United States: For City-Supervised Mitchell-Lama Cooperatives Thinking About Privatization: Think Again

An Overview Of The Article II To Article XI Conversion Program

As of August 15, 2016, there are 20 City-Supervised Mitchell-Lama Cooperatives that are eligible to voluntarily dissolve and become either a market-rate cooperative or condominium. This Stroock Special Bulletin provides information regarding a meaningful alternative to privatization that may be helpful to shareholders of these 20 cooperatives. It's the Article II to Article XI Conversion Program – a program that is in line with the mission of the Mitchell-Lama law, and which also provides modest equity appreciation to existing shareholders and much-needed middle income housing for future generations to come.

Overview

The Mitchell-Lama program is widely viewed as one of the most successful contributors to affordable housing in New York City history. The fact remains, however, that the statute explicitly permits voluntary dissolution, which has been interpreted to mean that Mitchell-Lama cooperatives can privatize – to dissolve and reconstitute themselves as free-market cooperatives or condominiums. As the real estate market in New York City continues to thrive, more Mitchell-Lama cooperatives will face the question of whether to privatize or remain under State or City supervision.

Since the inception of the Mitchell-Lama program, at least five of the City-supervised Mitchell-Lama cooperatives have chosen the privatization route – dissolving and reconstituting as free market cooperatives or condominiums. Two more submitted offering plans that recently were accepted for filing by the New York State Attorney General's office ("NYAG"), and now the shareholders must vote on whether to voluntarily dissolve. According to a representative from the City's Department of Housing Preservation and Development ("HPD"), although at least 60 Mitchell-Lama cooperatives (with a total of approximately 30,000 apartments) remain in the City's portfolio, at least five of these are exploring privatization (in addition to the two whose offering plans have already been accepted for filing).

If the rate of Mitchell-Lama privatizations continues, then New York City could potentially lose more affordable housing at any moment. The number of Mitchell-Lama cooperatives that are at risk of loss – approximately 20 of the 60 Mitchell-Lama cooperatives that remain under City supervision – could severely undercut the efforts being made under the Mayor's Housing New York: A Five-Borough, Ten-Year Plan to add an additional 200,000 units of affordable housing units to the City's landscape – 120,000 units of which will come from efforts to keep existing units like Mitchell-Lama apartments affordable for future generations.

One alternative to privatization under Mitchell-Lama is conversion under New York City's Article II to Article XI Conversion Program (an "Article II to XI Conversion"). A key benefit of an Article II to XI Conversion is that the units continue to provide affordable housing for future generations, while also providing modest equity appreciation.1

The Mitchell-Lama Dilemma

Among the goals of the Mitchell-Lama program were to stabilize New York neighborhoods, to provide affordable housing for moderate-income individuals and families, and to create long-term cooperative housing for tenants.2 The dilemma arises because another goal of the Mitchell-Lama program is to provide an "exit strategy" for investors in Mitchell-Lama buildings to encourage private investment in affordable housing. So, built into Mitchell-Lama are two potentially contradictory mechanisms – one that encourages the creation of affordable housing, and the other that facilitates the conversion of that affordable housing to free-market cooperatives or condominiums.

Privatization of Mitchell-Lama cooperatives to market-rate cooperatives or condominiums, and the resultant loss of affordable housing, is particularly problematic in certain areas of the City that not only have Mitchell-Lama cooperatives, but also have average rents that are well above what a typical moderate-income individual or family can afford. For example, public records show that sales of shares in a Mitchell-Lama cooperative on the Upper West Side of Manhattan that privatized in 2009 have had an average price of $841 per square foot, which is an average price for a two-bedroom apartment of $842,429.3 That price is substantially above the price for shares in a typical Mitchell-Lama cooperative, where prices tend to be mostly in the five-figure range. Clearly, the goals of providing affordable housing for moderate-income individuals and families, and creating long-term cooperative housing for tenants, don't necessarily survive a voluntary dissolution of a Mitchell-Lama cooperative.

