REAL ESTATE DUE DILIGENCE (Part 2 of 2)
This is part 2 of a 2 section article about conducting due diligence on real estate transactions and should be read in conjunction with the sister article.
Financing The Purchase
While Condominiums generally do not set limitations on how much a purchaser may borrow, co-ops generally do. The purchaser must first determine if the co-op will allow the buyer to purchase the apartment with a loan which is secured by a pledge of the shares of the co-op. Many older co-ops do not allow financing at all. For those co-op’s that do allow financing, it is important to determine what the financing limitations are before the contract is signed. If the purchaser wants to finance 80% of the sales price but the co-op only allows 70%, then the transaction should not proceed.
Maintenance/Common Charge History
It is prudent to see what the history of any increases of common charges or maintenance has been over the years. If there are large fluctuations in increases, this may be a sign of poor management. It is customary to have a 2% to 7% increase in maintenance each year but common charges could be much smaller since real estate taxes are paid separately by the owner. In addition, it is possible that unit owners may be entitled to a rebate on real estate taxes – in a co-op the rebate is issued as a credit against maintenance and in a condo, the unit owner receives the credit from the city directly. As a note, only New York residents and those who claim the property as a primary resident are entitled to the rebate.
An assessment is a monthly expense that is added to the maintenance or common charges for a certain period of time (usually between 6 to 12 months). The assessment is generally instituted by the board of the building to cover an upcoming expense (ex. New roof or a new boiler) and can be used with the reserve fund or without the reserve for a capital project. A purchaser should determine if there were any past, present or future assessments planned, what they were for, how long the last, how much will be raised.
Real Estate Taxes and Tax Abatements
In a co-op, real estate taxes are imposed on the entire building and not on the individual apartments and is paid Condominium apartments and one to four family residences are taxed annually and paid either quarterly or bi-annually. The tax year in the 5 boroughs runs from July 1 to June 30. Taxes in the 5 boroughs can be checked on line at http://nycprop.nyc.gov/nycproperty/nynav/jsp/selectbbl.jsp. In addition, it is possible for a condominium to have a real estate tax abatement in place (known as a 421-a tax abatement). Depending upon how long the abatements stays in effect, it is conceivable that real estate taxes can increase dramatically when the abatement expires. In addition, it may be wise to ask what steps have been taken by the board to try to reduce the taxes for the building.
For co-op apartment purchases, the purchaser should determine how much of the maintenance is tax deductible. Maintenance includes the owners’ pro-rata portion of the interest on the building’s underlying mortgage and the pro-rata portion of the real estate taxes on the building. Each year, the co-op, its managing agent or the building’s accountant will provide a statement how much of the maintenance is tax deductible (most maintenance in co-ops are approximately 40% to 60% tax deductible). For condominium apartment owners, no portion of the common charges are tax deductible but 100% of the real estate taxes are. For both co-ops and condos, 100% of the interest paid on an apartment loan is tax deductible. If the apartment is not a primary residence, an owner may not be able to deduct these expenses (please check with your accountant).
Number of Units in the Building, Number of Units Owner Occupied, Number of Units Owned by the Sponsor.
If there is a high investor concentration in the building or if there is a high volume of sponsor owned apartments in the building, the purchaser may have a difficult time securing a loan. If there are many investors, there may be many sublets which places more wear and tear on the building due to tenants moving in and out. Also, owner-occupants tend to take better care of the general areas of the building. Co-op’s generally do not allow subletting. As a note, many lenders will not provide financing to purchasers if there are more than 30% unsold apartments in the building. While this may not be an issue for a purchaser if it is an all cash transaction, if unsold units remain high when you want to sell, a purchaser may experience difficulty obtaining a loan if the transaction is conditioned upon financing. If the Sponsor is unable to sell sufficient units after the Condominium has been declared effective, the Sponsor will be required to pay the loan, real estate taxes and common charges on the unsold apartments perhaps creating a financial burden. If the Sponsor fails to make these payments, it could have a serious financial impact on the building and you will have a very difficult time selling the Apartment.
