As new member of the POA, we read with interest the February 2008 issue which featured an article relative to condominium conversions and wanted to present the other side of the issue. This article is written from the perspective of a property owner of a multiple dwelling unit or a cooperative complex considering conversion.
In our last conversion, the aggregate value of the community that converted to condominiums rose from approximately $21,000,000.00 pre conversion to over $45,000,000.00 after conversion. While that increase also reflected a general increase in the housing market, the fact is that the process of conversion to a more marketable condominium product resulted in a tremendous increase in equity for the owners of that complex. We could not understand the focus in the article on the potential for increased taxes on the condominium owners as a reason not to proceed with what amounts to a legal “name change.” This type of logic is tantamount to refusing to invest in stocks that could appreciate because the profit may be taxable. Applied to a conversion, the logic makes less sense given the fact that the property owner often sells the condominium units and the tax burden is paid by the new owners. The conversion is designed simply to make the same property more valuable for the property owner. Sophisticated investors understand that they can utilize the increased equity for refinance purposes or draw upon it for other investments.
Our company converts cooperatives to condominiums and we find that many owners have contemplated the idea of conversion but have difficulty processing the many factors which must be considered. While many communities have taken advantage of this process, the decision whether or not conversion is right for your community is fact sensitive.
How Does It Work?
A conversion simply means that the legal title of the building changes from a single owner to individual condominium owners in “fee simple.” In an apartment building, the property owner creates new tax parcels for each unit that are offered for sale to prospective condominium owners (in a cooperative, shares of stock are tendered and replaced by a deed).
What Are the Benefits?
Increased value. As a condominium, the same unit typically has an increased market value than as a rental or a cooperative unit. In cooperative buildings, conversions are preferred because banks approve more loans and lend at better rates to condominiums than cooperatives which increases the marketability of the unit. Many banks have burdensome underwriting guidelines on commercial building loans and outright refuse to give loans on cooperatives. Banks have more security when the collateral is a deed to a condominium rather than shares of stock in a cooperative.
Cash Out. Property owners often want to use their equity to retire or make additional investments and seek to market their buildings. Many property owners find conversion attractive because they find that marketing individual units for sale to prospective homeowners rather than finding another investor for the entire building is easier and yields a greater sum because the individual units are worth more as condominiums than rental units.
Shift Maintenance Obligations. Another appealing feature to a property owner is that the maintenance obligations can be shifted to the new condominium association once a certain percentage of individual owners purchase their units. Some property owners retain a few units as rental units as the condominium association undertakes the maintenance of the common elements.
Capital Repairs. Buildings that are in need of repairs where a property owner is unable or unwilling to fund the work find that capital contribution fees raised from the new condominium purchasers can be used for necessary renovations and capital repairs. These repairs can also be financed by the new condominium association using only the maintenance fee obligations as collateral for the loan.
Considerations
Long term rental income vs selling units. The first consideration is whether an owner of rental property finds it more advantageous to receive rental income indefinitely or receive sales proceeds at one time during transition. The former provides for a steady stream of income (subject to market cycles) while the latter provides for a larger, immediate recovery upon sale.
Tax treatment. As referenced above, the relevant tax consideration for the property owner is not how much the increased taxes are for the new condominium owner that he sells to, it is how and when the property owner’s income from conversion/sales are treated. Capital gains rules are ever changing and we refer to your tax consultant. Generally, however, whether a property owner’s gain on the disposition of real estate is taxed as ordinary income or capital gain depends on the purpose for which it is held. For these reasons, we recommend that you consult a tax specialist if the differential in tax treatment (ordinary v. capital gains) is a deciding factor in converting these units.
Tenant Considerations. Tenants are entitled to protections that prohibit the immediate eviction of tenants by owners wishing to convert. In most New Jersey counties, tenants are provided different protective periods based on their status (e.g. disabled, senior citizens, income level). Many tenants may elect to purchase their units and can often take advantage of “insider prices” that allow them to share in the increased equity arising from the change to fee simple ownership. Often, developers offer incentives to the tenants who purchase to close early (in the form of discounts, closing costs, etc.) and to those tenants that are unable to purchase to leave (cash payments, moving costs, rent payments in other locations, etc). There are distinct rules relating to these offers that must be followed and tenants can never be asked to waive these tenancy rights. Our company is experienced in negotiating with both types of tenants and has noted success in reaching prompt resolutions with tenants in either purchasing or relocating them to comparable housing. The fact that tenant rules are strict and are designed to be protectionist in nature should not dissuade the property owner from considering the financial benefits of converting.
Transition/Management of Condominium Association. There is typically a period of transition during which the property owner (a/k/a/ “Sponsor”) will have to engage in discussions and negotiations with the new condominium association over building and operating issues. This will last until the conversion is completed. Issues arise based on construction defects, maintenance problems with the physical components, operating systems, inadequate reserve funds to maintain the building or failure to warn of building/area characteristics before they purchased.
Where to go from here?
The buildings and communities that we have converted have experienced success and the property owners find that condominium conversion allows them the flexibility to cash out, reinvest and retain some rental units at the same time. Our company performs feasibility studies without charge to assist property owners with this decision.
James M. McCarthy is counsel with CondoConversions, LLC and can be reached via e-mail at jim@condoconversionsllc.com or via telephone at (800) 226-0234.