ARTICLE II TO ARTICLE XI PROGRAM AS AN ALTERNATIVE TO PRIVATIZATION

Overview

Fortunately, the Article II to XI Program provides an alternative to voluntary privatization that meets the statutory intent of creating long-term stable housing at reasonable cost, while promoting a new concept – shared equity homeownership. The Article II to XI Conversion is accomplished by conversion of the Mitchell-Lama cooperative to a Housing Development Fund Company ("HDFC"). The HDFC is characterized by three distinguishing features that are inherent for shared equity homeownership:

  • Owner-occupancy of residential property;
  • The fair allocation of equity between one generation of lower-income homeowners and another; and
  • The sharing of rights, responsibilities, and benefits of residential property among the HDFC and its shareholders and a third party representing the interests of a larger community, which in this case would be HPD as the supervising agency.4

Benefits of Shared Equity Homeownership

The Article II to XI Program meets all of the elements of shared equity homeownership by:

  1. requiring shareholders to occupy their apartments as their primary residence,
  2. requiring flip taxes on initial sales and subsequent sales, and
  3. giving greater autonomy to the board of directors to make critical decisions on behalf of shareholders, while requiring a healthy but reasonable level of oversight by HPD.

In addition to the policy and social responsibility goals that might drive a Mitchell-Lama cooperative to consider conversion to an HDFC under the Article II to XI Program instead of privatization, there are some very practical reasons as well, such as:

