While many real estate developers are grappling with the costs of the COVID-19 pandemic, astute investors are surveying opportunities, particularly in distressed condominiums. COVID-19 has shined a spotlight on the vulnerabilities of the New York new-development condominium market, highlighting underperforming projects throughout the city. This article is intended to guide savvy investors in capitalizing on this current market.
Real estate developers in more impacted condominiums are being forced to consider alternatives to their pre-COVID-19 business plans, which include selling units to bulk purchasers, bringing new partners into the capital stack and refinancing the project's existing debt. Whether one or more of these options are feasible and prudent for a given property will depend on a number of factors, including, most notably, the developer's basis in the property and the number and size of the unsold units. For example, in many instances, it is not economically feasible to refinance a project, as construction, inventory and bridge loans have become increasingly difficult to secure as the cost of debt has inflated. Our team previously addressed considerations for lender/borrower workouts for all real estate assets, and a link to that article can be found here. The following is a discussion of investment strategies and considerations a "purchaser" should be mindful of when pursuing a distressed condominium opportunity.
What are the kinds of investment opportunities in a distressed condominium?
There are two primary means of investing in a distressed condominium.
An investor can purchase multiple units as part of a "bulk sale." A bulk sale refers to the purchase of either 10 or more units or at least 20% of the units of the condominium. This threshold determines whether a bulk purchaser is subject to regulatory oversight by the New York State attorney general and is deemed a "sponsor" or "successor-sponsor" of the offering plan of the condominium.
Alternatively, an investor can purchase an equity interest in the developer/sponsor and thus become a new member of the sponsor entity as part of a recapitalization. As a result, the investor acquires an indirect ownership interest in all unsold units in the project.
What is disclosed in the offering plan? Is an investor a "principal" of sponsor?
In the event of a bulk sale, the offering plan must be amended to disclose that the purchaser entity is a successor-sponsor of the offering with respect to the units it purchased. As the successor-sponsor, the investor has all the rights, obligations and liabilities of a sponsor under the offering plan only with respect to the units it owns on and after the closing date of the bulk sale. The amendment will also disclose that the original sponsor remains liable as sponsor prior to the closing date and retains its rights, obligations and liabilities with respect to units it will continue to own, if any.
Further, a bulk purchaser must identify at least one individual as a "principal" of the successor-sponsor. A principal is an officer, director, shareholder or other individual who owns an interest in or controls the successor-sponsor and is actively involved in the planning of the offering. A principal submits a certification as to the accuracy, truthfulness and completeness of the disclosures in the offering plan.
In the case of a recapitalization, the specific details of the transaction and the decision-making authority of the investor determine whether an amendment to the offering plan is necessary and whether any individual(s) should be added (or removed) as a principal of sponsor.
Identifying the principal(s) of sponsor is a critical strategic component of a transaction for both a bulk sale and a recapitalization. This is a nuanced analysis, which also involves weighing the potential liability of the principal, that we place particular emphasis on when counseling clients. The determination has meaningful consequences, since the addition and/or removal of individual principals is a material factor the attorney general considers when determining whether existing purchasers have the right to rescind their unit contracts, as more particularly discussed below.
What rights will an investor have to make future decisions impacting the condominium?
In a bulk sale of all unsold units, the investor inherits all the rights of a sponsor and controls the offering: The investor can modify prices; control the release of units to the market; rent rather than sell units; reconfigure the size and layout of some or all of the units; and, subject to the condominium documents and zoning restrictions, change the use of the unsold units.
Notably, a bulk sale does not need to include every unsold unit at a condominium. The investor will have the rights of a successor-sponsor described above only with respect to the units it owns. In this scenario, as part of the transaction documents, the two sponsors must establish their relationship dynamic, including the coordination of offering plan amendments, to ensure successful competing sales programs, protection of respective interests, and shared control of the condominium board and other decisions.
In a recapitalization, the extent of an investor's decisions and its ability to control the project are negotiated. The rights of a new equity partner are dependent on the size of the partner's position in the entity and its role as operator or investor. Major decision rights will be stipulated in the transaction documents, making clear what rights the investor has to control the setting of prices, modify the unit mix, or select an operator, as well as its ability to force sales of units, among others.
Will existing purchasers under the offering plan have a right of rescission?
In either scenario, the attorney general will determine whether the transaction constitutes a material and adverse effect on existing purchasers thus triggering a right of rescission. This is a case-by-case analysis that will largely depend on the facts and circumstances specific to the project and transaction. Prior experience and reputation of any new principal(s) and, if applicable, the successor-sponsor are critical factors in this analysis. The risk of such determination may be mitigated if the appropriate disclosures are made to both the attorney general and the public. Notably, even if the investment is not deemed material and adverse to existing purchasers, other events causing (or resulting from) distress in the condominium may trigger a right of rescission for existing purchasers. It is crucial that investors, together with counsel, focus on these factors during diligence.
What are the transfer and mansion tax considerations?
At the closing of a bulk sale, transfer taxes will be due to both New York City and New York State. The nature of a bulk transaction triggers real property transfer tax at the commercial rate, which is higher than would be payable if the units were purchased individually. In addition, a "Mansion Tax" may also be due to New York State. Taxes payable in connection with a recapitalization depend entirely on the specific terms of the transaction. Certain transaction structures, for both a bulk sale and a recapitalization, are more tax efficient than others. It is recommended to structure deals in collaboration with counsel and evaluate tax considerations as part of the underwriting process.
There is no "one size fits all" approach to investing in a distressed condominium. The various elements discussed in this article make clear that each investor's strategy and the unique facts specific to a particular project will dictate whether a bulk purchase or a recapitalization is worth pursuing. A bulk purchase allows an investor to step into the role of a sponsor and comprehensively reset the sales program. However, as a successor-sponsor, a bulk purchaser has direct obligations and responsibilities under the offering plan. In a recapitalization, the investor becomes a partner in the existing sponsor and structure, obtaining an opportunity to negotiate the exact structure that caters to the bespoke needs of a particular investor. Both may be appealing options that allow investors to capitalize on the current market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.