New York's Cooperative and Condominium Community
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The six-story cooperative on Manhattan’s Upper West Side needed cash – and a lot of it. The building’s northern wall was showing its age: leaks, crumbling bricks, and other signs of wear. After consulting with an engineer, the board decided it was time to initiate extensive repair work. The cost would be very large and the board needed to find some financing options. The treasurer talked with mortgage broker Patrick Niland, president of First Funding, who suggested an unusual idea: why not borrow the money from the shareholders?
Unusual, certainly, but not unheard of. The 86-unit 55 Liberty Street in lower Manhattan and the 50-unit 90 Eighth Avenue in Brooklyn’s Park Slope had both successfully taken out loans from their shareholders and staved off financial ruin. Attorney Stuart Saft, a partner at Wolf Haldenstein Adler Freeman & Herz, reports that at least two buildings he represents have also borrowed money from shareholders. And Steve Greenbaum, director of management at Mark Greenberg Real Estate, remembers one large cooperative that accepted a loan from a single shareholder.
“They had a water bill that was out of control and they needed to raise the money because it was costing them 18 percent,” recalls the management executive. “It was killing them; we had to stop the bleeding.” One of the major shareholders offered a loan, apparently reasoning that if the shareholders were all going to get assessed, he would get assessed proportionately higher than everyone else. So, he made a loan to the co-op of $100,000 – and earned money on the interest he charged, instead of losing it through a special assessment.
“It’s brilliant,” notes Greenbaum. “If you can get a private loan, it’s great. For our building, it was very swift, it was very painless, and it worked.”
Another example is 90 Eighth Avenue in Park Slope. The co-op had a sponsor who wasn’t paying maintenance on his units, and the board faced rising expenses. “They felt the sponsor should pay, or they would take over the apartments from him,” recalls attorney James Samson, a partner in Samson, Fink & Dubow, who represented the building. “They needed the money but they didn’t want to raise the maintenance on the apartments. So, they just borrowed money from shareholders to the point where they could survive. Not every shareholder could contribute and those that did got promissory notes and were paid back.”
The biggest plus – besides getting the money, of course – is that this sort of borrowing is comparatively cheap. At least, cheaper than taking out a traditional loan.
Observes Niland: “The benefits to borrowing from a shareholder or shareholders are you avoid all the third-party reports. You don’t need an appraisal; you don’t need an engineering report or an environmental assessment; and your legal fees are probably much less because you don’t have that complicated a loan document. You may not even need title insurance. You may be able to create a security instrument that protects the people at a much lower cost than you get in a mortgage. You can probably get it quicker, too, because there’s no loan committee and no underwriting per se, because everyone knows what they’re lending on – they’re living in it.”
Such a loan can also be attractive to shareholders, who can make a profit on investments – and help out at home at the same time.
Still, the caveats must be considered. Among them:
There can be potential conflicts. “It raises tremendous conflict of interest problems, which is why more buildings don’t do it,” Saft notes. “Will the people who do participate get some advantage not available to others?” Agrees Samson: “The negative on it is there is a technical conflict of interest because there is a divergence of economic parallelism; i.e., not every shareholder is [being treated] the same [way] – some are now creditors.” That could raise legal hurdles if someone wants to challenge the loan.
There could be charges of favoritism. Legal problems could arise from shareholder discontent. “We’ve gone through this in different buildings and the people who didn’t participate get angry at those who did participate,” Saft says. To avoid this, you have to advise each of your shareholders about what you are doing and give each an opportunity to participate. “They would take an equal share,” explains Saft. “If you start out with 20 shareholders, and 10 of them say they want to participate, then each of the 10 shareholders would have the right to participate for one-tenth of the loan. That way, no one is at a competitive advantage over anyone else. It has to be made available to everyone.”
Your loan documents may prohibit secondary financing. If the bank holding your primary loan prohibits secondary financing, all that means is that you can’t record a second mortgage. However, the lenders may be satisfied with personal loans, with the unconditional guarantee of the co-op corporation to pay them back.
You’re dealing with a person, not an institution. “They [the shareholder-lenders] don’t do this every day,” Niland says. “Remember, their life situations change. The lender could die, so then you’ve then got an estate involved – that may or may not cause complications. Somebody gets divorced and their interest gets tied up in the asset distribution. Someone declares bankruptcy – now what happens? Someone moves. Someone gets into a dispute with the co-op. All sorts of stuff can go on that could cause problems, and if you’re going to address them you should do that in some sort of legal document. That makes your legal document more complex. There’s cost there and potential problems.
“Whereas with an institution,” he continues, “everyone knows how they operate, there’s a loan document that’s long and detailed and covers almost every eventuality that you can think of, and two attorneys sit down and haggle out all the fine points. After that, it goes into an operations department and every month you get a bill and you send a check. But for that convenience, there is a cost.”
Other advice: don’t borrow more than you need. Notes Niland: “I wouldn’t borrow money needlessly. It’s the kind of thing you can look out in the marketplace and see it’s going to cost X and then you find a shareholder or shareholders who are willing to provide the financing, which costs you Y, and Y is significantly less than X. You don’t have to go to business school to know which one to pick. But why borrow all that money and pay all that interest if you’re not going to spend it right away?”
Get your professionals involved. Any financial transaction with the co-op requires that all the professional advisors sign off on it –your attorney, your managing agent, and your accountant (be sure there isn’t some negative tax ramification).
Finally, how do you determine that this approach is right for you? Niland says you should ask whether you can get a loan from a conventional source at the same or better rates. “If you’re talking about $200,000 to $300,000, the closing and other associated costs from a true commercial loan you’d get from a bank are going to be the equivalent of 20 points,” he observes. “Twenty points are like ‘knee-breaker’ rates. From your standpoint, you could go down to your friendly loan shark on the corner, and pay him 20 points – and if you don’t pay, he’ll break your knees. The banks don’t break your knees; they break your pocketbook. It can be a pretty expensive process – until you start borrowing bigger sums of money.
“So instead of doing that, you can go to a wealthy shareholder, for whom $200,000 may not be that much money in the overall scheme of things. He may have half-a-million or a million dollars in his retirement fund, he directs a portion of it, and he makes four percent. Here you come to him and you say you’d like to borrow $200,000, and you’ll pay ten percent. And he says, ‘Whoopee.’ He just took that portion of his portfolio and quadrupled his interest rate. He’s thrilled because it’s his building, and his attorney’s going to write a document that protects him, and he plans on living there for the next ten years. It’s a nice investment.”
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