Apartment owners and investors that are bumping into regulatory obstacles making it more difficult to buy and sell assets are finding relief with a creative new insurance product. Varney Agency has introduced a first-of-its-kind insurance product that helps to mitigate some of the risk associated with rent overcharges that allow buyers and sellers to go to the closing table with greater confidence.
The product is now rolling out in New York City where the 2019 Housing Stability and Tenant Protection Act (HSTPA) has created an incredibly difficult environment for landlords to own and operate rental apartments. One area of particular concern for the apartment industry is changes in laws governing rent overcharges, as well as rules related to how an owner can destabilize rent-restricted units and amortize costs. “There is a clear need for more affordable housing in New York City, and across the country,” says Patrick Yannotta, senior vice president of Commercial Real Estate at Varney Agency. “However, in our view, the regulations have done the opposite of what they were intended to do, which is to preserve and create affordable housing for New Yorkers.”
Many industry participants believe the regulations are contributing to lower supply and lower quality of housing. The regulations have disincentivized owners to repair, maintain and improve existing properties. In fact, there are an estimated 40,000 to 50,000 rental units sitting vacant in New York City. Landlords are holding these units vacant or in disrepair because it doesn’t make financial sense to repair or renovate the units if they can’t recapture that investment with higher rents. In addition, HSTPA opened up significantly greater risk in the area of rent overcharges by extending the statute of limitations for rent overcharge claims and allowing courts to look back at apartment rent histories over a significantly longer history, potentially decades.
Brock Emmetsberger is one multifamily investment sales broker who has experienced those challenges firsthand. Late last year he was selling an apartment building with rent regulation where, due to the HSTPA, the client faced newly assumed potential rent overcharges – at no fault of his own. The seller had no control or knowledge of decisions that were made by previous owners of the building back in the mid to early ‘90s, and yet he is now being held accountable for those prior decisions.
“At the time, I kept thinking – how is there not insurance for this,” says Emmetsberger, a senior managing director at B6 Real Estate Advisors. He called Yannotta and asked him if that type of insurance existed. He said it didn’t, but he would look into it. “I knew if I could go to anyone who would successfully be able to create such a policy and help mitigate overcharge risk, it was going to be Pat and the creativeness that Varney has,” he says. This new product has the potential to eliminate significant risk associated with rent overcharges, which will be especially impactful in a market like New York City where close to half the housing stock – roughly 900,000 units – are rent-regulated. “Depending on how it’s delivered, this product has the ability to tremendously change the current market dynamics,” he says.
Impediment to sales activity
The new rules and regulations have created a chilling effect within New York City’s multifamily investment market. Owners face challenges when trying to sell assets, with prices being discounted due to rent overcharge risks. On the other side of the table, buyers that are trying to purchase assets are having a more difficult time getting comfortable with the risks. There is more paperwork and documentation required to prove that units have been legally deregulated – some of which are difficult to find or no longer exist. “It seems like over the years, the goalposts have moved significantly, in terms of what was acceptable and legal to what they are today. It really has become a challenge to comply with the rules,” says Yannotta.
Policy changes have placed more obligations on property owners to demonstrate that past rents, even charged by past owners, were increased in a legal manner which requires significant proof that improvement expenses were paid and new rents were calculated properly. “The key concerns for buyers and sellers today mainly revolve around the reality that the physical building is a secondary consideration when doing a risk assessment of the investment opportunity,” says Bob Knakal, head of the Private Capital Group for JLL in New York. “The primary consideration is the paperwork and files that support the property’s operation. And given that the new owner is responsible for the misdeeds of all prior owners, volumes and volumes of documents need to be reviewed and understood,” he adds.
Another issue that is adding to frustrations for owners and sellers is that New York State’s Division of Housing and Community Renewal (DHCR), which is in charge of enforcing those rules, has been inundated with requests that have created a processing backlog that now stretches nearly four years. There are several thousand cases pending that will provide new case law in the area of rent overcharges. “There needs to be greater clarification on what can and can’t be done, but it is going to take years to get through that process,” says Yannotta. In the meantime, owners and investors are trying to transact in a market where there is a lot of uncertainty and potential risk.
“The environment that we’re in now has created a tendency to be conservative when it comes to due diligence,” says Marino. There seem to be a lot of buildings on the market that are running into issues with regard to rental history for various reasons. In addition, there is still a lack of clarity on how case law is going to be applied, which is contributing to more caution from buyers. Some buyers are shying away from deals where there is uncertainty or lack of documentation, while others are using it to negotiate a lower sale price, he adds.
Varney develops a creative solution
Varney Agency worked with some of the most experienced investment sales brokers, multifamily investors, and attorneys in New York City to find a solution to the problem. The result is a new insurance program that rolled out in June that helps mitigate risks associated with potential rent overcharge exposure. “Our program was designed to help owners and investors either sell or get comfortable purchasing a property knowing that they have some sort of protection on the back end,” says Yannotta. “This is really a creative solution that has never been done before.”
The Varney product was designed to take place at the transaction level. The insurance provides coverage when title and deed is passing from one entity to another. It’s not designed for use by bad actors who want to buy an insurance policy to protect themselves against issues that they created or that they know exist. The policy provides coverage against some of the unknowns. For example, adhering to the new regulations means digging up leases or contracts from work that was done 15 years ago. “That is extremely difficult. So, our program is designed to help at the transaction level, and it will provide coverage for the rent overcharge as a result of an adverse decision by the DHCR,” says Yannotta.
The insurance product will provide coverage for defense costs and also pay for any rent overcharges and penalties that may be deemed by the DHCR. Policy limits are up to $2 million per building. The premium of roughly 10% to 15% of the coverage is a one-time cost at closing with coverage that will be in place for two to five years depending on individual policy underwriting. Effectively, it is a contingent liability solution that will be attached as an endorsement to a rep’s and warranties insurance policy at closing.
“The new rent overcharge insurance coverage offered by Varney Agency will benefit apartment investors, and the broader apartment building market by eliminating some of the uncertainty that has been embedded in the system,” adds Knakal. “Markets dislike uncertainty and anything that minimizes uncertainty is welcomed by the markets. Investors will be able to sleep better at night knowing that if they missed a detail, it will not come back to bite them.”
Varney Agency rolled this program out in New York City because it is at the forefront of rent regulation. However, many of the large cities across the country are beginning to adopt some form of rent regulation, and the agency expects that the new product will be able to help landlords across the country. Bob Desrosiers, Managing Director of Equity at Varney Agency notes, “The effect of a policy like this is cleaner and faster deal execution. We view insurance as a tool that investors can use to solidify their position on a building and create more reliable projections as an overcharge claim will be covered and not hit the bottom line in the early years of ownership when capital is earmarked for upgrades or efficiency projects instead of being diverted to defend claims.”
Taking the initiative to address a problem with a creative solution is par for the course at Varney Agency. The family-owned business has deep experience in the insurance industry that spans nearly 50 years, and the firm prides itself on taking an entrepreneurial approach. It’s this approach that has led us to focus our expertise on specific industries, such as the Real Estate and Development Team which is headed up by Jack Cowie and Pat Yannotta. “As a firm, we look to create solutions to problems within any industry,” says Yannotta. For example, to help clients manage rising insurance costs they introduced a program called RE-PAID that allows top-performing clients to earn back up to 50% of their annual premium. “We recognize that the traditional insurance landscape is presenting significant headwinds with respect to cost and the capacity of these insurance companies, and we try to be as innovative as possible in a very challenging market to help our clients find solutions,” adds Yannotta.
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