Is Conversion the Answer to Government Overreach?
- Sep 09, 2020
From the East Coast to the West Coast, we regularly hear stories of municipal and state governments attempting to regulate housing to the point where it is no longer private property but a government-run enterprise. One of the refrains that we are hearing is that there should not be landlords who can profit on housing, but housing should be run by the government and made available to everyone equally.
The proponents of public housing ignore the law of supply and demand and the fact that all real estate is a depreciating asset and no real estate needs more money spent on it for repairs and maintenance than housing, because renters have no equity interest. The proponents of government-owned housing also ignore the fact that the government would lose all the taxes that landlords pay, or that when this was tried before in the United States and globally, it was followed by severe shortage of housing and various accusations of corruption. On top of that, landlords are about to be faced with more environmental regulations in which all housing will have to be radically modified to accommodate reducing and eliminating real estate’s carbon footprint. Perhaps it is time for landlords to find another use for the capital that is presently tied up in multifamily housing while they can.
The Current Alternatives
A property owner who wants to liquidate their investment basically has two options. They can find another investor or operator to purchase the property and be paid a price based on the return on investment and the likelihood that the current ROI will continue. Or they can convert it to condominiums or cooperatives and sell the individual apartments to the residents or other users or other landlords’ residents who want to own their own homes. In that event, the price would be based on the aggregate value of all the apartments rather than the current ROI. With interest rates low—and likely to remain that way for a few years as the country recovers from the pandemic, recession and civil unrest—this is the perfect time to introduce renters to homeownership.
There is a belief in some circles that renters do not appreciate the value of homeownership or will not want to pay what the property is worth on the open market, but my experience differs. I have been privatizing government-subsidized housing in New York City for more than two decades and the rumors do not deter renters from becoming homeowners. In my experience, government-subsidized residents have traded in their below rents for ownership of their apartments and borrowed the money to purchase the right to do so. In one 1400-unit complex, more than 85 percent of the residents purchased or flipped their apartments when offered a price of 70 percent of market value of their apartments. In several other instances, the renters traded in their permanently subsidized leases for the ownership of their apartments with no certainty how high their operating costs might increase. Yes, we had to educate the residents, but, as one resident described the process, “we converted socialists to capitalists.” When we first met them, their focus was on keeping their rents low, and when we left, their focus was on market value.
The federal government and most states and many cities have their own procedure or laws for converting real estate to cooperatives or condominium ownership, and selling the units that have to be considered. But the most important part of the job is educating the renters and attempting to keep the homeowner’s costs (debt services, real estate taxes and common charges) not significantly greater than the rent the resident was paying. Frequently, this involves the owner leaving debt on the property or taking back purchase money financing, but every project is different.
The disadvantage to converting a building to a condominium or cooperative and selling the individual apartments vs. selling it to an investor is the federal (and state) income tax consequences. That is because the sale of the parts, although producing significantly more sales proceeds, would be taxed at ordinary income rates rather than capital gain rates, unless the seller does a 1031 exchange prior to closing or the Internal Revenue Code is amended to tax capital gain and ordinary income at the same income tax rates. Of course, the gain is based on the seller’s basis in the property. To paraphrase John Jacob Astor’s adage about real estate, “buy wholesale and sell retail.”
Stuart Saft is practice group leader of Holland & Knight‘s New York Real Estate Practice.