Are We Facing a Financial Squeeze?

Drip. Drip. Drip.

Drip. The new federal tax law promises to skewer taxpayers in high-cost states, including New York and New Jersey. Their pain will very likely spread to the housing markets, hitting co-op and condo owners literally where they live.
Drip. Boards already feeling squeezed by rising property taxes and new regulations now face the added prospect of declining property values and a sharp slowdown in unit sales.
Drip. If sales decline, boards and their property managers will lose vital transactional revenues, such as flip taxes or fees for buyer applications.
Drip. The coming renegotiation of 32BJ building-employee contracts will probably result in higher salaries and benefits for unionized workers – and higher costs for boards.
Drip. Operating costs and interest rates keep creeping upward.

“There’s a combination of things happening that don’t look good,” says accountant Carl Cesarano, a principal at Cesarano & Khan. And those things – the relentless drips wearing down many co-ops and condos – could wind up engulfing shareholders and unit-owners. “It could be a perfect storm,” Cesarano says.

A Time for Caution

It’s too early to predict just how dire a scenario lies ahead, or whether the city’s real-estate market will rebound from a noticeable slowdown at the end of last year. Buyer apprehension about the final form of the tax bill had a significant cooling effect on the Manhattan market during the last quarter of 2017, according to a recent report from Douglas Elliman Real Estate. Sales of co-ops slid 11 percent while condo sales were down 14 percent compared to the same period a year ago. Overall, the report said, Manhattan sales were at the lowest fourth-quarter level in six years, since the nadir of the last recession. (See the report at http://bit.ly/DE-Q4)

Attorney Elissa Brinn, a senior counsel with Hodgson Russ, says the spring buying season will provide more clues about where we’re headed now that the tax bill is law. In the meantime, she says, boards may want to add a “layer of conservatism” to their budgeting process. “As in, ‘Is it really necessary for us to redo the hallways right now?’”

The most troublesome aspect of the new tax law is the $10,000 cap on annual deductions for state and local taxes, including income and property taxes. For New York-area homeowners who itemize their deductions, that’s a very big hit, given the region’s high tax rates. And it could depress home sales and values.Take a property owner who pays state and city income taxes of $45,000, and another $25,000 in property taxes, says attorney Timothy P. Noonan, a partner at Hodgson Russ. When you were allowed to deduct the full amount of $70,000 from your federal tax liability, “every dollar really cost you 60 or 70 cents, depending on your tax bracket. Now, it’s costing you almost the whole thing – around $67,000. And that’s a real stinger.”

Homeowners will in effect end up paying out more in property taxes – which could potentially make home ownership less appealing than renting. Further reducing the incentive to buy is the tax law’s scaling back of the mortgage interest deduction. For new home purchases, the maximum deduction for mortgage interest is now based on $750,000 of the principal instead of $1 million. Brinn notes that for middle-class buyers in, say, Queens or Staten Island, that change isn’t likely to matter. And Noonan doesn’t think it will be “as big of a deal” as the cap on state and local tax deductions. Nevertheless, he adds, it doesn’t help.

Moody’s Analytics has predicted that the tax changes could so reduce the incentive to buy that prices in expensive markets like New York will decline by about 10 percent initially. Cesarano, the accountant, agrees that the changes can’t help but depress the market, at least in the short term. And that could cut into co-ops’ and condos’ transactional revenue, such as flip taxes or fees for buyer applications. “Buildings that rely on high turnover and use flip taxes to fund their reserves could very well be hurt by this,” Cesarano says.

Boards may find that they will have to make up for a revenue shortfall, perhaps by raising maintenance or changing their fee structure. Or maybe they will change the way they evaluate buyers. Cesarano notes that because the tax law preserves incentives for real estate investors who treat their property as a business – usually through limited liability companies (LLCs), also known as shell companies – that segment of the market isn’t as likely to suffer. And so, “maybe some boards will decide to be more investor-friendly,” he says. For some boards, “shell company” might no longer be a pejorative.

Declining Values, Rising Taxes

If sale prices do decline, shareholders and unit-owners should not expect a corresponding decrease in their property tax bills, warns Paul J. Korngold, a tax specialist at the law firm of Tuchman, Korngold, Weiss, Liebman & Lindemann. More likely, he says, taxes will continue to rise.

That’s because of the way co-ops and condos are valued. Under state property tax laws, those housing units are not valued based on their sale prices, or sale prices in comparable buildings. They are valued based on rents from rental buildings, Korngold says. And the value of rentals is likely to rise, if, as is predicted, a lot of would-be buyers, contemplating the tax changes, opt to rent instead.

“As the demand for rental units increases,” Korngold says, “the law of supply and demand may cause the rents in buildings not subject to rent stabilization to increase rapidly.” As it is, many New York City co-ops and condos are still moving toward their actual – meaning, higher – assessed value in what’s commonly known as “transition creep.” That’s because increases in assessed value are phased in over a five-year period, Korngold explains. Given the rapid rise in rents in recent years, he says, “many co-ops and condos have an actual assessed value much greater than their transition-assessed value.”

Boards should be prepared for a backlash from residents. “If you were budgeting $1 million for taxes, and this year it goes up to $1.1 million, and everyone starts screaming at your annual meeting, you’ve got to explain it,” Korngold says. “People are calling me about this, and I explain it to them and they say, ‘That’s not fair.’ And I say, ‘Fair is not a concept under the law.’”

Higher Staff Costs

The Apartment Building Agreement between the Realty Advisory Board on Labor Relations in New York (RAB) and the Service Employees International Union, Local 32BJ, expires April 20. The contract, which is renegotiated every four years, affects some 3,000 apartment buildings in New York City (not including the Bronx) and close to 30,000 building workers.

While wage adjustments in new contracts usually reflect general inflation, benefit costs tend to have a much higher rate of increase, says Howard Rothschild, the president of the RAB. This time around, as in years past, Rothschild expects that “the union will be looking to keep and potentially enhance the benefits that are in the contract, along with a wage increase, while, from the companies’ point of view, the issue will be cost containment and control.” Under the last agreement, wages were increased by 2.7 percent annually, and the overall deal resulted in an annual cost increase of 3.3 percent. That’s in line with how union negotiations usually shake out, according to Rosemary Paparo, director of management with Buchbinder & Warren. “You can look at a building’s budget line for salaries and other compensation and know that it will increase about 3 percent from year to year,” she said in an email. “This time around could be different, but probably not.”

A comparable union agreement for Westchester County expires September 31. “The union is looking for a little bit of increase for their members, and the buildings are looking for a little bit of give and take, maybe some additional work to cover some of the costs,” says Brian Scally, the director of management at Garthchester Realty and a member of the negotiating committee.

Health care in particular promises to be a tough issue. “Health care is always a big one, as it’s getting more and more expensive,” Scally says. “In the past, there’s been no charge to union members. Some of the buildings are very much looking for some form of a payment from the members.”New York contract negotiations haven’t led to a strike since 1991. Rothschild says there’s no reason to be anything but hopeful that the RAB will avoid labor unrest this year. But, he adds, “who knows what will happen between now and then?”

Drip, drip, drip.