  • The Article II to XI Program Is Designed to Take Less Time Than Privatization. An Article II to XI Conversion does not require a feasibility study or a full blown offering plan. Instead, a Mitchell-Lama cooperative wishing to explore conversion to an HDFC need only conduct a vote of its shareholders to hire an attorney to complete the required Proxy Statement – a short form offering plan created by HPD and the NYAG, which includes the salient information needed to make an informed decision about whether to convert to an HDFC, discussed below;
  • The Article II to XI Program Is Less Expensive Than Privatization. Although HPD does not maintain a database of the costs incurred in the conversion process, several factors strongly suggest that it is less expensive than putting together a privatization plan. For starters, there is no feasibility study requirement. Second, the NYAG, in conjunction with HPD, has provided a helpful memo on the disclosure requirements for the proxy statement – the document that is distributed to shareholders (in lieu of a full blown offering plan) prior to the vote on whether to take advantage of the Article II to Article XI Program.5 The memo also states that conversion to an HDFC does not require the payment of a filing fee. For a Mitchell-Lama privatization, the fee can be as high as $30,000. Additionally, in an effort to avoid the long and drawn out review process required for privatization offering plans, HPD created a model Proxy Statement. Taking all these factors into account, average time for review and signoff for conversion to an HDFC should be significantly less than the current estimate of one to five years for a privatization plan.6
  • Preservation of Much-Needed Affordable Housing for Future Generations. Unlike voluntary dissolution – which does not meet all of the elements of shared equity homeownership – the Article II to XI Program preserves affordable housing for at least an additional 30 years, if not longer, for individuals and families earning up to 130% of the area median income. At present, Mitchell-Lama cooperatives serve individual and families earning up to 125% of the area median income. Therefore, practically the same group of moderate income New Yorkers continue to be served under the Article II to XI Program.
  • Maintaining HPD Supervision and Oversight Over Major Financial Decisions. Although some Mitchell-Lama shareholders bristle at the perceived "big brother or sister" aspect of supervision by the City, absence may make the heart grow fonder. After a Mitchell-Lama cooperative leaves City supervision, there is no governmental agency charged with fielding complaints or ensuring that the cooperative is functioning in accordance with its governing documents and the law. Unfortunately, there are virtually no governmental resources available for shareholders in unsupervised cooperatives, despite numerous efforts to create an Ombudsman at the NYAG to assist homeowners. Therefore, shareholders need to think long and hard before they give up governmental oversight and supervision, which can be especially important with respect to major decisions such as entering into contracts in excess of $100,000. Under the Article II to XI Program, governmental oversight is much less than it is as a Mitchell-Lama cooperative, but there is some supervisory oversight. As part of the HDFC conversion process, HPD requires the HDFC to enter into a regulatory agreement, thereby providing HPD with an opportunity to maintain oversight over the HDFC.
  • Modest Equity Appreciation. Prior to conversion of a Mitchell-Lama cooperative, when shareholder-owners sell their shares back to the cooperative, they do not realize gain from any appreciation in the value of their shares nor are they able to recoup or otherwise offset monies spent on capital improvements. This means that if, for example, a shareholder paid $12,000 for her shares when she moved into the Mitchell-Lama cooperative, but spent $15,000 on capital improvements during their occupancy, when she sells the shares back to the cooperative she will receive, with limited exceptions, only $12,000 in return. This situation has been pinpointed as the primary reason so many Mitchell-Lama shareholders decide to take advantage of voluntary dissolution. The Article II to XI Program provides some relief in this area. For example, the typical two-bedroom apartment in a high-rent area may have a sales price up to $334,265.7 Although this is substantially less than recent sales prices of units at recently privatized Mitchell-Lama cooperatives in high-rent areas such as the Upper West Side cooperative, it is still far above the prices that are currently charged under the Mitchell-Lama program. Under the Article II to XI Program, the board of directors must adopt a flip tax policy that captures a higher percentage of profit from original Mitchell-Lama shareholders at the time of initial sale, as well as a lesser flip tax for future sales by subsequent shareholders. HPD recommends a first flip tax of 25% of profit and a resale flip tax of 5% of profit. Either way, the Article II to XI Program allows the HDFC to build up healthy reserves through flip taxes while permitting a modest equity appreciation, which is not available to Mitchell-Lama shareholders.
  • Greater Autonomy to Board of Directors. Many Mitchell-Lama shareholders believe they don't have the power, as shareholder-owners, to make certain decisions they should be able to make. For example, the Mitchell-Lama program has very strict rules on admissions, subletting and succession rights, to name a few. And because these requirements are in the statute, neither HPD nor Mitchell-Lama boards of directors have any flexibility on these issues. Under the Article II to XI Program, boards have more autonomy. For example, waiting lists are not used to fill vacancies, unless the board decides otherwise. Second, shareholders are able to will their shares to their heirs, and upon board approval, income-eligible heirs may also occupy the apartment. These are changes that many Mitchell-Lama shareholders welcome.

PROXY STATEMENT DISCLOSURE UNDER THE ARTICLE II TO ARTICLE XI PROGRAM

HPD and the NYAG have taken several steps to smooth the transition from Mitchell-Lama cooperative to an HDFC. Most significantly, the NYAG has taken the position that Mitchell-Lama cooperatives engaging in an Article II to Article XI Conversion are not required to file a new offering plan. Instead, the Mitchell-Lama cooperative must present to its shareholders a proxy statement, which must at minimum highlight the following:

  • Special Risks associated with leaving the Mitchell-Lama program and converting to an HDFC;
  • HPD requirement that 66 2/3% vote of shareholders required to convert to an HDFC;
  • Dissenters rights which must be offered under N.Y. Bus. Corp. Law § 623;
  • Salient aspects of the regulatory agreement that the HDFC must enter into, which will require: 1) approval by HPD of contracts entered into by the HDFC that exceed $100,000; 2) mandatory maintenance increases based upon Consumer Price Index, unless HPD agrees to forgo such increases; 3) adoption of occupancy standards that are analogous to the standards for Mitchell-Lama cooperatives; 4) mandatory reserves; 5) mandatory flip taxes; and 6) maximum resale prices affordable to individuals and families earning up to 130% of the area median income;
  • Transfer taxes are not triggered under the Article II to XI Program; and
  • A new partial real estate tax exemption to be granted to the HDFC, co-terminus with the regulatory agreement and financing provided by the City of New York.

