Investing in metropolitan area co-ops.

There are basically four ways to invest in New York Metropolitan area cooperatives: 1) Purchase performing underlying building mortgages; 2) purchase non-performing or sub-performing underlying building mortgages; 3) purchase bulk units in cooperatives (with or without unsold share status); and 4) cooperative work-out situations, also known as "White Knight" investors.

Investing in cooperative apartment projects has become popular in the last 18 months as investors began to see real opportunities that were created from the de-control of rent-regulated units and the substantial discounts available on over-leveraged and other non-performing underlying building mortgages.

Recently, the market has begun to firm up with regard to prices, since many new players have entered the market and the overall supply of co-op workout situations has dwindled. The borough of Manhattan has been largely restructured and most large-scale workouts that remain are in the outer boroughs, Westchester, Long Island and New Jersey. There is now an oversupply of capital relevant to the available product.

Performing Underlying Co-op Building Mortgages:

Perhaps the most conservative investor category, performing first position underlying co-op mortgages are building loans secured, in most cases, by the building and land owned by the cooperative corporation. These liens represent a senior claim to the property, subordinate only to real estate taxes and water and sewer charges levied by the appropriate governmental authorities. Recently, most of these investments involve lending institutions that seek yields ranging from 150 to 300 basis points over the comparable treasury note rate. In today's rate environment, this translates into an 8 to 10 percent cash-on-cash return; stable but not exactly the kind of returns that many opportunity investors are seeking.

Asset quality is crucial in pricing such assets. The Carlton Group, Ltd. recently consummated the sale of a $9 million performing underlying co-op mortgage on a prime 200-unit apartment building on Manhattan's Upper East Side known as The Park Regis.

This mortgage was unique in that it has a 50-year self-liquidating term (with 30 years remaining) and bears interest at a below market rate of 7.875 percent. A money center bank purchased the asset for a securitization with an investment banking firm. The mortgage sold for just under 90 percent of its face amount. The asset was priced to the bank at 190 basis points over the interpolated 20-year treasury note.

The relatively steep pricing for this asset is attributable to the high quality nature of the property. The Park Regis is 100 percent sold with very few investors, featuring apartments that are primarily priced from $500,000 plus; the mortgage represents a very low loan-to-value ratio of approximately 20 percent of the total worth of the building and the land. Assets like the Park Regis are relatively scarce and command the highest prices in today's co-op investor market.

Non-Performing and Sub-Performing Underlying Co-op Mortgages

Investing in riskier cooperative underlying mortgages generally involves a higher return on investment. For the mortgage itself, prices now range from 60 to 80 percent of face amount, with most investors demanding a front end cash-on-cash return of at least 9 percent and requiring a relatively quick exit strategy of 1 to 3 years through the refinance of the underlying mortgage to a third party lending institution. This exit strategy is accomplished either through selling at least 51 percent of the apartments to owner-occupants or refinancing the mortgage with an aggressive lender that will lend on projects with less than 50 percent sold to owner occupants (even aggressive lenders generally shy away from projects that are less than 25 percent owner-occupied).

Many loans in the New York Metro area have been restructured into what we call Phase I loans, i.e., the principal balance of the loan remains the same, but the interest rate has been reduced to a below market rate. These loans are generally classified as "sub-performing" loans and will probably have some problems at the point of refinance. Phase I loans have recently traded in the 70 to 80 percent range, depending upon the level of under collateralization. Final workout will probably involve a longer term commitment to the asset through a self-liquidating long-term mortgage that slowly reduces the indebtedness of the cooperative corporation without too much of a discount on the lender's part.

Bulk Sales

In many troubled cooperatives, sponsors and investors have stopped paying maintenance charges for large blocks of shares to apartments. As with mortgages, prices on bulk units have increased over the past three years as the market becomes more liquid and investor competition increases for the best projects. Most investors prefer "holder of unsold share status," which means the investor takes over the former sponsor position and retains the rights and liabilities attributable to that of the former sponsor. This usually means that board approval is not required for the sale or rental of units held in the bulk. As a general rule of thumb, rent-stabilized apartments are valued at approximately 15 to 25 percent of vacant value.

For instance, de-controlled apartments that are not subject to rent stabilization or rent control now command prices of 50 to 70 percent of their true market value. Rent stabilized and rent controlled units are still severely limited in their value due to the rights of the current renter. It is still possible, in the outer boroughs, to purchase apartments in bulk for as little as $3,000 to $5 000 per apartment, assuming the tenants are statutory. This pricing results in discounts of up to 90 percent of true market value. Negative cash flows on apartments, defined in terms of Actual Rent versus Maintenance Charges, most significantly affects the value of an apartment. It will be interesting to see the effects of Gov. Pataki's future policy decisions regarding rent stabilized apartments and how they affect the value of bulk cooperatives.

