How to Upgrade Your Building's Retail Space to Market Rate

Aside from such quotidian quality-of-life issues, he says, boards should also be concerned "whether the type of use that's going to be put in projects the type of image the building is looking for." While a building can impose restrictions on the type of tenant it wants to have, it "lowers the space's value if, for instance, you can't put a restaurant in," Schwartz says. 

"Ideally a co-op would like to have a pharmacy or a bank," adds James Goldstick, vice president of marketing at MGRE. "[There's the potential for] no noise, no music, no venting, no odors." But just for that reason, he notes, "they're usually not the ones willing to pay top dollar."

How much should you charge for your space(s)? That's something your professionals will advise you on. "It's not prudent to go by what you may read in trade papers because you aren't seeing the full story," says Adelaide Polsinelli, a principal and senior management director for Eastern Consolidated. "Was it a short-term lease? How much was the security deposit? Was there a benefit to that tenant versus another? There are too many behind-the-scenes scenarios that are not fully explained in the press. Just because so-and-so rented to CVS for $150 a foot doesn't mean CVS is going to like your space or that it's worth the same — or maybe it's worth more; you may have a [Certificate of Occupancy] that allows selling in the basement, for example."

Whatever rent you wind up charging for your space, you may not get the new cash-flow right away. In fact, says the board member whose co-op recently underwent a market-rate upgrade, "The standard deal is that the tenant gets a period free, which is the building's contribution to the build-out," that is, the tenant's renovation. "Then the tenant starts paying rent after that. It's six to twelve months typically," the board member says, calling it "a marketing tool."

The build-out may include renovation to make the space compliant with the federal Americans with Disabilities Act (ADA) and similar local ordinances, and to bring the space up to city building-code requirements. But those aren't the co-op's worry. "Whoever does the renovation has to comply with the ADA and has to make [the space] code-compliant," says attorney Schwartz. But, he adds, huge renovation expenses are going to detract from the value of the space when negotiating a lease.

A Taxing Issue

Finally, while all this is going on and while you wait to see what the final figures will be, there's the tax issue to tackle.

Commercial real estate is taxed at a higher rate than residential real estate. "If you have a commercial tenant paying a huge rent and it bumps up the tax for the entire building, the co-op in essence is going to pay the same rate as the commercial space, which isn't fair," says Seth Kobay, president of Majestic Property Management.

The IRS has taken "a potential position," says Stephen Beer, a partner at the accounting firm Czarnowski & Beer, that with market-rate rents, a co-op is "making a profit off the commercial space separately from running the building as a cooperative." However, "most of the tax lawyers I've spoken to believe that because these buildings came with the commercial space when the cooperative acquired them, and that because of zoning [for what's called mixed-use buildings that have both residential and retail space] these spaces are an integral part of the cooperative function" and not subject to commercial tax. On the other hand, Beer cautions, "No cases I'm aware of clarify the rule, so the risk exists of the IRS saying [commercial] tax is due."

There are ways to mitigate the dangers. One involves how the co-op allocates deductible expenses related to the space. "The worst way," says Beer, "is the square-foot basis. Let's say," using arbitrary numbers for easy math, "that your commercial space rents at $100 a square foot. Apartments' maintenance tends to be much lower rent, say $25 a square foot. The IRS would say your profit is $75 a square foot. But if we [allocate expenses based] on market value — what you could sell that commercial space for, compared to residential apartments — that would be the most advantageous" for reasons that he concedes are "very complex." Beer says that he primarily sees allocations based on a third method — usage — meaning how much of the building's systems heat, electricity, and other systems are used by the commercial space.

He also cautions that if boards lower shareholders' maintenance to keep the co-op's taxable income as low as possible, shareholders may not be able to deduct their full portion of the building's underlying mortgage interest and property taxes.

"Let's say residents are only paying half the expenses allocated to those things," with profits from commercial rents paying the other half. "Then residents can't deduct 100 percent of [their share of] the co-op's taxes and mortgage interest" on their personal tax returns. "They can only deduct 50 percent." But residents still might come out ahead. "Instead of paying $1,000 a month maintenance they're paying $200 a month, and instead of getting a $500-a-month tax deduction they're getting a $100 tax deduction" — so their net monthly payment is $100 as opposed to $500. "It's a communication issue mostly."

A co-op, of course, might not want to be in the commercial-leasing business. In that case, says Polsinelli, "sometimes it's best to sell off the retail space. Or, you say to the buyer, 'For $5 million, we'll assign X amount of shares to it and cond-op it,'" turning the space into a condominium unit within the co-op. "The buyer owns it, and gets their own tax bill." A downside is the board's loss of control over the space, restrictions notwithstanding, and the condominium unit's owner doesn't need your permission to sell it. And all that is topic enough for another story in itself.