Confirm Name On Title (stock or deed), Confirm Number of Shares (co-op) or Percentage of Common Interest (condo), Confirm Name of Co-op or Condo
A purchaser’s attorney should always confirm that the names on the contract match the current owners. For a condominium or a house in the 5 boroughs, this is fairly easy. A copy of the deed can be found on the ACRIS website at (http://a836-acris.nyc.gov/CP/) but you will need to look up the block and lot to do so. For a co-op, the only true way to see who the owner is, you must look at a copy of the stock certificate (which is not public record). The deed will also reflect the name of the co-op and what percentage of the common elements are allocated to the apartment if a condo. The stock certificate will reflect the name of the co-op corporation and how many shares are allocated to the apartment if a co-op.
Accounts Receivable, Unpaid Monthly Common Charges or Maintenance and Arrearages
The purchaser’s attorney should confirm the maintenance of common charges in the building are the same as stated by the real estate brokers. The purchaser’s attorney should also try to find out the maintenance or common charge history of increases (if there are large increases every year, the building may not be managed well) or if there are anticipated increases in the near future. It is not unusual for maintenance or common charges may increase every year or every few years due to salary increases, insurance increases and, electricity and fuel increases (and for a co-op, increases in real estate taxes and the underlying mortgage interest rate), The purchaser’s attorney should determine if the maintenance or common charges are current in the building. If there are large accounts receivable, this may place a financial burden on the budget. For example, if a unit owner is in foreclosure and is not paying the maintenance of common charges in a building that is small (ex. 10 units), the failure to receive this income can put a strain on making monthly operating expenses. The shortfall will either have to be made up from the other apartment owners or from the reserve fund.
A purchaser should try to determine if the roof, boiler, windows, plumbing, elevators and electric wiring are in good condition and that there are no hot water, water pressure, water infiltration, unusual noises and odors, mold, vermin or bedbug problems.
Each five to ten years, the building may need to complete Local Law 11 compliance (i.e. making sure that the exterior of the building is safe and bricks or mortar are not loose). This can be an extremely costly expense. The purchaser’s attorney should determine the condition of the exterior of the building and when Local Law 11 inspections are due.
When you sell the Apartment, you will be required to pay New York City and New York State Transfer Taxes. For apartments sold under $500,000.00, the NYC transfer tax is presently 1% of the sales price. For apartments sold over $500,000.00, the NYC transfer tax is presently 1.425% of the sales price. The NYS transfer tax is presently .4% of the sales price. In addition, you will be required to pay the New York State “mansion tax” equal to 1% of the sales price as closing.
Are there any unreasonable restrictions. Many high end Condo’s require that all windows contain white backed shares to keep the outside of the building looking uniform. This is where there may be restrictions on pets, rentals, use of the hallway (no mats), no attachments to the doors.
It is always a good idea to make sure all amenities are up and running. Amenities can include a garage, pool, health club, playroom, recreation center, fitness center, wine cellar, bicycle room and terraces/roof decks. I always recommend that purchasers look at the amenities before signing a contract.
If there is a storage unit that comes with the apartment, it is important to confirm it gets transferred with the apartment. Some storage units in co-ops do not transfer with the apartment and can be placed on a waiting list for another owner in the building. In a condominium, a storage unit may be transferred to the purchaser in a deed or pursuant to a license agreement. In a license agreement, the apartment owner does not own the storage unit but “leases” the storage unit from the condominium. In such instances, the purchaser’s attorney should make sure that the original storage unit license and an assignment of the storage unit license is transferred to the purchaser at the closing.
Lot Line Windows
A lot line window is a window that abuts the adjoin property’s “lot line” or property line. If an adjoining property is constructed and the height exceeds the window in question, the city will require that the window be permanently closed. Lot line windows are required to have fire-rated glass (glass that has been tested and acts as a barrier to flames and smoke), which distinguishes them from non-lot line windows. Lot line windows don’t affect you as an apartment dweller unless your neighbors build up to the level of your apartment or higher. You’d then be required to close up the window at your own trouble and expense, losing both natural light and view. Most lot line windows are on the side of buildings and not on the façade. In New York City, a room must have a true (not lot line) window and ventilation to be considered a bedroom. If the only window is a lot line window, then legally that space isn’t a bedroom and never was. If you’re looking at a listing, rooms with lot line windows are often referred to as “additional living space” or interior office space for a desk.
