[IMGCAP(2)]The usual fallback tactic--renting vacant apartments--could produce unsatisfactory revenue. Holding the project for a relatively short period could expose the sponsor or lender to steep losses when they eventually sell the project. Holding for a long period--particularly for a lender-turned-sponsor--may be unappealing in that lenders prefer to lend, not own or manage real estate. And trying to sell individual units may be unrealistic, given the difficulty in meeting the requirement of Fannie Mae--and many jumbo lenders, who tend to follow suit--that 70% of the units be sold for financing to be available.

In these trying circumstances, sponsors and lenders in New York should at least consider converting troubled condominium projects to cooperatives. Co-ops fell out of favor a while back, but it strikes us that they are worth at least another look and some number-crunching. Even if substantial profit is out of reach, a conversion-driven workout could lead to breaking even--a worthwhile goal in this market.

A hypothetical, but realistic scenario that results in a win-win: A 100-unit condo project is offered at an aggregate of $100 million--$1 million per unit. There is a $45 million first mortgage--$450,000 per unit--with annual debt service of $2.4 million. If you assume conversion to co-op and that the shareholders will pay $200 a month for real estate taxes after tax exemption, $1,000 a month for maintenance, and $2,000 for interest on the loan, the lender can effectively give the units away and still emerge whole.

If the sponsor remains on board and collects even a modest purchase price, those funds would help reimburse his lost equity. That's because the shareholders will pay $3,200 monthly, covering the debt service and allowing the sponsor or lender to part with the units for a token. That is without even taking into account the other benefits: shareholders generally don't need title insurance; the lower purchase price would mean lower closing costs for them; and most importantly, deductions from both income taxes and interest on the mortgage would subsidize buyers' carrying costs.

Here, we will consider sponsors' and lenders' positions to be similar. We note, however, that for condo sponsors to convert to co-op, they will have to negotiate with their lenders. All parties will have to coordinate with the Attorney General's office on consumer-protection issues such as disclosure and transparency, rescission rights of earlier buyers in the project, time horizons for them to assess their options and restated plans.

The most obvious reason that a cooperative structure might relieve pressure on lenders is that if they keep the mortgage in place, they can restructure it as a typical underlying co-op mortgage with a term of five to 15 years; the loan would become performing. This alone would increase the likelihood that the lenders would recoup their investments.

Under the win-win scenario above, the major portion of each purchaser's price will be included in the underlying cooperative mortgage. This essentially represents the transfer of what would have been individual condo buyers' debt to the cooperative entity. The purchaser could pay an equivalent monthly amount but would not have to apply for financing.

Sponsors, lenders and buyers of shares of cooperatives should disregard the old saw that co-ops are less desirable because boards can restrict resales and subleases; condo-like rules can govern cooperatives. Co-ops lost favor in the early Nineties due to unfavorable changes in tax law intertwined with caps on rents, resulting in an inability of sponsors to deduct losses. The tax laws remain, but today's scenario assumes no rent regulation.

There are some factors that would complicate condo-to-cooperative conversions, to be sure, and some processes that must be followed. To the extent that sales are not made, sponsors or lenders will pay the maintenance fee to the cooperative on the unsold shares. Then again, they would have to do similar to meet their obligations if the project were a condominium. If some condo units have closed, their owners--and the owners' lenders--would have to consent to the conversion; there, negotiations could be complicated, but owners should see the value of avoiding being an owner in a sea of renters and being unable to resell or refinance.

Consider the following:

• If a condo offering plan has been filed but not yet declared effective, the sponsor can seek permission from a likely agreeable Attorney General to "test the market" or convert without soliciting indications of interest. The latter, especially in smaller projects, may require filing a restated offering plan, but here, the AG is likely to credit the original filing fees--no small savings at a time when every dollar counts. (In larger projects, a new cooperative offering plan may be required, but the AG seems disposed to crediting half of the original fees.)

• If a condo plan has been declared effective but no units have closed, the sponsor would have to abandon the original plan and file a new one--an option that might be proscribed by regulations that limit the circumstances under which sponsors can abandon "effective" plans. Seek competent counsel to examine whether the regulations would allow it and, if so, how best to craft an argument on that point.

• The most challenging scenario is when a condo plan has been declared effective and units have closed. Because a bona fide condo exists, the AG would be disinclined to consider a restated offering plan, but the possibility of a conversion to a cooperative remains a possibility. This might be achieved by having the condo and sponsor --or condo and lender if there has already been a takeover--jointly apply for a no-action letter as long as the internal threshold in dissolution documents has been met. Again, consult counsel to help navigate these waters.

In short, it may make good business sense to convert troubled condominium projects to cooperatives, and it may be possible to do so under the various laws and regulations that the Attorney General's office enforces. It is a possibility at least worth considering.

Erica Buckley is an assistant attorney general in the Real Estate Finance Bureau in New York City. The views expressed are those of the author and not those of the Office of the Attorney General. To contact the author, click here.

Douglas P. Heller is a partner at Herrick, Feinstein LLP. To contact the author, click here.

The views expressed in this article are those of the authors and not Real Estate New York.

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Co-ops Can Ease the Condo Crisis

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