Evaporation of the Escrow

The Housing Stability and Tenant Protection Act of 2019 turned co-op boards into “unintentional roadkill,” in the words of one poetic attorney. He means that the law, which was intended to protect renters from unscrupulous landlords, has had unintended and harmful consequences for co-ops. These consequences stem from the fact that co-op boards have a landlord-tenant relationship with shareholders in the corporation – based on the proprietary lease – and have therefore been deemed subject to the same restrictions the law has imposed on landlords of rental properties.

These restrictions include limits on evictions, late fees, credit-check costs and application fees, among other things. Now another unintended – and unwelcome – consequence is squeezing a co-op lifeline: apartment sales and the cherished flip taxes that frequently accompany them.

By limiting security deposits to one month’s rent, the Tenant Protection Act has robbed co-op boards of a trusted tool when dealing with purchase applicants whose financial credentials are somewhat marginal: the escrow. Before the law went into effect, many boards negotiated an arrangement that granted purchase approval to marginal buyers if they put an agreed-upon amount of maintenance into an escrow account. Under some of these agreements, the money was refunded after a specified amount of time if the shareholder made timely payments; in extreme cases, the co-op held on to the money until the apartment was resold. If the account had to be drawn on to cover arrears, the shareholder usually agreed to replenish the account. All that is gone.

“It’s definitely a problem,” says Steven Sladkus, a partner at the law firm Schwartz Sladkus Reich Greenberg Atlas. “I was just dealing with a 50-unit Manhattan co-op where the buyer was borderline qualified. The board liked the applicant and wanted it to work – if the buyer agreed to put a year’s worth of maintenance in escrow. I told them they couldn’t do it.”

Different Levels of Comfort

As always, there are workarounds. One is to secure a guarantor, a person or company that agrees to cover any arrears if the shareholder comes up short – a prevalent fear as the pandemic continues to ravage the job market. Typically, a friend or relative of the buyer is the guarantor, but sometimes it’s a company that charges a fee. Then there is another type of third-party guarantor, says David Berkey, a partner at the law firm Gallet Dreyer & Berkey. “In the rarest of circumstances,” he says, “if the buyer doesn’t have a family member, the seller might step in and agree to be the guarantor.”

Different guarantors offer different levels of comfort. Some merely promise to cover shortfalls in maintenance payments. “That might alleviate some concerns,” Sladkus says, “and having another person on the hook is certainly nice. But that guarantor doesn’t put up money the co-op can put its hands on.”

A workaround that’s closer to an escrow account is the so-called “non-recourse guarantee,” under which the guarantor puts up a negotiated amount of money – which can be in excess of the one month’s worth of maintenance allowed by the Tenant Protection Act. Unlike escrow accounts where the guarantor will continue to cover monthly payments if need be, non-recourse guarantees do not get replenished after they’re drawn down. When the money is gone, it’s gone. “The liability of the guarantor is limited,” says Ken Jacobs, a partner at the law firm Smith Buss & Jacobs.

It’s nice, as Sladkus says, and it’s certainly a higher level of comfort than a guarantor’s promises, but it doesn’t approach the level of protection that used to come with escrow accounts.

And the presence of a guarantor doesn’t guarantee that the maintenance will get paid. “They may be solid financially today, but not tomorrow,” says Carl Cesarano, a principal at the accounting firm Cesarano & Khan. “If the guarantor can’t make the maintenance payments, the board may then have to start a lawsuit against the shareholder, which will cost time and money. In the meantime, they’re not getting their monthly payments.”

Cesarano advises caution when boards approve a purchase after a guarantor company signs a contract to cover the maintenance in case of default. “Boards need to read the fine print before approving such a purchase,” he says, “because that coverage may only last for a certain period of time.”

When vetting personal guarantors, Cesarano adds, boards can give themselves an extra level of comfort by setting a high bar, such as requiring an income in excess of 40 times the monthly maintenance, the conventional bar for buyers. And help might be on the way from another source. A bill, S1505, has been introduced in the state Senate that would exempt co-ops from the restrictions imposed on landlords by the Tenant Protection Act, including the elimination of escrow accounts.

A Ripple Effect

In a real estate market already reeling from the coronavirus pandemic, the shutdown of the escrow-account option has added an extra drag on co-op sales. “It’s really a big problem,” says Daniele Kurzweil, a licensed sales associate at Compass. “The law was trying to level the playing field for renters, but it backfired. The unintended consequence of the limit on security deposits is that co-op boards are suffering. It’s a gray area. Technically, if someone who’s marginal is trying to buy into a co-op and offers to put up a year’s worth of maintenance in escrow, the board legally can’t do it. A lot of co-op boards aren’t doing it because of this gray area.”

The fallout is rippling through other facets of co-op board deliberations. Kurzweil says that many of the boards she deals with are beginning to realize that they’re working with “outdated numbers” on such things as minimum down payments, the buyer’s liquidity after purchase, debt-to-income ratio and percentage of income that goes toward housing costs. “We’re seeing co-ops changing their requirements, making it easier to qualify,” she says. “Instead of demanding a 50% down payment, for instance, they might be demanding 30%.”

Today, Kurzweil adds, some boards are looking beyond the buyer’s salary and taking into consideration bonus history if the applicant works in finance or another field where annual bonuses are frequently far larger than salaries. On the flipside of the equation, buyers with extensive investments prefer to make smaller down payments and keep their investments intact – while taking advantage of low interest rates by financing more of the purchase price. Boards are increasingly willing to listen. Kurzweil adds that the coronavirus pandemic – and the rising unemployment that came with it – has led some boards to put more weight on applicants’ job security than on their income. In any event, Kurzweil says, “boards are realizing that financing isn’t necessarily a bad thing.”

Amid all this uncertainty, one thing is for sure. The Tenant Protection Act and the pandemic have been a one-two punch for co-op boards – and for buyers who are not quite capable of meeting boards’ purchase requirements. “I’ve seen boards that won’t even consider someone who’s on the margins,” says Berkey, the attorney. “Now that boards can’t look to an escrow account, those people on the margins are having more difficulty buying co-op apartments.”