The Commercial Space Challenge

Brick-and-mortar retail stores are feeling the heat from the boom in online shopping, and that’s reflected in mounting store vacancies in New York City, especially on stylish Madison Avenue. Asking rents for ground-floor retail space have fallen in 14 of Manhattan’s 17 most desirable shopping corridors, according to the Real Estate Board of New York. As a result, co-op and condo boards that rely on income from their commercial space are scrambling.

The challenges are daunting, and the stakes are high. Afraid that a prime asset will become a liability if commercial spaces sit empty or rents decline, boards are trying to minimize risk by locking in guarantees. But what is a fair price for peace of mind?

Locking In Annual Income

Taking the long view, one Upper East Side co-op signed a 99-year lease with an investor group for a large ground-floor commercial space with multiple shops whose existing lease runs until 2030. The deal provides an upfront payment of several million dollars to the co-op, followed by annual payments of close to $1 million for the next 13 years, until the 99-year lease kicks in.
Once the new master lease takes effect in January 2030, income from the retail space will be split 60/40 between the operator and the co-op. The new lease also guarantees the co-op a base annual income. If there are vacancies, the risk will fall solely on the investor group.

The agreement gives the board a clear idea of “the worst-case scenario for budgeting,” says attorney Jeff Reich, a partner at Schwartz Sladkus Reich Greenberg Atlas, who represents the co-op’s board. “They’ve protected their downside and will achieve some of the upside.” The board, he adds, was “willing to take a little less in terms of base rent and a little less upfront in order to be able to participate in the increased revenue streams that someone is able to derive from this asset.”

Ira Meister, president of the management firm Matthew Adam Properties, says he’s recently seen some investor groups offering co-ops unrealistically high upfront payments to get them to sign a long-term commercial lease. “They’re offering a lot of money, like stupid money,” Meister says. “And when it’s too much money, it makes me very nervous. I’ve seen offers in excess of $10 million in upfront payments.”
One reason he’s wary of generous offers is the current slump in New York’s retail market. “If you look at the Golden Mile on Third Avenue between 57th and 79th Streets, it’s like Death Valley,” Meister says. “There are so many vacant stores. And on that line there are a lot of co-ops and condos.”

Meister recognizes that retail rents are cyclical, but he worries that rich deals may lead to defaults if investors cannot attract tenants willing to pay the rents required to make the leases profitable. If there is a default or a bankruptcy, the co-op would become just another creditor with which the investor would try to re-negotiate its deals.

A co-op in downtown Manhattan managed by Choice New York Property Management is weighing a much more modest offer for a 99-year lease from a Connecticut-based private equity fund. The proposed upfront payment is under $1 million, and the revenue-sharing component is less alluring than a 60/40 split, says Michael Feldman, co-owner of Choice New York, who is advising the co-op on the deal. “But it’s for a smaller space” than the one in Reich’s building, Feldman says, adding that he doesn’t share Meister’s “stupid money” concerns. “When you look at it on a per-square-foot basis, it seems like a golden ticket,” Feldman says. “But if you actually do the math, it’s not crazy.”

Reich knows of a few other co-ops that have entered into long-term agreements similar to his building’s, and he expects other deals to emerge as existing leases on commercial spaces expire. Such boards are, in effect, willing to trade a potential future bonanza for long-term peace of mind. Some, however, question the wisdom of the trade-off.

Sacrificing Future Profits

A co-op that gives someone a 99-year lease is “giving away the future value of the retail income stream which could be theirs, which could be much more than whatever the cash infusion they’re getting today is,” says Adelaide Polsinelli, principal and senior managing director at Eastern Consolidated, a commercial brokerage. She advises against settling for a flat rent – even as high as $1 million a year – for the next 99 years when the space could be worth much more in 50 or even 20 years.

Polsinelli concedes that some co-op boards may feel they don’t have the capacity to lease the space and manage the tenants, which is why they would welcome an investor who’s “going to take that off their plate.” If a board wants relief from the daily headaches of managing commercial space, a managing agent could handle those, she says, while a good broker would be able to lease the space after vetting tenants to the co-op’s liking, mitigating any risks.

“Usually, once you give up your right and assign a 99-year lease to a third party, that third party can put whoever he wants in there,” she warns. “It depends on what your agreement is with him. Before engaging in this relationship, a board should put the lease out for bid to make sure they are getting a competitive price for the lease and not leaving money on the table.”

Co-ops should, at the very least, protect themselves by negotiating Consumer Price Index increases and rent resets into long-term commercial leases, Polsinelli says, and they should never agree to a flat rent for the term of the lease. The lease agreement should also specify what would happen in the event of a default, she adds, because if the operator can’t get tenants and the space is vacant, it makes the building look bad. Under the agreement, an investor that defaults should be required to “relinquish control of the space back to the co-op and forfeit the security deposit,” she says. That will allow the co-op to find tenants at the lessee’s expense.“When you give away control of the ‘face’ of the co-op to an entity that has no vested interest in any other part of the property, you’re giving away more than just the value of the retail,” she says. “It can have an impact on the value of the apartments above.”

Don’t Forget the Tax Man

When the wave of co-op conversions began to crest in the 1980s, the state attorney general mandated that sponsor control of commercial leases would last no longer than 30 years, after which sponsors would turn over their rights to the co-op board. Despite the softer retail market, co-ops with 30-year, sponsor-controlled leases due to expire soon will be in a fortunate position. They’ll be able to get the full revenue that the commercial space is pulling in, says attorney Alvin Schein, partner at Seiden Schein. Sponsors have probably been keeping most of the rental income from the commercial space, but once their rights expire, co-ops will begin collecting 100 percent of that income. That’s the good news; the bad news is that the co-op’s tax bills will spike. But the added income will also boost their leverage to refinance the mortgage to meet any cash needs for capital improvements.

Some boards that are having trouble renting their commercial space have opted to sell the space. That’s the solution that Buchbinder & Warren, a property management and brokerage firm, offered to one of its clients. It was a co-op with residential loft units and commercial space that wanted to maximize its income and reduce its taxes. On Buchbinder & Warren’s advice, the board created a condop, which is a legal concept that separated the property into two sections: one containing the residential units and the co-op shareholders; and the second containing a commercial condo unit for the ground-floor commercial space. The board then sold the commercial unit.

The benefit to the newly-created condop – beyond the chunk of money it ended up with, and the fact that the commercial unit is now participating in the operating expenses – “is that the percentage of real estate taxes to the residential unit, which is the co-op, is forever decreased because part of the real estate taxes are now [being paid by] the commercial unit-holder,” says Rosemary Paparo, director of management at Buchbinder & Warren.

Another way to achieve peace of mind would be a variation on that scenario: divide the building and sell the retail space condominium unit to a not-for-profit entity that plans to occupy the space itself and would qualify for its own tax exemption. That might make the not-for-profit amenable to paying a higher price for the retail space, Schein says.

He adds that a co-op or condo board that opts to hold onto its commercial space needs to understand the challenges, including negotiating leases with multiple retailers. “It’s going to take a certain amount of work by the board,” he says. “It will change things on the board. But if they can handle that, that’s probably the best solution long-term.” Co-op boards that agree to take on those responsibilities should get “an honest-to-God independent appraisal” from a firm that specializes in retail property, not a broker who “makes impossible promises” just to get a listing, says Meister, the property manager. An appraiser can provide information based on neighborhood and citywide trends so the co-op has realistic rent expectations. “If a space is reasonably priced,” he says, “it rents.”