Condemnation—Project Influence Rule— Air Rights

This decision involved a condemnation comprising of three apartment buildings, containing 40 apartments located in Brooklyn (properties). The “taking” took place on Jan. 27, 2009. The condemnation occurred in connection with the creation of “Willoughby Square” (project). A key issue was “whether the properties should be valued based on the zoning in place at the time of vesting.” The properties were zoned C6-4.5 at the date of vesting (vesting date). The properties had previously been zoned C6-1. They had been rezoned on May 9, 2004.

The claimant argued that “the properties should be valued based on the C6-4.5 zoning that had been in place for five years on the date of vesting.” The city countered that “the upzoning to C6-4.5 was part of the project for which the property was taken and therefore could not be used to value the property pursuant to the project influence rule.”

The court held that “the rezoning to C6-4.5 was part of the project for which the properties were condemned and pursuant to the project influence rule, the properties should be valued based on the prior C6-1 zoning.” The city had also contended that appreciation in the value of properties in the neighborhood had resulted from the Project and “should be disregarded pursuant to the project influence rule.”

The project influence rule provides that for condemnation purposes, the value of a property “should be neither enhanced nor diminished by the impact of the project….” Here, the “properties were part of the…plan that included the creation of Willoughby Square, as well as several other actions and re-zonings that were part of the Downtown Brooklyn Plan” (Plan). The Plan and related land use actions were intended “to encourage the development of office buildings in downtown Brooklyn.” The court noted that since the properties “were slated to be condemned for over five years before they were actually taken, their value would not have increased but would have been depressed by the impending condemnation.” Most of the development that transpired “in the…vicinity since the re-zonings in 2004, was for hotel and residential development, rather than office buildings.” Thus, such development had not been the result of the project, which was intended to encourage office development, “but a result of the investment backed expectations of real estate investors who believed the area had a different highest and best use than that envisioned in the plan.” Moreover, nearby development resulted in part from “the impact of other projects,” e.g., MetroTech and Atlantic Yards. The court opined that “[t]he impact of these other projects would not fall within the project influence rule.”

The properties included 38 rent-stabilized apartments. Appraisers for both the city and the condemnee (claimant) agreed that given so many rent-stabilized tenants, it was “not feasible to vacate and demolish the buildings to redevelop the land.” Both appraisers concluded that “the highest and best use of the buildings” were as rental housing.

The city's appraiser (city) valued the property at $1.75 million. The claimant's appraiser (claimant) valued the property at $7.1 million. Each party employed “the income capitalization approach and the comparable sales approach” and the values determined by each approach were “not significantly different.” However, the claimant also included a $2.1 million dollar value for the sale of unused development rights (TDRs). The city accorded no value to the TDRs. The court explained:

Both the income capitalization approach and sales comparison approach are appropriate to value an existing income producing residential building, particularly where the actual income and expenses of the property are known. Generally, the sales comparison approach can provide more accurate indication of value when dealing with rent stabilized buildings.

The…buildings are rent stabilized properties and any increases in rent are limited by the rent stabilization law. The building's average rent…is significantly below the market levels for the area.

The claimant noted that “properties similar to the [properties] are not purchased for their current rental income alone but rather for the potential of realizing higher levels of income upon the turnover of statutory tenancies. This is particularly so for large rent stabilized buildings in gentrifying areas that have rents significantly below market.” Rent stabilized rent rolls may be “increased by aggressively evicting…statutory tenants,” making “major capital improvements (MCI)” and making improvements in individual apartments once they become vacant (IAI). The court noted that the sales comparison approach advantage is that “it captures the amount that investors are willing to pay for the potential to significantly increase the rents of rent stabilized buildings, even though it does not separately breakout how much of the purchase price reflects that potential.”

However, the court did not rely on the sales comparison approach of either appraiser, since “neither indicated which of the comparable sales were rent regulated.” That “information is restricted by statute to the owners and tenants of a particular apartment, and thus not available to appraisers, without knowing which comparable sales are rent stabilized an income capitalization approach based on actual income provides a more accurate indication of value.”

There were slight differences in the parties' potential gross income projection. The court adopted the claimant's potential gross income and applied a 5 percent vacancy and collection loss deduction. Additionally, the claimant challenged the city's capitalization rate as too high and argued that “capitalizing the effective gross income (EGI) by an income multiplier is a better method than dividing the net operating income (NOI) by a capitalization rate.” The claimant explained that “typical investors looking to buy apartment buildings, similar to the subject buildings, do not decide how much they are willing to pay based on capitalizing income after expenses but by an income multiplier.” He asserted that the foregoing is true “because the income figures on residential properties are less susceptible to manipulation than expenses and because an income multiplier is easier to work with for relatively simple buildings.”

The court found that “the gross income multiplier (GIM) is a more accurate method of capitalizing their income.” However, the court noted that the claimant had not provided adequate “support for his effective gross income multiplier (EGIM) of 14.” The court cited a study that showed the average GIM for multifamily housing for the second half of 2008 was 10.5. That demonstrated that investors were paying on average 10.5 times the rent roll for multifamily properties in Brooklyn” and that the purchase prices for such properties included “an increment over the value of the current rent roll, reflecting the expected upside of the potential of increasing the rent roll.” The court concluded that the average of 10.5 was “the most appropriate multiplier for the subject buildings' income” and the capitalized value for the buildings of $3,958,857.

The city countered that such building value resulted in “an unrealistically low capitalization rate of 2.4 percent.” However, the court opined that a $3,958,857 value resulted in a capitalization rate of 2.98 percent and that was “within the range of the actual capitalization rates of 1.99 percent to 3.77 percent of the city's…comparable apartment building sales.”

