The space has been selected, the business terms agreed upon and a contract prepared for attorney review. If the property is a commercial condominium or co-op, review of the building’s financial statement is essential. It gives a snapshot of the building’s financial condition. This is part and parcel of pre-contract signing due diligence, which also includes review of board minutes and building-wide operating documents—especially the offering plan if it’s a new(ish) construction—discussions with the managing agent, and engineers’ and architects’ inspections and reports.
Today, commercial condominiums and cooperatives (retail, office and medical) are becoming increasingly popular alternatives to leasing space. Advantages include building equity, predictable occupancy costs, tax advantages, and no business interruption by reason of required lease renewals. The goal of attorney due diligence is to establish that the unit and the building are in reasonably good condition—physically, financially and as to management/co-owner matters.
Yes, it does make a difference if the deal is condo or co-op. In a co-op, the co-op corporation is responsible for the underlying building mortgage and real estate taxes. In a condominium, each unit owner alone is liable for mortgages and taxes on his unit. So co-owners in a cooperative building are far more dependent on each other (through maintenance charges to pay the mortgage, taxes, etc.) than are owners in a condominium (separate tax lot/liability for mortgage, taxes, etc.).
To start, ask for the past three years of financials, as that information will be important to get a clear picture of where things have been and where they’re going. Are the statements audited in accordance with GAAP? Some lenders insist on audited financials. Then we look at the balance sheet (which also shows cash reserves) and statement of income and expenses. On the balance sheet, check the cash reserve fund. Is it adequate to take care of major repairs? If the space is a co-op, is it adequate to fund the refinancing of the underlying mortgage? Or would these costs be the subject of a substantial increase in maintenance charges or common charges or possibly an assessment against all owners? (That word “assessment” is obnoxious per se as it means a substantial additional expense and, typically, a diminution in the value of the unit.) The rule of thumb here is that the reserve fund should be an amount equal to 25 to 35 percent of the annual budget.
As to the statement of income and expenses, a simple first question: Is income sufficient to meet current expenses? This does not mean that the building has to be run at a profit—some successful buildings carry a chronic deficit—but we evaluate the likelihood that monthly charges will have to be increased to meet any shortfall or to cover any special assessment that is imposed. (Per co-op/condo accounting specialist Ira Fox of Faber Fox & Co., make sure you look at income before depreciation and amortization to get the right picture.) Does income reflect any extraordinary, non-recurring items such as an insurance recovery or a special “tax” on owners’ transfers (a so-called “flip tax”)? In the co-op scenario, are there any footnotes concerning imminent expiration of the current mortgage? Are there any arrears? Is co-op income sufficient to comfortably pay mortgage and tax payments? What is the tax abatement status (taxes may rise precipitously at the end of an abatement program)? Are there any big variations in owner arrears? Is there any pending litigation? Generally, we laser in on any line items that may have the effect of significantly increasing common charges or maintenance or precipitate an assessment.
Lastly, I never underestimate the value of second opinion, so while I may come up with issues, I leave it to a qualified accountant to have the last word on this topic.
Jeffrey A. Margolis, Esq., is founding principal of The Margolis Law Firm in New York City, where he specializes in “dirt law”—buying, selling and leasing. He writes monthly for The Commercial Observer on legal issues.