Protecting Against the Current Real Estate Market

For the past several months there has been a steady drumbeat in the press about the overheated real estate market. Is it a case of modern-day tulip mania or merely a reflection of the laws of supply and demand? Will prices continue to surge or is there a crash looming? Although macro economic factors doubtless are at play, nevertheless there has been little discussion of what action, if any, individual co-op and condo boards, buyers and owners can or should take, as a matter of law or policy, to protect their respective interests and preserve the stability of their buildings in this environment.

What Co-op Boards Can Do

It is well established that absent discrimination, co-op boards can accept or reject buyers at will, and have the lesser included power of imposing financial criteria for admission. Past market cycles teach that exercise of this power tends to be self-regulating and elastic, with rejections rising as does the market, because these boards know there will be someone else waiting in the wings. The current market, however, presents unique challenges. There are plenty of buyers, but with prices soaring, many are stretching to make purchases beyond their means, lured by the prospect of cheap money offered by banks in the form of interest only, adjustable rate, even pay-what-you-will loans (that may result in negative amortization). As rates rise, these exotic products, if used in sufficient numbers, may come back to haunt not only affected owners, but the financial well-being of the building.

To some extent, boards are caught between a rock and hard place. On the one hand, they are under pressure from brokers and owners to keep prices high, and indeed in sagging markets, some have attempted to set floor prices below which approval would be withheld. See, eg, Oakley v. Longview Owners, Inc., 165 Misc. 192. On the other hand, they are obligated to act in the longer-term best interests of shareholders, which, in this market, may not be coextensive with those of individual sellers seeking to cash out at record levels and buyers extending themselves to pay the price.

Although most co-op boards use their legal power over admissions to limit the amount of financing, they appear reluctant to restrict the type of financing, opting instead for the seemingly more palatable alternative of imposing increased liquidity requirements in the form of multiples of mortgage and maintenance or amount of the purchase price. See, eg, Rogers TK: “The Undesirable Rich.” The New York Times, Mar. 6, 2005, Sec. 11, pg.1.

Buyers: The Legal Reality

Savvy buyers may be able to escape these heightened barriers to entry by purchasing directly from sponsors, who have greater incentive than ever to sell given the combination of rising prices and a post-Jennifer Realty legal climate. But as holders of unsold shares, they are exempt from the financial requirements imposed by co-op boards, and can sell to whomever they like on whatever terms they choose. Moreover, the recent decision in Kralik v, 239 East 79th Street Owners Corp, 2005 N.Y. LEXIS 1261, potentially extends the class of owners exempt from board-imposed requirements, at least when it comes to subleasing. Given the existence of enough units in any building, this legal reality could undercut board efforts in this market to encourage a financially stable shareholder base and replace the problem of unsold sponsor apartments with apartments bought with precarious underlying financing.

Whereas co-op boards have the power, but sometimes lack the will, to take protective action, condo boards have long been thought to be constrained by the rule against unreasonable restraint on alienation of real property. Under the right of first refusal standard in condos, boards cannot reject buyers whose finances or financing are questionable, but only have the unrealistic option of buying the unit on the same terms and conditions, and that usually requires consent of a majority of owners. Because their hands are legally tied, many boards do not scrutinize buyers' finances, making entry relatively easy for those who might not pass co-op admission standards. In more “normal” markets, even though boards lacked the power themselves to protect their buildings from tenuous purchasers, their job was largely done by the due diligence performed by lending banks. That safeguard, together with voluntary compliance by buyers with board requests for escrow, guarantees or prepaid monthly charges, usually sufficed to stave off significant problems. In today's market, however, with prices at record highs, buyers extending themselves and banks enabling purchasers with newly created and riskier loan products, the calculus is different, yet the limitation on board power remains the same.

Possible Rescue?

Coming to the potential rescue is Demchick v. 90 East End Avenue Condominium, 2005 N.Y. App. Div. LEXIS 5717, in which the Appellate Division, for the first time, ruled that a condo's bylaws could be amended to restrict sale of a luxury building's five studio apartments only to owners of other units in the building. It is too soon to say whether the decision is factually limited or portends the possibility that condo boards may soon have power to reject buyers outright, and thus to impose financial criteria for their admission. Although Demchick, taken together with other recent decisions granting greater control to condo boards (see Shapiro S: “Is It a Condo or a Co-op?” New York Real Estate Law Reporter, May 2005, pg. 1), suggests the broader interpretation. Nevertheless, the answer is unlikely to come in time for such boards to protect against some of the more questionable transactions and types of financing of the present market, including, in some markets, use of letters of credit instead of cash for down payments. See Dunham KJ: “Hot Condos, for Just a Letter.” The Wall Street Journal, May 19, 2005, Sec. C, pg.1.

