Last Escape From Rent Stabilization: Sub Rehab & Demolition

13 minutes read

For rent-stabilized buildings whose finances have collapsed, owners might have only one way out: deregulation through demolition or substantial rehabilitation.

Owners are increasingly asking about this, according to a LinkedIn post by real estate lawyer Sherwin Belkin.

His message could be an attempt to drum up business, but Belkin says he is “absolutely getting many more inquiries.” There is every reason to believe him.

Not only is distress among rent-stabilized buildings rising (because interest rates and operating costs have risen, rent increases have lagged and housing court is broken), but their outlook became even more dismal with the mayoral primary victory by Assembly member Zohran Mamdani, who promises to freeze their rents for four years.

The distress is concentrated in fully or largely rent-stabilized buildings. When Mamdani talks about landlords’ profits rising 12 percent, he omits that this is driven by properties that have lucrative market-rate units mixed in. Purely rent-stabilized buildings are doing much worse, in some cases declaring bankruptcy or facing foreclosure.

An uptick in inquiries about sub rehab and demolition, however, does not necessarily mean more projects are happening. Among the requirements: Buildings must be in bad physical condition and mostly vacant before the rehab begins (which is an incentive to not maintain a building).

Buyouts backfire

Getting approval from the state’s Division of Homes and Community Renewal is difficult because the agency sees preserving affordable housing as part of its mission. Also, the legislature got rid of a policy that presumed buildings qualify if vacancy is at least 80 percent.

That change took effect Jan. 1, 2024, but even projects that began before that date are held to extraordinary scrutiny by HCR.

Take 117 North Fourth Street in Williamsburg, which an entity called Creas Inc bought for $9.75 million in 2023 from an LLC linked to Jeff Sutton’s Wharton Properties, property records show. (Traded identified the buyer as the Cras family.)

Judging from the price and the building’s history, the buyer assumed the 2022 sub-rehab application would be approved. The building was entirely vacant and the applicant had submitted photos of its poor condition before replacing more than the minimum 75 percent of its major systems.

But in January 2024, HCR denied the application, saying the rehab did not meet its criteria. Remarkably, one reason given for the denial was that the three tenants who vacated had accepted buyouts ranging from $150,000 to $175,000.

These amounts, the agency claimed, proved that the apartments were valuable and not in bad shape — an absurd claim. The payouts were six figures because the building’s value would triple if it could escape rent regulation, which required vacancy. If occupied, the units were worth little.

The agency also argued that the “before” photos were not dated and the locations of the captured images were not well documented, making it unclear that the four-story building was substandard or seriously deteriorated just before the renovation.

State law says nothing about buyouts disqualifying a property. HCR’s criteria don’t even mention them. “Having bought a tenant out is not probative or even relevant to the physical condition of the building,” said Belkin, who followed the case but was not involved in it.

The owner asked HCR to review its initial ruling, but the agency upheld it, as did state Supreme Court Justice Gina Abadi on July 1. Whether an appeal will succeed is anyone’s guess.

No tenants had objected to the deregulation of 117 North Fourth Street. Rather, HCR decided on its own to rebut the presumption that the building’s 100 percent vacancy did not make it eligible.

Buyer in a bind

The court’s ruling that the building shall remain rent-stabilized leaves Creas in a horrendous position. The buyer borrowed $6.1 million from Valley National Bank for the deal, but the most it could collect in rent — perhaps $150,000 a year — would only pay about half of the debt service. Operating expenses and property taxes would add to the red ink.

Creas’ $3.65 million down payment looks like a total loss. Valley National might lose even more. Whether it forecloses on the building or sells the loan, it can expect pennies on the dollar. The only winners here appear to be Sutton, whose firm paid $2.8 million for the unmortgaged building in July 2020, four months into the pandemic, and Andrzej Trojanowski, the seller in that deal.

This is a cautionary tale, but taking a shot at a sub rehab still makes sense if the alternative is watching a building’s value decline until it becomes impossible to refinance or simply worthless.

Landlords’ strategy of asking the state legislature to amend the 2019 Housing Stability and Tenant Protection Act has not worked, outside of getting a modest rent increase for individual apartment improvements.

The upshot: If a sub rehab or demolition is a building’s only way out of a financial death spiral, cutting corners on the application could be fatal. Better to hire an expert. Preferably someone who will date the photos.