If a Purchaser has a pet, it must be determined if the building allows animals. Many co-ops and some condominiums prohibit pets. The standard co-op contract contains a provision as to what pets the purchaser has. Keep in mind, the co-op may want to see the pet before approval is granted. Failing to disclose the pet can result in the co-op requiring the owner to permanently remove the animal after closing.
Leasing and Subleasing
Condominium ownership is the appropriate vehicle for an investment and leasing out the apartment. The purchaser should determine what the rules are for leasing. For a condominium, the tenant will not need to be approved but the condo does need an application and must waive its right of first refusal to rent the apartment. For a co-op, it is much more complicated. Most, if not all co-ops do not allow subleasing (it is a sublease as opposed to a “lease” because if the apartment owner is subleasing the apartment under the terms of a proprietary lease) unless there is hardship (ex. Relocation as part of a job, long term illness). The purchaser must determine what the sublease rules and regulations are. The co-op may limit the number of years and may impose premiums on the lease (ex. 15% of the maintenance per year). Furthermore, the co-op will ask for a formal application with a copy of the sublease and will also insist on meeting the subtenant.
Always check to make sure all appliances are in working order (don’t forget about microwaves and air-conditioners). Some air conditioning units may not be a standard window or through the wall unit but rather a HVAC (Heating ventilation air conditioning unit). It is advisable that a purchaser determine who is responsible for the HVAC unit as the replacement of a motor can be quite costly. I always recommend that the purchaser’s attorney include a provision in the contract that all of the appliances in the sale are in working order at the time of closing. If purchasing an apartment from an estate, the seller may not agree to add a provision regarding the working order of appliances. If the apartment contains a washer/dryer, it is important to know if the installation was permitted by the building. Similarly, if there is no washer/dryer but you desire to install a one, it is important to get a clear understanding if the building allow washer/dryer installations.
The purchaser’s attorney should confirm that the seller did not do perform any substantive alterations/renovations in the apartment without the co-op or condominium approval. The purchaser should determine if the co-op or condo requires the purchaser to assume any alteration agreements signed between the seller and the building. In such event, the purchaser will be required to make any future corrections to the apartment after the closing, even though the work was completed by the seller.
In addition, the purchaser’s attorney should confirm that there are no open building permits filed against the apartment with the New York City Department of Buildings. It is conceivable that the seller or even the seller’s predecessor performed substantive alterations/renovations to the apartment with co-op/condo approval but never obtained that appropriate building department sign offs for the work (i.e that the work was completed to building code). If such work was done without building department approval or sign offs or there is open building permit, if these items are not discovered before closing, the purchaser will assume these obligations and may have to retain professionals to close out the open permits at the purchaser’s expense.
If the purchaser intends to make renovations to a co-op or condo apartment, it is imperative that the sections of the proprietary lease and the building’s alteration agreement and house rules be reviewed. A determination must be made what type of alterations are permitted , when the work must commence and end and what time of the year the work must be performed. Older co-ops may limit the amount of noise or dust and insist on work be completed during the summer months only. Many co-ops impose imitations when work can be performed (ex. 9 am to 5 pm Monday through Friday and no holidays), what part of the year the work can be performed (ex. Summer months only), penalties if work is not completed within a certain time frame and what documents may be needed for review by the co-op or condo (ex. Contractor agreement, projected expenses, insurance, etc).
In addition, if the work is substantive, the co-op or condo may inquire how the changes may affect the operating systems of the building. At a minimum, the building may require detailed plans and specifications and the review by the building’s engineer. It is unusual that the board will review the alterations prior to or simultaneously with the transfer of the apartment.
Condition of Common Areas
Take a walk around and look at the condition of the common areas of the building. Inadequate maintenance may be signs of an ineffectual board or lack of funds.
