Opening Your Mail To A Bill For A Million Dollars
I hate opening my mail, as it rarely brings anything that I look forward to dealing with. Bills, invitations to destination weddings in Buffalo, laminated flyers that make me feel guilty when I put them in the trash (what exactly is the recycling protocol on laminated postcards?). But a recent article about a shareholder at Trump Plaza in NYC brought things to a new level. An owner of a one bedroom on the 30th floor opened her mail to read an invoice for an assessment of $900,000! I know the title of my article says a million, but it’s more catchy than $900,000!
Of course, “only in New York” works not only to give us hundreds of options for world-class theater on any given night, but also vaults us into the hyper-surreal world of the $900,000 assessment. How exactly does this happen? The good news is, it’s quite rare. And in this case, careful due diligence prior to buying should have shed some light on the potential for this event. Let’s take things apart on this building to see what happened.
This is a coop built on a land lease. Most coops are built on land that the coop owns outright, known as “fee simple absolute” ownership to the dirt upon which the structure is built. But there are other options when building. Sometimes the owner of a lot is not interested in selling, either due to tax or estate planning implications, or the desire for a stream of rent payments in lieu of selling in a down market, in some circumstances the owners of the lot will “lease” the dirt to the coop, which in turns builds or renovates the structure on the land, and organizes itself as a coop like any other. Condos can be built on a land lease too (like Battery Park, or One Brooklyn Bridge, but that is much more rare than a coop land lease).
So how does one analyze the economic impact of buying an apartment in a land lease building? Suppose you are looking at two identical apartments in equivalent buildings located on the same block in NYC. Both are coops on land leases. In the first building, there is one year remaining on the land lease, and the underlying documents give the coop no absolute right of renewal to the lease. The rent for the remaining year is $100,000. In the next building, there is 100 years remaining on the land lease, also with no right of renewal, and the rent there is also $100,000 per year, guaranteed to remain level for the entire period. Which apartment is worth more? Clearly the second. The first is not so much a purchase, as it is a one year rental of an apartment. Indeed the market value of that apartment is the fair market value of the rental for one year, less the required maintenance flow for the year.
But most land lease situations are not so black and white. Here are a few steps I go through when evaluating a land lease coop apartment:
Step 1: Is the apartment selling under market? By this I mean, if the apartment were available in an identical building not on a land lease, would it sell for more? In most cases, there is some discount associated with a land lease coop.
Step 2: How many years are left on the land lease? This is easy to answer by reviewing the underlying building documents. Leases terminating within 30 years will be difficult to finance.
Step 3: Once the lease expires, are their rights to renew? This question addresses whether the coop has an automatic right to renew an expired term, and under what base rent.
Step 4: What are the escalation provisions? This is absolutely the most important factor in evaluating a land lease building. Take for example a building like Trump Plaza. The ground lease calls for an adjustment in 2024 to 8% of the market value of the land. That analysis led to a potential tenfold increase in ground lease payments, with the attendant impact on maintenance charges.
Step 5: What would it cost the coop to buy the land now? This question is a little harder. Take for example our scenario above, with the $100,000 annual rent for 100 years. If that rent is grossly under market, then the value of the land is diminished, due to the negative impact of the fixed ground lease payment. In the Trump Plaza scenario, however, the answer was $185,000,000. This number was arrived at after extensive evaluation of the land subject to the land lease.
Step 6: If the board did, what would be the financial impact on the apartment in question? And here is the key to the whole analysis. If the board buys the land the day after you close, what would be the financial impact? That’s easy to arrive at. First take the shares allocated to the unit, divided by the total shares outstanding, and multiply by the purchase price. In the example above, that resulted in $900,000 assessment. But there is also a positive impact to the unit owner, as maintenance will certainly reduce as a result of the omission of ground lease payments. If ground lease payments are 20% of annual maintenance, then maintenance charges should immediately reduce by the same 20%.
Let’s suppose that the apartment in question is selling for $200,000 under market. And if the board bought the underlying land, it would cost the unit owner $300,000, but would reduce maintenance from $2,000 per month to $1,700. I would first ask the broker what this apartment would sell for if all other things were equal, but the maintenance went to $1,700 immediately. If the answer was it would increase the value $25,000, then the apartment delta is really $225,000 ($200,000 under market, with a positive $25,000 impact from maintenance reduction). That amount is less than the $300,000 that would be required to buy the land, and thus a potential buyer should weigh this before deciding whether to proceed.
There is no simple answer to the question, “should I buy in a land lease building.” Rather, careful analysis, along with the counsel of an experienced attorney, will help guide a buyer through this difficult decision.