Commercial space – the final frontier. Now that the infamous “80/20” rule has been relaxed, co-ops don’t need to keep commercial-space rents artificially low, below 20 percent of a co-op’s total income. With many long-term leases signed during the co-op conversion boom of three decades ago ending, boards are starting to realize they’re sitting on gold.
Or are they? It’s no secret that with New York co-ops, market-rate rents for ground-level storefronts are high. Specific numbers are hard to cite, since commercial-rent studies lump together residential retail space with office-building retail and office space. But Adelaide Polsinelli, a principal and senior management director for Eastern Consolidated, says storefront rents in places like Manhattan’s SoHo district “have tripled in two years,” although she and others warn that market rates vary by neighborhood.
Regardless, co-ops with expiring commercial-space leases can earn substantially more than before. There are pitfalls, such as taxes, finding good tenants, construction to customize spaces, and contract issues. So boards seeking to upgrade their buildings’ retail spaces to market rate face a complicated task. But a cross-section of professionals agrees that a set of specific steps can help you in this new arena.
The Lease You Can Do
Step one is to determine your financial goals, says James Goldstick, vice president of marketing at Mark Greenberg Real Estate. “Is it to keep revenue as high as possible to keep maintenance down? Or do you need a big chunk of money for capital improvements, so that you don’t have to refinance the mortgage or levy an assessment?”
“Boards should not look at any lease individually but develop a comprehensive plan for the entire building,” says Dennis DePaola, executive vice president of Orsid Realty. “Look at everything from the size of the spaces, the possibility of combining them, and lease-termination dates. If you’re depending on this income for a large portion of your operating revenue, it could be detrimental to have a vacant space for a prolonged period, so some buildings would rather have smaller spaces with staggered terminations.”
Once you have an overall plan, examine your leases. “There are two types of leasing scenarios,” says Goldstick. “One is where the co-op leases the entire commercial unit to one investor, who pays the co-op a fixed amount of rent each year, and that investor sublets each individual store or office to another tenant. And the second scenario is [where] the co-op leases the stores or offices directly.”
Either way, the first thing to look for is how many years the lease or leases have left. Says Polsinelli: “The next board could come in and suddenly find there’s only a year left on a lease.” Conversely, boards may find that a lease has ten years left on it, “and so the board says, ‘I don’t have to pay attention to it.’ But the lessee can’t necessarily optimize the value of the retail space, since he or she can’t rent it for longer than ten years. And it doesn’t make sense [for the lessee] to put in capital improvements if [the lessee] can’t amortize them over a long period of time.” This, she says, presents an opportunity to negotiate. “You can say, ‘Give us back the lease, we’ll pay you a nominal amount upfront or a portion of what we go out to the market with.’”
Boards and their attorneys also need to check the proprietary lease and any other pertinent governing documents. “Look at those [leasing] documents, and look at the governing documents,” says Seth Kobay, president of Majestic Property Management. “Then, if you have a readily marketable space, the first thing to do is look for a broker.”
Go for Broker?
Your existing management company could serve that purpose, suggests DePaola, who notes, “There may be something in your agreement with the managing agent as to what happens when space becomes available.” Saying “there are pluses and minuses” to using either your management company or an independent commercial broker, he argues that, “a managing agent may have a much longer view of the relationship” with the co-op and will be aligned with the co-op’s long-term goals and nature. “It’s in [a commercial broker’s] best interest to get a deal done ASAP. They’ll say, ‘This is the best dollar [amount] and the tenant passes our tests.’”
“A co-op must be careful when hiring a manager to do a leasing agent’s job,” counters Polsinelli. “This is not to say some managing agents will not do as good a job in leasing a space. However, most may be limited in their ability to access the wide variety of retailers that a leasing broker has daily contact with in their regular course of business,” she says. “A reputable broker will present respectable tenants who will thrive harmoniously with the co-op and add value to the overall property.”
Whoever you go with, that person will need to do a market analysis and prepare a report for the board. “With a lot of these old buildings,” says Kobay, “the configuration of basements can be all over the place. We had a building where a restaurant was getting deliveries through a [sidewalk] trapdoor that led through a tight corridor to a basement space.” Sometime afterward, “there was a vacant retail space on the ground floor. Eventually it got rented. And we found the [basement] corridor was now going to run right up to a portion of the space the new tenant was taking.” In order for the restaurant to continue taking deliveries through the trapdoor, “we had to section off [part] of the corridor, so now there was one door for one tenant and another for the other.”
