Major Capital Improvements (MCI’s) – A Real Incentive for NYC Landlords with Regulated Units

  

Say you have a building in upper Manhattan that has a majority of apartments that are renting for well below market due to rent regulation. Your rents are so low that  no one ever moves. After all, where could they possibly get a comparable deal? Year after year you see your tax, water/sewer, and heating bills go up, often by double digit annual percentages. Yet, when the Rent Guideline Board comes out with their annual determination, the “evil landlords” are rewarded with a 2% rent increase on one-year leases and a 4% increase on two-year leases. Wow! You’ll be lucky if that increase covers half of your increase in expenses.

One of the few tools that landlords have to combat what might otherwise be an ever declining net operating income is the Major Capital Improvement (MCI) law. Some time ago, DHCR saw that there was no incentive for financially pressured landlords to reinvest in a building’s infrastructure. Yes, sometimes having to buy a new boiler or a new roof is unavoidable, but given that landlord’s were effectively getting a 0% return on MCI investments, there was a tendency to let many rent regulated buildings decay. The MCI law changed that.

Under the law, certain capital improvements can allow a building owner to garner rent increases that are in addition to the often minuscule RGB annual increases. Specifically, so long as an item being replaced has reached it’s “useful life,” you are allowed to effectively recoup your investment over a seven year period, i.e. 84 months. DHCR has determined what improvements qualify and has assigned useful lives to all the items. (qualifying MCIs and useful life). Yes, the application process is a bit bureaucratic and DHCR has been taking forever to process MCI applications these days ( due to personnel cutbacks, it now generally takes a  year or more vs. what used to be as little as 3 months), but where else can you get as high as a 14.28% annual return on your investment these days, with minimal risk?

How do you get that return? Well, assuming you do a qualifying MCI, say a new roof, and DHCR approves your application, you get to take the cost of the improvement, divided by 84 (the number of months in seven years), and increase your aggregate monthly rent by the resulting amount. Thus, if you spend $84,000 on new windows throughout your building, you get to pass $1000 per month in added rents onto your tenants (assuming they are all regulated units). The actual allocation of that $1000 is proportionate to the number of rooms in each apartment. In other words, if there are 100 rooms in the building, a 5-room apartment would get 1/20th of the total monthly MCI increase assigned to it.

The 14.28% return will get trimmed back if you have commercial space in your building as DHCR can view stores as “benefiting” from the MCI. Thus, a portion of your spend doesn’t get to pass through to your residential tenants. Also, if you have unregulated apartments, you can’t pass on an increase to them. Furthermore, if you have any regulated apartments that are effectively already at market, perhaps with preferential rents, it might not be prudent to hit the tenants with an MCI increase if it could cause them to move out. Furthermore, there is the time between when you invest in the MCI and when you receive a DHCR order that grants you a rent increase. However, note that DHCR also grants something called a “temporary MCI increase” which effectively allows the landlord to recoup the lost increase from the time the application is docketed until when the order is granted. Docketing usually seems to take place within a couple of months of receipt of the application by DHCR.

Another nuance is that you can’t increase a rent stabilized tenant’s rent more than 6% a year from MCIs (15% for rent controlled units). This 6% includes both pass through of permanent and temporary MCI increases. If you hit that cap, you don’t lose the benefit, you just have to consume it the balance over 6% in the subsequent year(s). This is another factor that can whittle a bit more away from my 14.28% number.  So, if an MCI is going to cause a $100 rent increase to a $1000 apartment, you can only take $60 of the increase this year and the other $40 gets added a year later. If you start hitting the cap and find yourself with multiple overlapping MCIs, and multiple temporary MCIs, you’ll need a strong spreadsheet guru in house to properly manage and calculate increases on a unit by unit basis. The whole thing gets further complicated by the fact that the “legal rent” that is used for all future renewal rent calculations goes up by the whole MCI the moment it is approved, even if the 6% cap will take 3-4 years to consume.

This last nuance is something almost no one I’ve meet in our business, even specialized consultants, understands. It doesn’t make that big a difference, but it can add a few dollars per month across all your apartments, which only gets further compounded over time. I only learned about this fine point by visiting DHCR some time back and asking questions of a really responsive supervisor at their Queens offices. At that meeting I was handed an opinion letter which is linked here and answered all sorts of complicated questions that come up that most people in our business can’t properly answer. I’m willing to bet that no one reading this blog has seen this letter before, but that many of you will know someone that can benefit from it.

Though I’ve pointed to a number of things that can reduce your effective return from your MCIs—delayed approval by DHCR, 6% caps per year, the negative effect of commercial space, and the impact of market rate units, don’t forget that the gains you get awarded are then compounded every year that you do a renewal lease (since the MCI becomes part of the base rent). Thus, over time, the real return can conceivably exceed 14.28%. Furthermore, if you figure that a well maintained building in upper Manhattan can now fetch 10X gross rent roll, then a $70,000 MCI, which can increase rents by $10,000 a year (1/7th), would have the impact of increasing the building’s value by $100,000 ($10K x 10). In the case of a building where a buyer is focused on the cap rate, the value from that $70,000 investment might be even greater. So you get added cash flow now and a kicker if/when you sell the building.

The bottom line is, if you have the cash, have predominantly below market regulated rents, and have items that in your building that are at their useful life, you MUST do MCI’s. And if you’re in a position to refinance at today’s crazy low rates, try to pull out some extra principal that you can plow back into your building via MCIs. If you can borrow at 3% and get a 10%+ return on that money, wouldn’t you do that all day long?

If you have any questions on MCIs, would like to simply talk shop, or are looking for a knowledgeable, hands-on, tech-savvy property management company, I can be reached at 212-203-5613 or mvinocur@bemnyc.com.