The purchaser should be comfortable with the square footage of the apartment before the contract is signed. The seller and broker generally make no representation what the square footage is. Quite often what is told to you regarding square footage can be substantially higher than the actual square footage. If you are financing, the lender’s appraisal may reflect a different/lower square footage.
Artist in Residency
Many Condominiums and Cooperative buildings in the SOHO district of Manhattan are designated as Artist In Residency (AIR) building. AIR restrictions appear on the certificate of occupancy issued by the NYC Department of Buildings. The AIR designation requires that at least one (1) “occupant” in the unit be a “certified artist”. The term “occupant” has been viewed very loosely and sometimes can be a person that visits the unit every once in a while. A “certified artist” is a person that has an “artist certificate” issued by the NYC Department of Cultural Affairs (they have certain guidelines as to who can be considered an artist or not). Strictly speaking, all owners must be in compliance with the AIR designation and be a “certified artist”. If the restriction were enforced, there is always a risk that the Department of Buildings, Landmarks Department or other New York City governmental agency which regulates the use of units in SOHO could require you to vacate the unit if you are not in compliance. Notwithstanding the previous information, the law governing AIR is antiquated and was formed at a time when SOHO was occupied by artists living in inexpensive apartments and needed certain protections. Since then the artists have largely moved out and buildings have been converted to high end lofts and apartments that still have “certified artist” restriction.
Generally speaking, AIR restrictions are not enforced. In addition, when a purchaser decides to sell the apartment, a purchaser may not be as liberal in their interpretation of the risk and may result in a fewer number of purchasers who may be interested. Lastly, many lenders do not make loans to purchasers who are purchasing in AIR buildings. Generally, the co-op or condominium will require the purchaser to sign an indemnity letter at closing which provides that in the event the AIR designation is ever enforced by the Department of Buildings or Department of Cultural Affairs, the purchaser shall comply with the order.
Because of the changing skyline of the metropolitan New York area and the never ending construction of new buildings, it is difficult to determine any new developments in the neighborhood which will have an impact on views and light affecting the Apartment. Accordingly, there is no guaranty that the future construction in the neighborhood surrounding the building will not result in the obstruction of views from the Apartment.
Certificate of Occupancy
The purchaser’s attorney should be sure that the building has a permanent certificate of occupancy (C of O). The C of O is issued by the New York City Department of Buildings which confirms that all work in the building is completed by the developer/sponsor and is ready for occupancy (i.e. has a working kitchen and bathroom). At a minimum, the building should have a temporary certificate of occupancy (TCO). The TCO is issued by the Department of Buildings and lasts 90 days and then must be renewed again. The sponsor/developer can obtain a TCO for a new building when some but not all of the apartments have been completed or if the common areas have not been completed. When a TCO is issued, it is important to make that the apartment bring purchased is included on the TCO and that the TCO is in effect ion the date of the closing.
Staff/Superintendent – It is prudent to determine if the building is staffed with a doorman (full time or part time) and that there is sufficient staff (superintendent or handyman) to address the day to day operations of the building. In smaller buildings, it is not unusual that the superintendent lives off premises or works part time.
Although not always available, it is prudent to review the operating budget for the current or forthcoming year. The budget may provide insight about the effective management of the building and/or an impending increase in maintenance or common charges.
Flip Tax and/or Transfer Fees
Many cooperative corporations impose a tax, known as a “flip tax”, when an apartment is sold. This tax is used primarily to build up a reserve fund. Subject to negotiated terms, the tax is usually paid by the Seller and is usually based upon a percentage of the sales price for an apartment. I have confirmed that this building currently has a flip tax based upon 1.5% of the sale price to be paid by the Seller. As a note, the first floor retail space was sold by a third party in 2014 for $50,000,000 and the Apartment Corporation received $750,000 as a flip tax which was distributed to the unit owners.
Condominium Application – More and more condominiums are asking for detailed applications. Please consult with the broker to determine what information will be required to submit with the Condominium application.