Eight, Nine, Tenant
The next step is deciding what type of tenant you want to have. “The biggest thing with co-ops is concern over how the space is going to be used and whether that use will interfere with, or have some sort of negative impact on, the residents,” says attorney Jeffrey Schwartz, a partner at Schwartz Sladkus Reich Greenberg & Atlas.
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 Goldstick. “[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 Polsinelli. “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 Kobay.
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.
Fannie Mae: Killing Lucrative Leases?
In a bizarre turn of events, two financially healthy co-ops learned in May that purchasers were unable to get loans from a commercial bank because the nonresidential portion of the building’s income was more than 15 percent.
“It’s like one step forward, two steps back,” laments Mitchell Unger, controller at the Lovett Group, a management firm. He found out the hard way about the new rule, which the Federal National Mortgage Association (Fannie Mae) instituted on March 31. A broker handling a sale at Forest Hills South, a Queens co-op Lovett manages, “was working with Citibank, who notified the broker that the buyers were being turned down at this tremendously healthy building since [the cooperative corporation] had more than 15 percent of its income generated from non-shareholder revenue.” Citibank also turned down buyers at another Lovett property, the tony 49 East 96th Street.
Fannie Mae’s newly updated Selling Guide – which outlines what lenders who want to sell their mortgages to Fannie Mae aren’t allowed to do – slaps this new limit not only on cooperatives but also on condominiums.
Most of Fannie Mae’s roughly two dozen strictures – which apply both to condos and co-ops, except for five that are co-op-specific – don’t affect the vast bulk of such residential buildings. “For the most part,” says Jerry Niemeier, vice president of risk management/co-op lending at Nationstar Mortgage, “mainstream residential co-ops and condos are not going to have an issue with” guidelines stating that the co-op/condo is not a timeshare, a continuing-care facility, or made up of houseboats, or does not fit into other narrow categories involving zoning and other legalities.
But in this latest update, two things in particular involve co-op/condo commercial space. The first – a good thing – is an increase in the amount of allowable commercial space in a condo, from 20 to 25 percent. The other, unfortunately, involves “non-incidental business operations owned or operated by the [homeowners association], including, but not limited to, a restaurant, spa, or health club.”
According to industry experts, Fannie Mae regards any income from sources not directly benefiting residential life to fall within the 15 percent stricture. Income from laundry rooms and community rooms benefit the residents. Commercial lease income or income from a cell tower does not.
Fannie Mae did not respond to numerous requests for comment.
There is a workaround for this problem, however. Lenders can request an “exception.” And many do, says Niemeier. “Someone from the lender will talk to Fannie Mae and say, ‘We’d like to have a waiver,’” he explains. “It’s not a loophole,” he notes, “but a formal process called a ‘credit variance administration system.’ We might say, ‘This co-op gets 20 percent of its income from [a cell phone] roof antenna. And this income is sustainable because there are three contracts with, say, Verizon, T-Mobile, and Sprint.’ After a lender gets that waiver, the lender has the ability to sell that loan to Fannie Mae.”
Indeed, this may be an out for buildings that have just signed 20- or 30-year leases with supermarkets, drug stores, banks, or even master lessees who, in turn, sublet commercial space. With such long-term leases in place, and depending on the retailer, Fannie Mae might well approve a waiver.
In the meantime, Niemeier says, some lenders don’t bother with selling to Fannie Mae, and so the Fannie Mae guidelines are moot. “They will do ‘portfolio lending,’ where they make a loan to what’s called a ‘non-warrantable co-op or condo,’ and hold onto that loan until the particular co-op or condo meets Fannie Mae guidelines,” if it ever does.
Have your board professionals read exactly what Fannie Mae says. The updated Selling Guide of March 31, 2015 is at: http://bit.ly/FannieMaeUpdatedSellingGuide and the initial announcement of November 10, 2014, is at http://bit.ly/FannieMaeAnnouncement.