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