It's not just the transfer process itself that poses real issues for boards today. As a result of the increased values attached to their apartments, many owners are seeking second mortgages in the form of equity loans or lines of credit, a relatively new and potentially troublesome development in co-ops and condos. Recognizing the problem, especially should prices decline, banking regulators recently issued guidelines warning the nation's banks to pay closer attention to their home equity loan portfolios and underwriting standards. (See Zalewski P: “Joint Guidelines from Bank, Credit Union Regulators Detail Cautions for Issuing Popular Home Equity Loans.” Miami Daily Business Review, May 19, 2005, Sec. Lending, pg. 1.) By way of self-protection, many co-op boards have, on their own, imposed debt-to-value ratios more stringent than those of banks, but condos, guided by the legal restrictions on transfers that have governed at least up until now, generally have taken a hands-off approach to owner refinancings.

Apart from their lack of control over buyer/owner financing, boards of condos generally do not restrict subleasing, a feature that makes them singularly attractive to investors in this market more interested in short term profits than long term housing. Although at least one court (Four Brothers Homes at Heartland Condominium II v. Gerbino, 262 A.D. 2d 279), has ruled that condo boards may impose sublet bans, thus far market forces have superseded judicial decisions.

Time for Condops?

By virtue of the legal restrictions under which they operate, condo boards may find themselves, in the event of a downturn, confronted with a more financially vulnerable pool of owners than that existing in co-ops. And because as a matter of law in condos, banks take priority over the building should there be defaults, owners could find themselves having to pay their share of any shortfall. For buyers seeking ease of entry, coupled with downside protection in this market, the condop — that poorly understood hybrid — may be the best alternative. Like condos, most condops only have a right of first refusal, but like co-ops (which they really are), they take first priority in case of default.

Conclusion

It is impossible to tell how this market ultimately will shake out, but given the differing legal structures of co-ops and condos, a little self protection where possible, and an educated understanding of the unprotected risks, may help to limit the downside consequences for all relevant parties.

For the past several months there has been a steady drumbeat in the press about the overheated real estate market. Is it a case of modern-day tulip mania or merely a reflection of the laws of supply and demand? Will prices continue to surge or is there a crash looming? Although macro economic factors doubtless are at play, nevertheless there has been little discussion of what action, if any, individual co-op and condo boards, buyers and owners can or should take, as a matter of law or policy, to protect their respective interests and preserve the stability of their buildings in this environment.

What Co-op Boards Can Do

It is well established that absent discrimination, co-op boards can accept or reject buyers at will, and have the lesser included power of imposing financial criteria for admission. Past market cycles teach that exercise of this power tends to be self-regulating and elastic, with rejections rising as does the market, because these boards know there will be someone else waiting in the wings. The current market, however, presents unique challenges. There are plenty of buyers, but with prices soaring, many are stretching to make purchases beyond their means, lured by the prospect of cheap money offered by banks in the form of interest only, adjustable rate, even pay-what-you-will loans (that may result in negative amortization). As rates rise, these exotic products, if used in sufficient numbers, may come back to haunt not only affected owners, but the financial well-being of the building.

To some extent, boards are caught between a rock and hard place. On the one hand, they are under pressure from brokers and owners to keep prices high, and indeed in sagging markets, some have attempted to set floor prices below which approval would be withheld. See, eg, Oakley v. Longview Owners, Inc. , 165 Misc. 192. On the other hand, they are obligated to act in the longer-term best interests of shareholders, which, in this market, may not be coextensive with those of individual sellers seeking to cash out at record levels and buyers extending themselves to pay the price.

Although most co-op boards use their legal power over admissions to limit the amount of financing, they appear reluctant to restrict the type of financing, opting instead for the seemingly more palatable alternative of imposing increased liquidity requirements in the form of multiples of mortgage and maintenance or amount of the purchase price. See, eg, Rogers TK: “The Undesirable Rich.” The New York Times, Mar. 6, 2005, Sec. 11, pg.1.

