Pitfalls for Buyers: Careful Drafting, Detailed Inquiries Minimize Risk
By: Adam Leitman Bailey & Dov Treiman
January 30th, 2008
Recent case law demonstrates that buyers of residential property with rent-regulated units have been blind-sided by financial risks arising from their attorneys’ ignorance of rent regulatory laws. Although many of these cases go unreported, the recent decision of Newport Partners v. DHCR,1 is typical of the hazards uninformed transactional attorneys can create for their clients.
In Newport, the purchaser of a building had to defend an overcharge proceeding. The seller of the building had, some time prior to the sale, performed extensive renovation work in two apartments, supposedly elevating those apartments out of rent regulation. Two years after the sale, the purchaser of the building had to defend the legitimacy of the rents charged for those apartments, based on the records of the renovations the purchaser had to obtain from the seller. The seller was uncooperative in providing those records to the purchaser.
In the proceedings before the DHCR, the purchaser claimed that it had relied in good faith on the rent registrations filed by the seller. The DHCR found that it is incumbent upon the purchaser of a rent-regulated building to secure records from the seller, including leases, rent ledgers, invoices, cancelled checks, orders and other documents necessary to establish the rents charged and paid.
The court sustained a finding of willful overcharge subject to treble damages, totaling more than $45,000.
Cases like Newport show that new landlords face hundreds of thousands of dollars in overcharge damages in naïve reliance on the paperwork of their predecessors. This article offers an alternative to naïveté with suggestions for well written enforceable contract clauses2 and well conducted due diligence.
Besides restricting a buyer’s ability to evict a tenant, rent regulation also severely limits the rental income a property owner may collect. There are over a million rent-regulated apartments in the City of New York and another seventy-five thousand scattered throughout portions of Nassau, Westchester and Rockland counties and certain upstate cities.3 Even in places where there is no rent control or stabilization, other rent regulatory schemes like Section 8 make understanding New York’s complex residential rent laws crucial when advising a client contemplating the purchase of a residential building. This is true even if the transactional attorney’s duty is completed by answering the first question in these deals by determining the building is unregulated.
In order to increase a building’s income and to prevent potentially financially devastating circumstances, the careful negotiation of the contract of sale is essential.
Rent-stabilized units comprise the largest group of regulated tenancies. To qualify, a building must contain six or more units. If it is a New York City building, it must have been built before Dec. 31, 1973. The operative date is Jan. 1, 1974 everywhere else rent stabilization applies.4 Rent-stabilized tenants are required to have written leases and, subject to delineated exceptions, landlords are perpetually required to offer renewal leases. Once an apartment becomes vacant and the legal registered rent rises above $2,000 per month, the apartment is no longer subject to rent stabilization. During a tenancy, an
apartment may be taken out of rent stabilization if the tenant has reported annual income of $175,000 or more for two consecutive years.
Rent control, enacted in response to the housing crisis following World War II, generally applies to residential buildings constructed prior to February, 1947 in municipalities that have not declared an end to the emergency. For an apartment to be subject to rent control today, the tenant must have been continuously residing in the apartment since before July 1, 1971.5 In addition, any immediate family member living with the tenant continuously for at least two years, may succeed to rent-control status. Rent-controlled tenancies are not required to maintain leases.6
Once a rent-controlled occupant leaves the apartment vacant, the next tenancy may be either free-market for legal rents above $2,000 or rent stabilized below $2,000.
Landlords may elect to take on the burdens of rent stabilization by taking advantage of the “J-51” and “421-a” tax abatement programs. While these are supposed to place the buildings temporarily in rent stabilization, if the leases do not contain language warning the tenant that rent stabilization is coming
to an end, the regulatory coverage is essentially perpetual. Thus, the purchaser’s attorney must examine all of the leases in the building to make sure that they contain the qualifying language.
For the smallest buildings and especially those dwellings being converted to personal use by the buyer, the goal should be to secure a vacant building at closing. A number of building purchasers have attempted eviction proceedings only to find that the building contains some essentially unevictable tenants.
To avoid this financial nightmare, the contract of sale should include a provision postponing the closing until vacancy and including daily penalties for each day the building could not be delivered vacant, allowing the purchaser rescission of the contract beyond some stated date. Because possession constitutes constructive and inquiry notice of a tenancy,7 a buyer should be knocking on every door to assure that supposedly vacant apartments really are unoccupied.
Since entirely vacant buildings are so rare, usually your client will be inheriting tenancies. For tenanted buildings, the contract of sale should include due diligence provisions that will allow one to determine the building’s potential profits or losses and ensure that a closing does not occur until these problems are resolved.
- First, the contract of sale should list:
- The status of all of the building’s units;
- The names of all tenants and occupants;
- The rents being collected;
- Any arrearages owed;
- Representations that no tenant is entitled to rental concessions or abatements; and
- Indications of the status of any proceedings pending involving any existing tenant.
The sales contract should require the disclosure of all past and current litigation. However, even with this provision in the contract of sale, no due diligence report is complete without a search of Housing, Civil, and Supreme Court records to learn whether the building is subject to any court orders or other litigation. A thorough search will also include running the indices on each of the tenants to ascertain who may be particular problems and chronic nonpayers.
To prevent the seller from granting favorite tenants “sweetheart” leases, the contract of sale should restrict the seller from entering into any leases postcontract without the buyer’s permission. However, the buyer will have to use that power intelligently since the buyer may want the seller to renew a lease to quicken the time to regain possession of a unit for an owner’s personal use or for the demolition of a building. Any renewal should be prepared or presented to the buyer for approval before signature.
