Wednesday, July 20, 2011

The Appellate Division, First Department Gives the "Substantial Rehabilitation" Exemption A Makeover


     The sanctity of the class of housing accommodations subject to rent stabilization has long been protected by New York State courts in accordance with expressly declared legislative policy.  Decades ago, the New York State legislature recognized and declared that there was a statewide emergency regarding the cost, availability and quality of rental housing.  The remedy to this emergency was expansion of rent regulation, thereby balancing the bargaining power between landlords and tenants, and securing tenants from eviction from their homes at their landlords' will.  Landlords suddenly had to deal in good faith with their tenants, and maintain the condition of regulated housing accommodations.  Rent regulation served a significant public interest.

    Though building owners have long complained that rent regulation is an undue interference with their property rights, the legislature has provided numerous exemptions from rent regulation to address such concern.  Of them, the "substantial rehabilitation" exemption rewards an owner's investment in its property by permitting the residences therein to become free market.  The exemption's rationale is that by investing in the quality and/or quantity of the housing it provides, the owner is contributing to elimination of the statewide housing emergency.

Strict Interpretation Of The "Substantial Rehabilitation" Exemption

     The phrase "substantial rehabilitation" was left undefined for many years.  Owners therefore sought to take advantage of it by making cosmetic improvements to their regulated properties and claiming that the building had been "substantially rehabilitated."  Similarly, owners of commercial properties who desired to convert them to free market residential buildings would perform the bare minimum amount of work required to legalize the building for residential use, and claim that the building should be exempt because it had been "substantially rehabilitated."

     Recognizing these efforts, Courts crafted a rule that the "substantial rehabilitation" exemption should be strictly construed against landlords.  The rule flows from the legislature's policy declaration that rent regulated housing is to be protected.  To allow ease of exemption would be to undermine the whole purpose of enacting rent regulation in the first place.

    Courts addressed owners' threat that they would not invest in their properties absent liberal application of the exemption by noting the availability of three alternative statutory means of recouping such investments without eliminating rent regulation.  First, owners could increase regulated rents up to 6% per year for "Major Capital Improvements they have undertaken in the building.  Second, 1/40th of the cost of individual apartment improvements could be applied to increase the regulated rent.  Finally, owners could establish a so-called "First Rent" at the market rate where they performed significant alterations to the structure of an apartment.  Given the availability of these measures, strict construction of the "substantial rehabilitation" exemption was justified.

The DHCR's Attempt To Define "Substantial Rehabilitation"

    The problem remained, however, of how to define what constituted a "substantial rehabilitation."  The statutes were silent, thereby leaving courts to sketch the contours of the exemption on an ad hoc basis.  The caselaw that developed was all over the place.  Contributing to the confusion, in 1992, the Appellate Division, First Department, came down with a decision in Eastern Pork Products Co. v. DHCR, 187 A.D.2d 320, 590 N.Y.S.2d 77, wherein the Court stated that a "commonly understood" meaning should be ascribed to the phrase "substantial rehabilitated."

    The New York State Division of Housing and Community Renewal (DHCR) stepped in to fill the breach.  The DHCR was given the statutory mandate to interpret and implement the rent regulatory laws in accordance with the legislature's intent.  The DHCR therefore promulgated a Rent Stabilization Code provision that attempted to define the term "substantial rehabilitation."  It followed that up in 1995 by issuing "Operational Bulletin" 95-2, which provided further guidance as to the agency's interpretation of the exemption.  Amongst other elements, O.B. 95-2 requires that in order to constitute a "substantial rehabilitation," the "rehabilitation" must involve replacement of at least 75% of all building-wide and apartment systems, such as plumbing, heating, gas, electric, and the like.  In order to demonstrate that this work had actually occurred, landlords were required to provide documentary proof, including architect's drawings, approved plans, contractor's statements, photographs and proof of payment.  It was the owner's burden; without adequate proof, the exemption simply could not be applied.

The Courts Adopt DHCR's Interpretation Of The "Substantial Rehabilitation" Exemption

     After the promulgation of O.B. 95-2, Courts repeatedly adopted and approved of it as providing the substantive requirements for establishing satisfaction of the "substantial rehabilitation" exemption.  In H.M. Village Realty v. DHCR, 304 A.D.2d 346, 758 N.Y.S.2d 32 (1st Dep't, 2003), the Appellate Division, First Department expressed that O.B. 95-2 conformed with its prior decision in Eastern Pork.  Numerous other Appellate Division First Department cases agreed, including Steffey v. DHCR, 276 A.D.2d 407, 715 N.Y.S.2d 835 (1st Dep't, 2000), Woodcrest Mgmt. Corp. v. DHCR, 2 A.D.3d 172, 767 N.Y.S.2d 774 (1st Dep't, 2003), and Pavia v. DHCR, 22 A.D.3d 393, 802 N.Y.S.2d 361 (1st Dep't, 2004).  It was therefore clear to tenants, owners, litigants and the lower courts, that in determining application of the "substantial rehabilitation" exemption, the operative standard was that provided under O.B. 95-2.   That is, until recently.