Buyers: The Legal Reality

Savvy buyers may be able to escape these heightened barriers to entry by purchasing directly from sponsors, who have greater incentive than ever to sell given the combination of rising prices and a post-Jennifer Realty legal climate. But as holders of unsold shares, they are exempt from the financial requirements imposed by co-op boards, and can sell to whomever they like on whatever terms they choose. Moreover, the recent decision in Kralik v, 239 East 79th Street Owners Corp, 2005 N.Y. LEXIS 1261, potentially extends the class of owners exempt from board-imposed requirements, at least when it comes to subleasing. Given the existence of enough units in any building, this legal reality could undercut board efforts in this market to encourage a financially stable shareholder base and replace the problem of unsold sponsor apartments with apartments bought with precarious underlying financing.

Whereas co-op boards have the power, but sometimes lack the will, to take protective action, condo boards have long been thought to be constrained by the rule against unreasonable restraint on alienation of real property. Under the right of first refusal standard in condos, boards cannot reject buyers whose finances or financing are questionable, but only have the unrealistic option of buying the unit on the same terms and conditions, and that usually requires consent of a majority of owners. Because their hands are legally tied, many boards do not scrutinize buyers' finances, making entry relatively easy for those who might not pass co-op admission standards. In more “normal” markets, even though boards lacked the power themselves to protect their buildings from tenuous purchasers, their job was largely done by the due diligence performed by lending banks. That safeguard, together with voluntary compliance by buyers with board requests for escrow, guarantees or prepaid monthly charges, usually sufficed to stave off significant problems. In today's market, however, with prices at record highs, buyers extending themselves and banks enabling purchasers with newly created and riskier loan products, the calculus is different, yet the limitation on board power remains the same.

Possible Rescue?

Coming to the potential rescue is Demchick v. 90 East End Avenue Condominium, 2005 N.Y. App. Div. LEXIS 5717, in which the Appellate Division, for the first time, ruled that a condo's bylaws could be amended to restrict sale of a luxury building's five studio apartments only to owners of other units in the building. It is too soon to say whether the decision is factually limited or portends the possibility that condo boards may soon have power to reject buyers outright, and thus to impose financial criteria for their admission. Although Demchick, taken together with other recent decisions granting greater control to condo boards (see Shapiro S: “Is It a Condo or a Co-op?” New York Real Estate Law Reporter, May 2005, pg. 1), suggests the broader interpretation. Nevertheless, the answer is unlikely to come in time for such boards to protect against some of the more questionable transactions and types of financing of the present market, including, in some markets, use of letters of credit instead of cash for down payments. See Dunham KJ: “Hot Condos, for Just a Letter.” The Wall Street Journal, May 19, 2005, Sec. C, pg.1.

It's not just the transfer process itself that poses real issues for boards today. As a result of the increased values attached to their apartments, many owners are seeking second mortgages in the form of equity loans or lines of credit, a relatively new and potentially troublesome development in co-ops and condos. Recognizing the problem, especially should prices decline, banking regulators recently issued guidelines warning the nation's banks to pay closer attention to their home equity loan portfolios and underwriting standards. (See Zalewski P: “Joint Guidelines from Bank, Credit Union Regulators Detail Cautions for Issuing Popular Home Equity Loans.” Miami Daily Business Review, May 19, 2005, Sec. Lending, pg. 1.) By way of self-protection, many co-op boards have, on their own, imposed debt-to-value ratios more stringent than those of banks, but condos, guided by the legal restrictions on transfers that have governed at least up until now, generally have taken a hands-off approach to owner refinancings.

Apart from their lack of control over buyer/owner financing, boards of condos generally do not restrict subleasing, a feature that makes them singularly attractive to investors in this market more interested in short term profits than long term housing. Although at least one court (Four Brothers Homes at Heartland Condominium II v. Gerbino , 262 A.D. 2d 279), has ruled that condo boards may impose sublet bans, thus far market forces have superseded judicial decisions.

Time for Condops?

By virtue of the legal restrictions under which they operate, condo boards may find themselves, in the event of a downturn, confronted with a more financially vulnerable pool of owners than that existing in co-ops. And because as a matter of law in condos, banks take priority over the building should there be defaults, owners could find themselves having to pay their share of any shortfall. For buyers seeking ease of entry, coupled with downside protection in this market, the condop — that poorly understood hybrid — may be the best alternative. Like condos, most condops only have a right of first refusal, but like co-ops (which they really are), they take first priority in case of default.

Conclusion

It is impossible to tell how this market ultimately will shake out, but given the differing legal structures of co-ops and condos, a little self protection where possible, and an educated understanding of the unprotected risks, may help to limit the downside consequences for all relevant parties.