In addition to the foregoing, the proxy statement must also include numerous disclosures that are necessary to assist shareholders in making an informed decision on whether to convert to an HDFC, including but not limited to:

  • The findings from a physical needs assessment, establishing any necessary major capital improvements and how such repairs will be paid for by the HDFC;
  • A Schedule A for the HDFC, which must include any changes in share allocations, projected monthly maintenance fees, and acceptable resale prices for shares;
  • A Schedule B budget for the first year of operation for the HDFC;
  • Terms of any mortgages that will encumber the building(s) to be owned by the HDFC, and how such financing will impact shareholders;
  • Summaries and copies of the governing documents of the HDFC, including but not limited to the certificate of incorporation, by-laws, proprietary lease, stock certificate, and regulatory agreement;
  • Tax consequences of the transfer, including transfer taxes and future eligibility of the HDFC as a qualified cooperative for purposes of IRC § 216;
  • Financial forecast for the shareholders if they were to remain a Mitchell-Lama cooperative; and
  • The procedure for carrying out the dissolution and reconstitution of the Mitchell-Lama cooperative to an HDFC.

Conclusion

As with any decision, a tremendous level of analysis and preparation are required before a Mitchell-Lama cooperative can embark on privatization or an Article II to Article XI Conversion. Because many of the issues require an understanding of relevant statutes and applicable regulations, Mitchell-Lama cooperatives should consult with competent legal counsel that can help the board decide what option will best serve the needs and goals of the shareholders. Although some affordable housing advocates might be happier if privatization were not an option, the Article II to Article XI Program does provide Mitchell-Lama shareholders with the ability to maintain affordable housing for future generations, with the potential to also benefit from modest equity appreciation.

Footnotes

1. Some Mitchell-Lama preservationists are advocating for an amendment to the Private Housing Finance Law to prohibit any form of privatization or change in ownership status, including Article II to Article XI conversions. See "The Seven Worries of New York City's Mitchell-Lama Tenants," by Abigail Savitch-Lew, March 2, 2016, City Limits.

2. The statute authorizing the Mitchell-Lama Program, N.Y. Priv. Hous. Fin. Law § 11-a(2-a), provides: "It is hereby found that improvement of the physical environment and revitalization of the quality of urban life in such municipalities would be promoted by cooperative action by tenants who are persons or families of low income to acquire ownership of their dwellings and to operate them on a nonprofit basis; that such cooperative undertakings, with their consequent pride and responsibility of ownership, would help to stem the abandonment of deteriorating but structurally sound buildings, which contributes to a substantial loss of much needed housing stock, and would lead to the stabilization and renewal of deteriorating neighborhoods. It is found necessary, in order to assure the feasibility of such cooperative undertakings, to make available to such tenants long-term financing on a favorable basis and tax exemption to enable them to purchase and maintain their dwellings at a reasonable cost." (emphasis added)

3. Information from www.streeteasy.com as of July 27, 2016.

4. Shared Equity Homeownership: The Changing Landscape of Resale-Restricted, Owner-Occupied Housing, by John Emmeus Davis.

5. See NYAG Guidance Document, "Requirements for Exemption Application For Conversions of PHFL Article II Cooperatives to PHFL Article XI Cooperatives" available at: http://www.ag.ny.gov/sites/default/files/pdfs/bureaus/real_estate_finance/Effective-memos/Requirements%20for%20Exemption%20Application%20for%20Art%20II%20%20to%20Art%20XI%20Conversions.pdf.

6. This estimate is based upon a review of offering plans submitted to the Department of Law over the past five years.

7. Sample pricing provided by HPD estimate ranges for high market areas and low market areas as follows: $273,054 to $112,632 for one-bedrooms, $334,265 to 146,347 for two-bedrooms, $396,018 to $172,163 for three-bedrooms. Prices are estimates provided by HPD for informational purposes only and should not be relied upon by any Mitchell-Lama cooperative.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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