After reporting last week about a new law aimed at freeing co-op and condo owners from self-dealing contracts struck by sponsors, we became curious not only about the sorts of sweetheart deals being struck, but whether there is a growing problem.
After all, in a recession, isn’t there more incentive than ever for sponsors to line their pockets at the expense of apartment owners…especially among developers struggling to unload inventory, versus sponsors of established co-ops and condos?
Tougher times, cleaner hands?
“Four years ago when the market was really hot, and buyers weren’t necessarily checking the last dollar on monthly maintenance costs, you might see a sponsor taking a $90,000 annual management fee, but when the board goes out to renew it after the sponsor loses control, they can find a contract for $60,000,” says real estate attorney Jeffrey Reich.
It’s not just about watchdog buyers. The need to stay competitive is also keeping developers more honest.
“There’s a check and balance to this,” says Reich. “On the one hand, developers might have an incentive to inflate the management fees, but on the other hand, they’re trying to keep the budget reasonable because they want to be competitive.”
And while the real estate boom provided cover for a wave of sweetheart deals among sponsors of newer condos, sponsor self-dealing peaked among co-ops in the 1970s and 1980s, when sponsors still controlled the buildings.
Back in the day
Self-dealing in co-ops traditionally revolved around leases of retail space and garages. (Unlike condos, commercial space in a co-op can not be spun off and sold separately from the apartments.)
Real estate lawyer Steven Sladkus gives an example.
“A sponsor may have a lease for all the store space on the first floor of a building," he says. "The lease term may be for 50 years with additional longterm renewals at a very, very favorable rental rate, payable to the co-op, for the whole space. The sponsor can then hack up the space and rent out to subtenants at much higher rents.”
Eventually a federal law, the Cooperative and Condominium Abuse Relief Act, was passed in 1980. It gave residents the right to cancel sweetheart contracts within two years after gaining control of the board from the sponsor.
But it came too late for many co-ops throughout the city, who remain saddled with unfavorable leases to this day.
The many flavors of sweetheart deals
Condo sponsors have little need to bother with sweetheart deals on retail and garage space: They tend to simply sell the space separately from the apartments to begin with, an option not available in co-ops.
Self-dealing may be at a lowish ebb these days, but if you're buying into a co-op or condo still or recently controlled by a sponsor, you will want to stay vigilant.
If you’re buying into a new condo, the deals must be described in the offering plan, says Reich. But if you’re buying into an older building, you’ll have to glean it from financial statements, minutes or interviews with property managers.
Here's what to look for:
- Laundry rooms: A sponsor who still controls the building forms an affiliate to operate the laundry room. Then the sponsor directs the co-op or condo to enter a contract with that company, under which the vendor pays the co-op or condo rent, but keeps all the laundry machine revenue, says real estate lawyer Aaron Shmulewitz.
- Pools and gyms: “I have seen cases where a building would have a pool and a gym, and the sponsor will reserve the right to own or lease the space, and then they make the building agree in the governing documents to a pay a certain annual fee,” says Reich.
- Maintenance and security contracts: “I’ve seen developers in larger complexes take maintenance or security contracts,” says Reich. “I’ve seen overcharges at 25 or 35 percent.”
- Management company: The sponsor forms an affiliate to run a management company, then directs the co-op or condo to pay the sponsor-controlled management company to manage the building, says Shmulewitz.
- “Warehousing” apartments: “We had a situation where the sponsor reserved for itself the right, in perpetuity, to relocate the Super’s unit” to a much smaller one, says real estate lawyer Robert Braverman. This gave the sponsor the ability to “warehouse” a larger apartment without paying for it. Twenty-five years after the building became a co-op, the sponsor wanted to move the super and his family to a studio. “We challenged that provision and won,” says Braverman.
Sponsor sweetheart deals targeted by new disclosure law