RESIDENTIAL 1 to 4 FAMILY HOUSES
For a residential home or townhouse, an inspection must be performed. The inspections can include termite, radon, soil, fuel, water, fireplace, bedbugs, asbestos (pipes), lead based paint radon, well water, septic tank. Please discuss these inspections with your attorney. The inspector should check the roof and basement for leaks, cracks in the foundation and dry rot, among other things. A purchaser should inquire about noise (trains, planes, etc), high tension wires and cell towers as well as water runoff. Also required is a review of the survey, certificate of occupancy, real estate tax bills, heating bills, deed and seller’s title policy when they bought the premises.
Just like a co-op or condo, the results of the inspection may have an impact on the amount of the purchaser’s offering price. If there are substantive or many repairs required or forthcoming, the purchaser may want to reduce the offer (until the contract is accepted, the sales price can be renegotiated but a seller does not need to agree to a reduced price).
The purchaser’s attorney should try to obtain a copy of the survey of the property. The survey is a footprint of the premises showing the property lines and structures. The survey should be reviewed by the purchaser to make sure the property lines are accurate or that there are no visible differences between the survey and what structures currently exist on the premises (ex. If the property currently has a garage but the survey fails to reflect the garage, it is possible that the garage was added without building department approval.
ADDITIONAL CONCERNS FOR ALL RESIDENTIAL PURCHASERS
Purchaser Financial Disclosure
Effective March 1, 2016, when one purchases aproperty (whether a condominium or cooperative apartment) in an entity (i.e. limited liability company, corporation, partnership other than a trust), the purchase price is in excess of $3,000,000 and the purchase takes place without bank financing, the purchaser must complete a financial disclosure form (on IRS Form 8300/FinCEN Form 8300) which discloses the source of the funds used for the purchase. In addition, all natural persons that compose all of the members of a limited liability company purchaser must provide their names, addresses and tax identification numbers. Also, all partners of either a general or limited partnership and all shareholders that own directly or indirectly 25% or more of the equity interest in the purchasing entity must also provide names, addresses and tax identification numbers for all of its partners or shareholders. Please refer to the following link https://www.irs.gov/pub/irs-pdf/f8300.pdf.
It is advisable to secure insurance effective the day of closing. We recommend that you obtain contents and improvement insurance which will cover your personal property and improvements in the apartment (like flooring, cabinetry, built-ins). In addition, we recommend that you obtain liability insurance to cover you in the event you damage another apartment or hurt another person. In addition, the lender in a co-op or condominium apartment purchase may require “walls in” insurance covering the walls, floors and ceiling inside your apartment. Please check with your lender regarding the specific insurance requirements when financing.
Foreign Investor/Non-New York State Residency Gains Tax FIRPTA)
The Internal Revenue Service (IRS) imposes a tax on the gain derived by a foreign person on the sale of their United States property. The buyer’s attorney is obligated to hold 10% of the purchase price at closing until the IRS determines the tax due. The net gain is taxed at approximately 15% but this amount may change and should be verified with your accountant. In addition, New York State currently imposes a gains tax at approximately 9% if the seller is not a New York State resident.
In a commercial purchase, there is generally a more extensive due diligence review involved. In addition to an engineer inspection of the premises, there may be the need to review leases, service agreements and employment agreements. Of key importance is whether income from tenants will cover the operating expenses of the property (i.e. real estate taxes, insurance, maintenance and upkeep, mortgage payments, etc.) A Phase I Environmental Review may also be required. Furthermore, a purchaser may need to retain an architect and/or contractor to review build-out and zoning issues prior to going to contract.
One of the big differences in a commercial purchase is that due diligence may be completed after the contract is signed. The seller will usually agree to a due diligence contingency period in the contract. This will allow the purchaser to conduct its due diligence within a certain time after the contract is signed (usually between 15 and 30 days). In this time, the purchaser can perform inspections, review leases, complete environmental reports and even have a title report completed. If the purchaser finds something unacceptable in its due diligence, the purchaser can terminate the contract and receive a refund of the down payment.
*DISCLAIMER – Nothing herein is offered as legal advice. All information in this article is for informational purposes only. Please consult with an attorney before taking any legal actions.