The contract must not only require that the seller indemnify the buyer for misrepresentations of the status of particular apartments, but must require appropriate proof that each vacant unit was the subject of a legal eviction or voluntary surrender. Similarly, the seller must be held to indemnify the buyer for any judgments or awards from overcharge claims or illegal evictions.
To ensure that the rent listed in the lease matches the rent paid to the landlord, the buyer should demand a copy of all existing and terminated leases of all occupied units as well as recent verification of rent payments such as copies of checks and tax returns. To avoid losing income, the buyer’s attorney should also collect or require at closing:
- A list of security deposits and a provision that provides for transfer of deposits at closing;
- Copies of existing and past litigation including any orders from any governmental agency relating to the property; and
- Documentation transferring any existing service contracts.
No contract should be signed without a permission letter signed by a seller permitting the buyer to review a copy of the building’s records at the state Division of Housing and Community Renewal (“DHCR”). Upon presentment, DHCR will provide a registration statement listing every registered tenant since 1984 as well as every tenant’s registered rent for each year. More detailed DHCR records will list any pertinent orders, such as findings, judgments, or orders reducing a tenant’s rent for reduction of services.
As Newport Partners, supra, teaches, however, reliance on these reports is not enough. They should be compared to the leases provided by the seller, all renewal leases, and the deal sheet. Such a comparison will assist:
- In determining whether the tenants have been charged the correct or legal rent;
- In verifying the legality of the apartments listed as deregulated or free market apartments;
- In obtaining data on any tenants without leases; and
- In discovering any illegal occupancies.
Furthermore, such an inquiry will assist in revealing any potential overcharge claims which could result in treble damages against the buyer and provide the ability to understand any inconsistencies or questions regarding the data.
While it is essential to put appropriate clauses in the contract of sale to protect the purchaser, no buyer’s counsel should place too much reliance upon them. The shrewd practitioner will not believe seller assurances of cooperation after closing, assuming instead that once the seller has the proceeds of the sale in hand, there will no longer be any seller participation in building affairs. Thus, it may be necessary to escrow part of the proceeds to secure against known pending problems in the building.
Similarly, the purchaser’s attorney cannot believe representations of deregulation. Instead, the buyer should attempt to obtain proof that none of the existing tenancies is rent regulated, that the building was never a six-family building before 1974, and that it was never enrolled in any program subjecting it to voluntary regulation.
All buildings built after 1938 and buildings with completed alterations pursuant to a building permit are required to have certificates of occupancy. The buyer’s counsel must obtain a copy of the building’s certificate to ensure that all of the units are being used only in their legally permitted ways.
The extent to which a buyer will assume violations and liens must be negotiated. One must also search the records at the Department of Buildings8 and, in the City of New York, at the Environmental Control Board and the Department of Housing Preservation and Development.9 While it is not essential that all these violations be cleared before title passes, appropriate arrangements for their financial consequences are vital. While there is no substitute for thorough physical inspections of the property, these records will often reveal illegal occupancies, violating the certificate of occupancy.
In order for a Single Room Occupancy (SRO) building to undergo structural repairs and renovations, it is necessary to obtain a Certificate of No Harassment, setting forth that there have been no efforts by the prior owners or the seller to harass the tenants out of the building. Similarly, Interim Multiple Dwellings10 have their own special issues. If the building being purchased was previously used as a factory or warehouse, particularly if it has cast iron architecture, if it is being used residentially, one must check for any proceedings pending before the Loft Board. In a minority of these buildings, residential occupancy is limited to “artists in residence.” To be a qualifying artist, the tenant must be certified by the New York City Department of Cultural Affairs. The failure of such certification leads to the eviction of that tenant, but leaves the landlord only able to rent to one who really is so certified.
Since many residential buildings also contain commercial units, the leases for any such units should be thoroughly reviewed with a search for options to renew, rights of first refusal and any services or repairs the new owner will be required to provide. Most commercial leases require tenants to sign estoppels letters confirming the tenancy and setting forth that the tenant has no claim against the landlord. The sales contract should require the seller to have the tenants complete these letters.
It is a complicated task to purchase a building with residential tenancies. However, with careful physical and documentary investigation, most of the potential traps for an unwary buyer can be revealed. The real crux is for the purchaser’s attorney to commit sufficient time and resources to take all the necessary steps to maximize the client’s profits and minimize the client’s risks. There is no formula for doing due diligence in these purchases. This article merely presents the starting place. The full report will have to note the circumstances peculiar to each unique piece of property.
1. 15 Misc3d 1125(A) (Sup NY Cahn).
2. 101123 LLC v. Solis Realty, 23 AD3d 107 (1st Dept 2007).
4. New York City enacted the Rent Stabilization Law in 1969. In 1974, the state enacted the substantially similar Emergency Tenant Protection Act of 1974. It extends rent stabilization to additional buildings in New York City, and rent stabilization-like regulations in suburban counties.
5. Prior to 1983, even tenancies that began after July 1, 1971 could become rent controlled if the landlord was guilty of a serious breach of the rent stabilization rules.
6. The advantage to landlords in their having a lease is the usual presence of a jury waiver clause. Attorneys’ fees clauses may be either an advantage or a disadvantage since RPL §234 makes them winner take all in litigation over lease violations.
7. Raines v. Moran, 57 NYS2d 800 (1945); In Re Euro-Swiss International Corp. v. Trimble, Marshal and Goldman, 33 BR 872 (SDNY 1983).