No more Frankenstein loophole 👻

Halloween is gone and DHCR made sure it took Frankenstein with it

The “Frankenstein-ing” of apartments, or the combination of apartments for a higher rent than the sum of previous rents, will be no more come next Wednesday. That is to say, the ability to set “first rents,” on apartment units after the combination of two or more formerly rent regulated apartments will still be possible, but doing so will be devoid of any economic incentive. A de facto ban. Earlier in the week, DHCR filed a “notice of adoption” to let the public know that this was coming. I wrote about this a year ago when an announcement was made initially proposing the changes, and you can click here to get more background information.

Attorneys from Belkin, Burden, Goldman summarized the key changes happening Wednesday as follows:

• When two rent-stabilized apartments are combined, the new legal rent is the combined legal rent of the two apartments, plus applicable increases.

• When a rent-stabilized apartment is combined with a non-regulated apartment, the combined unit is now rent-regulated.

• Where the space of a non-regulated apartment is increased by adding space from a regulated apartment, both apartments are rent-regulated;

• When the space of a regulated vacant apartment is increased, the rent for the new space shall be the prior legal rent, plus an increase equal to the percentage increase of the space, as well as other applicable increases; and

• When the space of a regulated vacant apartment is decreased, the rent for the new space shall be the prior legal rent, plus a decrease equal to the percentage decrease of the space, as well as other applicable increases.

• (Substantial rehabilitation) – DHCR has removed the presumption that a building which is at least 80-percent vacant is in significantly deteriorated condition and removed exceptions to the otherwise required replacement of building-wide systems where those systems were recently installed or structurally sound.

Things to think about:

• What does this mean for the value of partially vacant apartment buildings? The loans that underwrite them?

  • The value of rent stabilized properties in NYC has been on a steady decline since the summer of 2019. The HSTPA of 2019, Covid-19, and the ensuing spike in interest rates happened one after the other, and lead to a downward slope in values. This new rule set is more news from the state that is bad for real estate values. Another avenue for the raising of rents has been closed off. That means those select situations and opportunities for upside from contiguous vacant apartments are now closed. This hurts the market. This lowers property values. This adds more distress since loan values won’t change but equity values will. This is straightforward if you’ve been an active market player. Let’s go a bit deeper

  • This ruling raises the holding costs for partially vacant rent-stabilized buildings. Since the rent laws of 2019, half empty 6 family buildings were always odd commodities, far and away from being the belles of the ball. Investors wanted empty buildings to be renovated completely via substantial rehabilitation. Investors would begrudgingly take partially occupied properties and hope to Frankenstein units, or work other angles, like make use of spreads between preferential and legal rents. Now that “Frankenstein-ing” is gone (or will be, as of this Wednesday), properties like these will take longer to sell. Incentives for buy-outs decline and buildings stay in this limbo world of not-yet-vacant, but rents too low and units too run down to occupy with tenants. That means taxes, insurance, and traditional expenses must be kept up for longer before sales can be consummated. Owners will be pressured to fill up their empty units so as to cover their expenses, further pushing their buildings away from the much desired vacant properties which sell for more. Speculating on assets like these was made a lot harder by 2019 rules. This just made it a bit more difficult.

• Does this take the pressure off Governor Kathy Hochul?

  • It is rumored that Hochul is going to have to “trade” Good Cause Eviction in order to get the 421 a tax abatement, responsible for ~70% of multifamily building development from 2010-2022, passed by both houses of government. Bill S2980C lies at the Governor’s desk and proposes many of the changes that DHCR is passing this Wednesday to de facto repeal the Frankenstein practice. If DHCR takes the responsibility of passing these sweeping changes without the need for gubernatorial approval, it could put Hochul in a more flexible position when negotiating for more developer friendly policies. This could allow Hochul to at once tell tenant advocates that she facilitated Anti Frankenstein legislation, and to avoid getting too much flak from REBNY, CHIP/RSA, and other landlord groups that she otherwise would have received resistance from had she been personally responsible for these changes (like if she signed bill S2980C).

Sources:

(1)    Belkin Burden Goldman LLP – DHCR Adopts Significant Amendments to Rent Regulatory Provisions

(2)    DHCR summary of changes

1. Rent Stabilization Code (RSC)

2. Tenant Protection Regulations (TPR)

3. State Rent and Eviction Regulations (SRER)

4. City Rent and Eviction Regulations (CRER)