancing for at least two years, so the board can monitor the shareholder’s creditworthiness. Conversely, some boards have more lenient standards if a shareholder has been in good standing for two to five years.

When considering cooperative boards’ ability to place limits on shareholder financing, note that condominium boards do not have the same ability. This is paradoxical, because condo boards need the power even more than co-op boards do, since a condo board’s lien is secondary to a lender’s lien. If a lender forecloses, the condominium does not receive a dime of the unpaid common charges, assessments, or the board’s costs of collection until the lender is repaid everything it is owed, including principal, interest, default interest, and costs of collection. A cooperative, on the other hand, has the first lien on the shares that a lender finances, so the lender’s right to the collateral (the apartment) ceases to exist if the shareholder defaults and the corporation forecloses its lien. Part of the reason for this is that because the corporation pays the operating expenses as well as the real estate taxes on the building and the corporation’s mortgage, the amounts owed by the shareholders are significantly higher than the condominium’s common charges, which are only the operating expenses. Cooperative living does have its advantages.

Stuart Saft is a partner at Holland & Knight