Michael Vinocur
Building Equity Management LLC

Rent Controlled vs. Rent Stabilized — Don’t Fear Rent Controlled Units

It’s funny. Those buying into the regulated multifamily market often fear rent controlled apartments as though they are dead units. A landlord might have a 30-unit building with a few rent controlled apartments, in many cases paying less than $250 per month, and treat those apartments as having a frozen rent until the passing of the typically elderly tenant. This is not true.

In one of my buildings in Washington Heights, the combined rent from our three rent controlled units, when we purchased the building, was approximately $750 per month. Incredible, huh? Now, about 10 years later, with the same tenants in place, our combined rent for these three units is over $2350. That’s equivalent to 12% annual rent growth without a vacancy. It also probably equates to a $200K increase in the value of the building.

How was this possible? Through a combination of MBRs and MCIs and fuel cost adjustments. For those not savvy with the acronyms of DHCR (Division of Housing and Community Renewal which I think has now been rebranded as HCR, Housing & Community Renewal), MBR stands for Maximum Base Rent and MCI stands for Major Capital Improvements. Underlying the MBR law is an understanding by New York State that a landlord can’t properly maintain a building/apartment if the rent never goes up. Under the law, there is a formula that establishes the maximum rent that can be charged on a rent controlled apartment as a result of the increases I’m about to describe (this is different from the actual rent being charged and generally much higher). And so, you can take advantage of MBRs and MCIs until you hit this maximum base rent. The dollar amount is specific to each particularly apartment and is determined by a rather convoluted process beyond the scope of this blog, however once established, it is registered with DHCR and continues to go up every year by a published adjustment (which is more inline with the annual rent control board increases well below the 7.5% figure described below). On our three units that I described earlier, our maximum base rents are all above $1100, so it will be years, if ever, before I ever risk hitting that ceiling.

MBR Increases
MBR increases are typically 7.5% per year. They are approved for a two-year cycle based on an application that must be submitted to DHCR. Many months after submitting your application, you get a Maximum Base Rent Order of Eligibility which gives you legal permission to charge the increases. We use an outside consulting firm to file for us as they have greater expertise than we do and their fee is well offset by my not having to do it myself. Plus, I only pay the fee once, a percentage of my rent increase in the year granted, but I get the benefit forever. The increase compounds over time, so using a firm to file ends up being a reasonable upfront cost. If your increase doesn’t get approved until after January of the first year of the two-year cycle (which is always the case since, like every NY/NYC agency, they are backed up), you can then charge the tenant retroactively for any missed increases. On year two of the cycle, you already have your approval in hand, so on January 1 of the 2nd year of the cycle you automatically can take your second 7.5% increase.

What else do you need to know? Your building has to be relatively clean, i.e. fairly free of HPD violations. In fact, you must be able to show that you’ve removed 100% of rent impairing violations (C violations) and at least 80% of the other prior year’s violations. You don’t, however, have to invite HPD in to inspect and clear them of record, though that is not a bad idea at some point. You can simply have a licensed architect write an affidavit that affirms that you have removed enough violations.

As an aside, I was at an RSA meeting this past week where I heard the horror story of a gentleman who had invested in regulated units within a co-op, where some tenants at time of conversion had remained as renters, which clearly was their right. This fellow owned at least one rent controlled unit in this co-op. However, he couldn’t get MBRs because the building had too many violations. He was in the unfortunate position of owning in a building with terrible management, who had no incentive to fix violations. As a result, the apartment owner’s rent was frozen, seemingly forever! I believe his monthly maintenance fee to the co-op now exceeds the rent he gets. I really felt for the guy. He’s in a terrible position. At least I learned the lesson to not own rent controlled units in a building that is controlled by someone else.

MCI Increases
State rent laws allow you to gain rent increases across all regulated apartments for a specific list of major capital improvements done to your building. These include new boiler, windows, doors, electrical, plumbing systems, roof, etc. I’ll leave the nuances of doing MCIs for a future blog, but the bottom line is that you are allowed to amortize your investment over 7 years, or 84 months. The expense gets spread across all your apartments based on the proportionate number of rooms in each apartment relative to the building. One restriction is that if you do a really big MCI you are restricted as to how much you can pass through as a rent increase in one single year in order to not slam the tenants to hard in a single year (though you can carry forward excess amounts and capture them in future years). On rent stabilized apartments that annual cap is 6% of the base rent of the unit. For rent controlled units, however, it is 15%! And realize that if you do a reasonably expensive improvement, and your rent controlled apartments have very low rents, it’s not that hard to reach this 15% level.

What does this mean? In those years where you have significant MCIs as well as file successfully for MBRs, you stand to get 22.5% increases on the rent in your rent controlled units. Not bad, huh?

You can add further to this by annually filing for Fuel Cost Adjustments. Unfortunately, these adjustments only look at increases going forward, so if you never filed before, you can’t get the benefit of all the cost increases in the last several years. Still, going forward, you at least know you will get a rent kick if your fuel costs go up. I’m not sure how effective this will be for us in the future, now that we are heating with gas, but with #2 oil, our fuel surcharges have been adding a good 15% to the rent of the tenants.

The bottom line is that, in many ways, a rent controlled unit in your multifamily building has better rent growth potential than a low priced rent stabilized unit. In fact, within a couple more years, in the building of ours I used as an example, we are going to see the rents in our rent controlled units exceed those of our lowest stabilized units. Though brokers will always pitch you about a building’s upside if rents are low, if they are too low, people never leave (unless they are open to an expensive buyout). Thus, if we look only at those units where the tenant is never going to leave, you stand to increase your rent roll faster with units that are rent controlled rather than with ones that are rent stabilized.