Converting Rent stabilized units in NYC to free market units

[Samyak Rai]

Hello all,

I am currently analyzing a 9-unit MF in Manhattan. 8 out of the 9 units are rent stabilized, which really affects my cashflow. I know you can convert RS to FM by giving in writing, a note stating that you will be renewing your tenants lease, at least 60 days before the lease naturally comes to an end.

So I have two choices here, either buy at a lower price right now, accounting for actual income, and then later convert some of the RS units into FM, but NYC law states that some percentage of your units must be RS. The only way I see to get around this is convert the MF to designate them as 'condos', which do not need a percentage of RS units. 

I would really appreciate it if someone could help me regarding what the process of converting apartments to condos looks like, or if there is any other way to achieve the higher cashflow I will get if all the 9 units are free market. 

Best,

Samyak

[Bobbi Casalino]

Here's one way: (summarized by Invictus Property Advisors)

June 15, 2019 may come to be remembered as doomsday by the New York City real estate community.

Seemingly overnight and without much forewarning, lawmakers passed pro-tenant bills and sweeping regulations governing rent stabilized units. Nearly every mechanism used by building owners to deregulate units are now null and void.

The industry laments these latest changes as they will significantly diminish the housing quality, worsen the city’s housing crisis and put pricing pressure on free market units.

Legislators in Albany, for their part, may have cut off their nose to spite their face: the draconian changes will lead to less tax revenue to pay for essential government services.

While state legislators in previous years have taken the path of responsible and incremental reform, the current administration sealed the deal for the state’s biggest and most substantial rent overhaul in decades and maybe ever.

Unless repealed or terminated, these changes to the rent code will live in perpetuity. Specifically, individual apartment improvements, or IAIs, and major capital improvements, or MCIs, have undergone significant caps, vacancy bonuses abolished, and high-income deregulation scrapped, to name a few.

Multi-family purchasers in New York City who bought assets in the last 3-5 years could not have accounted for such drastic legislative risk. As capitalization rates for rent regulated buildings are projected to spike, certain property owners may have lost 30-35 percent in value literally overnight.

Highly leveraged investors whose business model focused on adding value to New York’s aging housing stock may not be able to afford the upkeep of these assets and are in jeopardy of letting their properties go into disrepair.

As the ink continues to dry on this newly enacted legislature, share prices of lenders with a high concentration of mortgages backed by rent-stabilized buildings in New York City are plummeting as landlords are exploring all options, including handing back the keys to their lenders.

Acquisitions that transpired under the previous rent laws will affect both mom ‘n’ pop landlords as well as large institutions.

Most notably, Blackstone Group bought New York’s Stuy-Town-Peter Cooper Village in a $5.3 billion deal in 2015. At the time of the acquisition, roughly 6,400 of the 11,000 apartments were deemed “affordable” for a period of five-20 years—not anymore. Given the recent changes, how will recent acquisitions be able to sustain this level of debt with property values crumbling across the city?

A saving grace of sorts for building owners: the new act does not affect Substantial Rehabilitation as a basis for deregulation.

That is, if 75 percent of the building-wide systems (i.e., there are a total of 17 building systems, including, among others, plumbing, heating, fire escapes, elevators, kitchens, bathrooms, pointing or exterior surface repair) are completely replaced when the building is 80 percent vacant, units subject to rent stabilization can be deemed permanently exempt and converted to free market status.

In addition to at least 13 of the 17 building systems that need to be upgraded, all ceilings, flooring and plasterboard or wall surfaces in common areas must be replaced; and ceiling, wall and floor surfaces in apartments, if not replaced, must be made as new as determined by DHCR.

From a valuation perspective, buildings that are at least 80 percent vacant will likely begin trading at a significant premium if they can qualify for the building-wide system improvements.

For example, a six-unit building with five-vacancies is 83 percent vacant and an investor would likely go through the Substantial Rehabilitation process to deregulate the vacant apartments. This building would trade for a significant premium to a comparable six-unit building with fourvacancies (i.e., 67 percent vacant and not eligible for the Substantial Rehabilitation exemption), as a purchaser in this instance would have to underwrite based on cash flow from the existing legal rents.

Although buy-outs of tenants are less likely to be initiated by owners in the current environment, those landlords whose assets would be favorably impacted by the Substantial Rehabilitation process would likely continue to offer financial incentives to tenants that would allow them to exceed the vacancy threshold.

This would likely play out as an “all or nothing” arrangement where an owner would offer a lump sum to a group of tenants as long as all of them agree to sign surrender agreements.

Prior to the rent reform, landlords benefited from each rent regulated vacancy. As a result, fewer rent stabilized tenants will be offered life-changing sums of money to relinquish their rights to their apartments and vacate.

Ironically, landlords of high vacancy buildings are further incentivized to “shelf” or “warehouse” units and keep them vacant for the foreseeable future.

Furthermore, if a property owner is close to meeting the thresholds for Substantial Rehabilitation, units are expected to remain vacant.

The new rules may have the unintended consequence of creating a perverse incentive to keep rent stabilized units vacant with low legal rents further exacerbating the affordable housing crisis and hurt the very same people policy makers, one can only hope, were aiming to protect.