Is My Building Eligible For a Sub-Rehab?
Is this property eligible for substantial rehabilitation (sub-rehab)?
This question often comes up now that other paths to achieving fair market status for apartments – and thus unlocking the robust rent growth that NYC has to offer investors – have been closed off. The data supports the common sense view that substantial rehabs would increase in response to tighter regulations. According to data collected by NYC's Rent Guideline Board (RGB), the number of units that became "permanently exempt" from rent regulations via sub-rehabs in 2023 more than doubled the average number for the metric in the trailing 9 years. And yet, while sub-rehab units are surging, investors with boots on the ground understand that getting approvals for sub-rehabs has grown more complicated and fraught with risk.
The Sub Rehab
If you are unfamiliar with the sub rehab, you are lucky and have not had to deal with the long winding process. Substantial rehabilitation, or sub rehab for short, allows investors to thoroughly renovate 75% of building systems in vacant or near-vacant apartment buildings in exchange for exempting those buildings from rent regulations.
NYC's Housing and Community Renewal (HCR) agency is charged with keeping NYC's housing stock affordable. It does not encourage removing units from the rent-regulated pool. Still, in cases where investors are willing to spend big money on reinvigorating properties that have long been vacant, it says, "Okay, that is a fair trade" to stave off what could become an urban blight or at least unusable housing. Investors seeking additional information on substantial rehabilitation can look at the Operational Bulletin 95-2, which details the requirements. I also provided readers with a *rough* sketch of the process of how to obtain the sub-rehab designation in a prior article here.
Investors didn't use the sub rehab mechanism historically because other pathways to making apartments free markets were easier and less costly. Consider the graph below to understand the relative prevalence between decontrol via other channels and the sub-rehab approach. To highlight this point, look at 2015, where 3400% more units were decontrolled via high rent/vacancy methods.
Looser rent regulations (i.e., lots of immediate upside in rent)
+ favorable capital markets
+ lax lending rules
= Very active investment sales period in the mid-2010s in NYC
So, sub-rehabs gained popularity because they became the only way to pro-actively turn rent-stabilized buildings into free-market properties. This is different from purchasing a 421-a or J-51 property and having the opportunity to decontrol units as-of-right when both tenants move out and tax abatements expire. Attorneys generally agree that, at the very least, the abatement must expire before units become fair market – and sometimes, this requires tenants to move out from the units as well. Either way, the investor is not actively making something happen but is waiting for something out of their control to happen to get free market status.
Key Changes
But there is more to the story than this because key events have taken place since the beginning of our timeline in 2014 that directly affect the viability of sub-rehabs. The big ones are 2019's Housing Stability and Tenants Protection Act (HSTPA), the advent of COVID-19, and Senate Bill 2890 C, which amended the ETPA of 1974 in 2023 to close the Frankenstein loopholes and make sub-rehabs harder to perform.
2019’s HSTPA:
With this bill, lawmakers removed the tools investors previously used to raise rents on rent-regulated properties. Further, it generally outlawed the removal of units from rent stabilization that didn't have special circumstances (e.g., tax abatement or sub-rehabs). Since the law's passing, cap rates have surged, and rent growth has slowed.
COVID-19 (mid 2020- early 2022)
Less than a year after HSTPA's passing, Covid-19 induced business closures, which cause uncertainty and confusion in real estate markets. When interest rates tanked some investors rushed to borrow cheap debt and do projects. Others, rushed to complete filings with DHCR to grant their units exempt status from work completed the year before. The uncertainty froze a lot of the retail and mixed-use market, and it encouraged select multifamily -transactions in a 'second-wind' post-2019.
DHCR Amendments (Fall 2023)
Though the hammer came down on the multifamily industry in 2019, there were still some narrow avenues to raise rents meaningfully and grow NOI. The primary method was to combine units (or separate two units) and set first rents. By combining or separating apartments, investors created new apartments that didn’t have prior rent histories. With no rent histories, the thinking went, owners could set the rents of apartments at whatever levels the market would bear and thereafter enter rent stabilization. This became quite popular.
There was a looser approach to sub-rehabs as well. Prior rules allowed investors and DHCR to assume that properties that were 80% or more vacant in fact needed substantial rehabilitations. So, in a post-2019 world, steely investors got on with it and made reconfigurations of apartments raise their rents above and beyond what RGB allowed. Investors set first rents, and when the opportunity was appropriate, they performed sub-rehabilitation.
Fall 2023 HCR amendments don’t get talked about much, but they were very damaging to investors who were still hungover from June 2019 rulings – and on the verge of facing the surge in interest rates. The rule changes removed most of the incentives to re-configure apartment perimeters.
Instead of setting first rents, “…where a landlord combines two or more vacant rent-stabilized apartments, the legal, regulated rent for the combined apartment shall be the sum of the rents of the formerly separate apartments.” Senate Bill 2980-C
Instead of a presumption that sub-rehabs are appropriate, the new law requires that owners file their substantial rehab within a year of completion and prove that a) there was no harassment to obtain vacant units and b) show that the building indeed in a substandard or seriously deteriorated condition requiring substantial rehabilitation. - Senate Bill 2980 – C
Interpretation
The number of sub-rehab units converted to fair market remained steady for the last nine years before surging in 2022 and 2023. This fits neatly with the timeline of legislative changes. Before 2019, sub-rehabs were not very compelling. After 2019, things picked up. Though the # of units sub-rehabbed didn't increase until 2022 and 2023, properties were bought and renovated during 2020-2022 before obtaining finalized paperwork from DHCR indicating their status. In other words, the big numbers produced in 2023 were probably from applications and petitions planned years before the DHCR amendment made it harder to get sub-rehabs approved.
Now that the burden of proof showing that a property deserves/needs a sub-rehab application has been shifted to the property owner or investor, I expect these applications to slow down. It will be an uphill battle to prove fair market status on these properties. Some owners I know have petitioned DHCR for a prior opinion letter or a binding determination letter and been rejected. Readjusting the business plan because HCR knocked it will cost a pretty penny, and many investors won't want to risk it.
So where will capital go in the short term?
1- Core/core+ 421-a properties.
I wrote about this previously, but this is just where capital must go. 421a statutory deregulation of apartments is now the only reliable method to decontrol apartments en-masse. Moreover, investors can achieve scale when buying these properties. Finally, the capital markets are kind(er) to these buildings than small properties. Agency spreads over treasury yields have come in, and with rate buydowns, investors are securing spreads as thin as 160 basis points over the treasury yield.
2- Sub-rehabs will still get done.
With rent growth in core Manhattan showing no sign of slowing down, market rents continue to grow in the outer boroughs with Brooklyn as the main beneficiary. When market rents cross a certain threshold in tertiary locations like Red Hook, Sunset Park, Flatbush, Midwood, and East Flatbush that presumably have run-down properties, the incentives to do sub-rehabs will eventually be there, and the cost-benefit analysis will say to do the deal.
We just completed a sub-rehab transaction like this. If you are curious about the viability of a sub-rehab on your property, please reach out.
I am bullish on NYC multifamily.
Best Regards,
Romain Sinclair
646 326 2220
Sources:
(2) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2023”
(3) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2022”
(4) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2021”
(5) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2020”
(6) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2019”
(7) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2018”
(8) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2017”
(9) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2016”
(10) Rent Guideline Board “Changes to the Rent Stabilized Housing Stock in NYC 2015”