If an apartment loses more than $100 per month, its value drops significantly, resulting in prices that are generally cents on the dollar. Conversely, if the apartment generates a significant positive cash flow, the asset is priced at 6 to 8 percent actual cash-on-cash returns, with the residual value of the apartments as an additional return to investors or up to 35 percent of market value.

Co-op Workout Situations

These complex and often challenging investor situations have also been termed "White Knight" investments, although we prefer the term "re-conversion." In these situations, investors generally purchase the building's underlying mortgage and obtain control of the sponsor unsold shares and/or other bulk units in the building.

The art and science behind re-conversions has evolved in the last two years due to a number of factors. The traditional approach to such investing consisted of working out the troubled co-op's finances by working simultaneously with the co-op's lawyer, owner occupants, lender and sponsor. While conceptually sound, investors find this approach to be time-consuming and often counter-productive.

Thus, the market has dictated a new approach: Investors purchase the underlying building mortgage directly from the lender and then begin negotiations with the cooperative's participants. This process has evolved due to increased competition for quality product and the desire on the part of investors to have increased leverage over the co-op in negotiating a return for themselves.

Co-op boards often over-value the co-op's bulk units and do not allow a market rate of interest to purchasers of the building underlying mortgage. Savvy investors have learned, the hard way, that by giving a co-op a chance to negotiate before they purchase an underlying mortgage, the co-op may have an unrealistic position with regard to the reduction they will achieve on existing debt. The co-op's position is often in conflict with the needs of the investor, which consist of returning the co-op to financial health in a relatively short period of time, while leaving the investor flexibility in terms of marketing and/or renting the bulk units.

Many investors prefer to rent units that become vacant rather than sell into a relatively weak market (especially in the outer boroughs and the suburbs). This is often in conflict with the co-op's owner-occupants, who desire a fully owner-occupied building. A balance must be achieved that maintains both a high quality asset both in financial and psychological terms to both owner-occupants and the investor(s).

Therefore, there is a growing trend for investors to purchase distressed underlying mortgages first and ask questions later.

The risk of such investing is a potential legal battle down the road in the event that the investor and the co-op cannot come to grips with what the underlying mortgage's basis should be and/or who should hold the remaining bulk units. Conversely, holding the position of lender does hold some protection for investors and is often helpful in gaining concessions necessary for an adequate return to an opportunity investor.

Profile of a Re-Conversion Investors

The components for a successful investor in the NY metre co-op market are: 1) knowledge of the market; 2) substantial capital/financing resources to purchase mortgages and/or shares on an "all cash" basis; 3) an ability to work with people effectively and forcefully; 4) knowledge of the legal and financial systems required of such investors; and 5) the marketing savvy to successfully consummate such transactions (i.e., sell or rent the apartments expeditiously). All the technical and financial expertise will result in nothing if the investor does not have the marketing expertise to effectively rent and/or sell units.

Often, this type of investor had experience as a sponsor in the 1980s and is thoroughly familiar with all facets of the conversion process. In effect, the investor is re-converting the property to restore the building to financial health.

An effective marketing campaign is crucial to the success of a reconversion. Often, the re-conversion involves a re-offer to existing rent-regulated and fair market tenants of record, on-site sales and active broker co-operation in the marketplace to maximize values for both owner occupants and investors. The Carlton Group, Ltd. was recently retained by a major savings bank to market 125 former sponsor apartments in a luxury high rise on East 57th Street in Manhattan known as 225 East 57 Street. Through an effective tenant re-offer, we sold approximately 52 out of the 70 rent-regulated apartments in just five weeks. In addition, 19 apartments have been sold to outsiders during the first month of the sales campaign. Such impressive results were achieved through balancing a low cash price with effective apartment renovations and the establishment of solid financials for the building.

The purpose of this article has been to survey the various ways that investors can take advantage of an area that offers true long- and short-term investment potential in today's real estate market. It is a specialized area that requires true knowledge of the vagaries of the New York metropolitan area multi family market. The Carlton Group, Ltd. specializes in the sale of bulk cooperative and condominium units in the New York metropolitan area. Carlton is also offers both performing and non-performing mortgages with a specialty in underlying cooperative mortgages.