     In the Appellate Division, First Department's recent decision in 22 CPS Owner, LLC v. Carter, 84 A.D.3d 456, 923 N.Y.S.2d 450 (1st Dep't, 2011), the Court appears to have changed course and reverted the state of the law back to the pre-O.B. 95-2 days of uncertainty.

The Appellate Division, First Department's Departure From Operational Bulletin 95-2

    In 22 CPS, at issue was whether a building located on Central Park South that had been converted in 1980 from primarily commercial to primarily residential use, creating 23 new residential units, was "subtantially rehabilitated," thereby exempting the units from rent stabilization coverage.  In the lower court, the landlord had asserted, without any proof, that the building was exempt from rent stabilization coverage on any basis.  The tenants argued that pursuant to the Emergency Tenants Protection Act of 1974, the building was covered because it was a pre-1974 building containing more than 6 residential units that had never been "substantially rehabilitated."  Despite the lack of any evidence as to the extent of work performed in the building during the conversion process, the lower court held that it was exempt from coverage.

   On appeal, the tenants argued that the lower court erred in determining that the building had been substantially rehabilitated because there was no proof as to the extent of work performed during the conversion. The mere fact of conversion of use, from commercial to residential, does not by necessity lead to the conclusion that sufficient work was performed to satisfy O.B. 95-2.  The tenants argued that the governing standard for determining the exemption is O.B. 95-2, which, amongst other elements, requires that at least 75% of all building-wide and apartment systems be completely replaced.  A conversion in use could be accomplished without meeting O.B. 95-2's standard.  They further argued that it is well established that it is the landlord's burden to prove, upon admissible evidence, the extent and actuality of the work performed, and that as a matter of policy, the exemption has been strictly construed against landlords in order to effectuate the legislature's intentions.  Thus, they concluded, it was erroneous for the lower court to liberally apply the exemption without requiring submission of any proof regarding whether the work satisfied O.B. 95-2.

     In opposition, the building owner argued that because there was a conversion from commercial to residential use, the standards providing in O.B. 95-2 need not be satisfied.  By the owner's logic, the mere facts of a change in use and creation of new residential units were alone sufficeint to constitute a "substantial rehabilitation," without any consideration of the extent of work performed.  The Court, in denying the tenants' appeal, adopted the owner's argument wholesale.

     In a unanimous decision, the Appellate Division, First Department held that despite the lack of evidence regarding the extent of the "rehabilitation" of the building, the change in use was alone sufficient to apply the "substantial rehabilitation" exemption to the building.  The Court cited its 1992 decision in Eastern Pork and other pre-O.B. 95-2 cases as supporting its holding.  The Court, however, disregarded O.B. 95-2 in its entirety, as well as the several Appellate Division, First Department cases that had adopted it as the standard for determining application of the exemption.

Implications Of The Appellate Division, First Department's Holding In 22 CPS

     22 CPS indicates a return to uncertainty for rent regulated tenants, and a trend towards liberal application of exemptions for rent stabilization by the courts.  Owners now have a license to apply for the exemption solely upon a claim that they have performed a change in use in their buildings, and need not demonstrate whether any work was performed, nor the extent of work performed.  In so construing the exemption, the Court eliminated the "substantial rehabilitation" exemption's built-in incentive to owners to invest significantly in their properties, as the bare minimum amount of work appears to be satisfactory.  By the same token, the Court may eventually render the Major Capital Improvement and individual apartment increases obsolete.  Owners have no incentive to apply for such increases, when they can simply apply for outright exemption upon the same amount of work.  In sum, the Appellate Division, First Department's decision in 22 CPS will have substantial negative impacts upon the class of rent stabilized housing in New York City.

Thanks for reading.  Be well, and always know your rights.


Your author's lawfirm, Jeffrey S. Ween & Associates, represents the tenants in 22 CPS, LLC v. Carter.  The tenants are currently seeking leave to appeal to the New York State Court of Appeals.


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  3. They further argued that it is well established that it is the landlord's burden to prove, upon admissible evidence, the extent and actuality of the work performed, and that as a matter of policy, the exemption has been strictly construed against landlords in order to effectuate the legislature's intentions. Thus, they concluded, it was erroneous for the lower court to liberally apply the exemption without requiring submission of any proof regarding whether the work satisfied O.B. 95-2.
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