The city had deducted “$746,000 from the capitalized value of the building's income for the estimated cost of building wide capital repairs” that had been recommended by the city's Dep't of Housing Preservation and Development (HPD). The HPD report did “not contain violations but only recommendations….” These were only “suggested repairs and improvements that the city might make” and it was unclear in view of the city's plans “to turn the site into open space” whether these improvements would ever be made. The city acknowledged that the repairs and improvements might not be “indicative of what work a private investor would undertake” and some of HPD's recommendations were “more in the nature of capital improvements than repairs.” Moreover, there was inadequate support for the assumption that wiring within the apartments were “rusted or exposed” or why “the apartments need to be entirely rewired.” Although such improvements may have been “advisable,” the issue was “whether a potential purchaser would make such improvement and factor in the costs of making such extensive improvements in determining a purchase price,” given the limitations of rent regulation and the “below market rents.” The city also acknowledged that if an owner elected to do the recommended repairs, it may have a “different time horizon to perform repairs.”

The court noted that an owner might undertake the city's recommended improvements in order to qualify for MCI increases and that owners may make MCI increases regardless of whether they are necessary to correct an outstanding violation. MCI increases are “capped” at 6 percent a year. However, it is permanent, i.e., it “continues even after the cost of the improvements have been recouped.” MCIs were intended “to encourage owners of stabilized units to make improvements, despite the relatively low rent rolls of stabilized buildings.” MCI's, together with IAIs, enable owners to raise rents above the “luxury decontrol” threshold.

The city did not include an offset to the $726,000 of improvements HPD recommended, for MCI increases. The court refused to deduct any amount from the capitalized value of the building for building wide repairs or capital improvements that a potential investor might undertake.

Additionally, although the claimant valued the TDRs at $2.1 million, the city claimed that the TDRs lack any value since there was “no available financing for development at the time of vesting and therefore no market for the TDRs.” The city argued that there was no “likely receptor site for the TDRs.” With certain limited exceptions, TDRs may only be sold to “an adjacent lot that shares a contiguous boundary of at least ten linear feet.” The claimant identified two potential receptor sites which were undeveloped and were being used as outdoor parking lots, at the vesting date. The city argued that the claimant failed to show that either potential receptor site needed TDRs, since there were “no plans to develop either lot prior to vesting, and…market conditions” at the time the vesting date “would not have supported the sale of the TDRs.” The court found that “market conditions in the area at the time of vesting did support the marketability of the…TDRs.” The court cited, inter alia, nearby development, “resulting in part from Atlantic Yards and Metrotech” between May 2006 and September 2008.

The claimant also had to show that the potential receptor sites had an interest in the TDRs. The absence of plans to develop the receptor sites before vesting was not dispositive since the two receptor sites were part of the project for which the properties had been condemned. The court explained that the project had been announced in 2004, several years prior to the vesting and therefore, “the lack of plans to develop these lots, while other development was occurring around them, was a result of the planned condemnation and must be disregarded, pursuant to the project influence rule.” The court believed that there was “little doubt that, absent the project, the lots would have been developed in a manner similar to the surrounding blocks.” The court noted that the claimant did not have to demonstrate that the property was going to be part of a development assemblage at the vesting date, but rather, the claimant had to demonstrate that as of the vesting date “there was a reasonable probability that in the reasonably near future it would have been put to such use.”

The court also considered “whether the amount of floor area available as TDRs would be significant given the size of the potential receptor lot.” The court found that there were “significant increases in allowable FAR that could have enhanced the potential feasibility of a development on either [receptor] lot, had the vesting for the project not occurred.” Moreover, the purchase of the TDRs would have ensured that “no taller structure would be built on the subject properties” and that “would protect the views, light and air of any floors developed above the height of the existing building, and thus increase the value of such extra stories.” Thus, the court held that the claimant had demonstrated “that but for the impending condemnation there was a reasonable probability that within the reasonably near future, the receptor sites would have been developed and the TDRs…would have been purchased.” Accordingly, the court found that the TDRs had value on the vesting date and should be considered in valuing the properties.

The appraisers disagreed as to the full amount of floor area that could be transferred to a potential receptor site. The court explained that when ascertaining the amount of unused FAR (floor area ratio) available for transfer, “the donor site is not considered alone. The donor site and the receptor site are merged into one lot for zoning purposes and the FAR is measured by the allowable zoning for the combined lots.” After reviewing several comparables and a real estate investment study, the court agreed with the claimant appraiser that “no adjustment for market conditions, is warranted from 2007” to the vesting date.

The city had also argued that the TDRs could not be used for residential development, since the existing buildings exceed the maximum residential FAR. If either receptor site acquired the TDRs, “the amount of residential TDRs that could built on the receptor site would be reduced by 1,070 square feet. However, the receptor site could still be developed to a maximum FAR of 6.5 with up to a commercial FAR of 6.” The court noted that “[a] hotel is a commercial use under the zoning resolution” and therefore “the receptor site could use all of the…TDRs for a hotel.” The court did make a 25 percent downward adjustment for the fact that transfer of the TDRs to either receptor site would reduce the allowable residential FAR by 1,070 square feet. That reduction yielded a value of $1,590,420 for the TDRs. Accordingly, the court held that on the vesting date, “the value of the properties' TDRs was $1,590,420, the value of the building was $3,958,857 and the total value of the subject property was $5,549,277 or $5,549,000 rounded.”

Comment: This case is of interest given the importance of the “project influence rule” and the proliferation of developments which utilized transfers of air rights.

Matter of the Application of the City of N.Y., [Index Number Redacted by Court], NYLJ 1202798041176, at *1 (Sup., KI, Decided Sept. 8, 2017), Saitta, J.

Scott E. Mollen is a partner at Herrick, Feinstein and an adjunct professor at St. John's University School of Law.