2019 Q2 Demand for Chicago Apartments Fuels Section 15 Deconversions

By Glenn Udell
In July 8, 2019

According to the Wall Street Journal and RealPage, demand for apartments surged nation-wide in the second quarter of 2019.  Chicago boasted one of the highest demand imbalances with a whopping 7,418 units sought by renters and only 2,617 rental units completed during the quarter.

It is no wonder then that investors continue their search for Chicago condominium buildings that can be converted into rental properties.  The latest high-profile condo deconversion target is the 39 story high rise, 2 East Oak Street, that sits dead center in what is affectionately (or derisively) known as the “Viagra Triangle”. (photo) Bounded by Rush and State Street on the east and west side, and Oak Street to the south, 2 East Oak is a concrete structure built in 1967 during a time when the address wasn’t so tony.

In the late 1960’s and early 1970’s, Rush street was a bawdy, liquor-filled strip bounded by some of the oldest, most expensive Chicago mansions to the north, south and east. If you look just behind the marquee for the infamous Faces nightclub in the photo below, you’ll see the 2 East Oak Street building in the context of the location in which it was built.

While my research hasn’t yet confirmed it, I’m inclined to believe that when built, 2 East Oak Street was originally constructed as a rental property. It would have been unusual for an expensive, new condominium to be built in an area that was still 20 years away from its rebirth and gentrification. (If you have any knowledge about the original commercial intent of the building, please email me.)

Today, given that the neighbor to the south is Barney’s of New York, and to the north, Gibson’s restaurant, it’s easy to see why New York real estate investment firm ESG Kullen is making a play to execute a Section 15 condominium deconversion of 2 East Oak Street.

For those who are occasional readers of my blog you’ll remember the name ESG Kullen as the suitor for 1400 N Lake Shore Drive. This condominium deconversion effort lasted over a year and featured:

  • A failed condominium association vote for ESG Kullen’s initial offer
  • A sweetened offer and subsequent winning vote to force a Section 15 deconversion
  • A terminated deal as a result of ESG Kullen’s inability to secure timely financing
  • A resurrection of the deal and favorable association vote after ESG Kullen secured financing

While the deconversion effort at 2 East Oak Street might go more smoothly than the 1400 N Lake Shore Drive transaction, the process has started – or stalled – in the same manner as the  aforementioned deal. As reported by Alby Galun in Crain’s, the condominium association board at 2 East Oak held a vote on June 25th to consider ESG Kullen’s $92 million offer. Of the 86% of owners (265 of 309) who cast a vote in person or by proxy, only 68.6% voted in favor of the deal.

The Board, likely dominated by absentee owners/investors who own multiple units, decided to extend the vote through July 16, ostensibly to allow those who didn’t vote to cast a vote.  I suspect there’s going to be a great deal of lobbying by ESG Kullen and board members sympathetic to the sale over the next two weeks.  Indeed, if history is any guide owners might expect a sweetened offer by ESG Kullen to nudge the owner vote to exceed 75%.

Section 15 Condominium Deconversion Investors are Very Sophisticated

As detailed in a previous post, no matter how generous the Section 15 deconversion offer, there will always be a percentage of owners who emotionally embrace their unit as a home, rather than an investment to be maximized. As one recalcitrant owner at 2 East Oak Street was quoted by Alby Galun in the Crain’s article, “There’s no reasonable price that anyone could pay us that we’d accept . . . It’s a sentimental investment.”

Large investors bidding for a Section 15 condominium conversion are very sophisticated. They are experts in real estate, finance, and with the help of counsel, the relevant laws. Partnered with an Association Board sympathetic to deconversion, there’s a lot of momentum on the side of the Section 15 buyer.

When BUPD Law represents a Section 15 buyer, or a condominium board sympathetic to deconversion, we counsel the highest level of transparency possible.  The most efficient deal is the deal that closes the first time, on-time and with a minimum of surprises.  Because there are so many “decision-makers” in a condominium deconversion – essentially all of the unit owners – the goodwill engendered by transparency goes a long way.

We also recommend the inclusion of several incentives to owners, enumerated here, that have been found to encourage a quick, positive deconversion vote from owners.

What Owners Reluctant to Sell Should Consider

For owners that would prefer not to sell their units, the first thing to do is to realistically evaluate not only the offer, but also the financial state and forecast for the condominium association.  Especially with buildings 20 years or older, there can be hundreds of thousands or millions of dollars in deferred maintenance, repair and compliance costs that have been ignored for years.

For example, the 2 East Oak Street building was constructed in 1967, a time when fire and safety provisions were not as strict as they are today. As recently as 2015 the building was on the City’s list of residential buildings not in compliance with the Life Safety ordinance. With fines of up to $500 a day, and untold costs to bring the building up to compliance, these costs will normally be born by the investors buying the building and should be considered when evaluating the deconversion offer for each unit.

If after a sober assessment of the financial state of the association an owner still wants to vote “no” on a deconversion sale, then they should insure that the association board is working to protect the best interest of all owners, not simply those who want to sell.

Like most real estate transactions, the potential buyer in a Section 15 condominium deconversion will likely have the ability to cancel the transaction, even after a favorable association vote. There’s also earnest money that the investment group must forfeit to the association, should the investor group exercise their right to cancel.

With this in mind, owners who don’t favor the sale should lobby fellow owners and the association for the highest possible earnest money amount prior to the first vote on deconversion. An investor-dominated association board has a great deal of leeway as to how association money is spent on exploring a Section 15 deconversion. Legal, engineering and accounting fees paid for by owner will total tens of thousands of dollars, regardless of the final status of the sale.

In concept, the earnest money required of the investment group should cover these and other tangible and intangible costs, should they exercise the right to cancel.  However, as evidenced by the cancellation of ESG Kullen’s initial deal at 1400 North Lake Shore Drive, the earnest money amount is often a relatively paltry sum that likely won’t come close to covering the costs born by the association.

As reported in Crains, ESG Kullen exercised their right to cancel the 1400 North Lake Shore transaction after an initial affirmative owner vote to sell. As a result ESG Kullen forfeited a paltry $50,000 in earnest money. As I pointed out in this blog post on earnest money and other owner protections, that amount is less than 1/10 of 1% on a deal potentially worth $110 million.

The de minimis threshold of a small amount of earnest money makes it too easy for the buyer to walk away from a deal, for almost any reason, after a hard-won association vote in favor of a Section 15 sale. An aggressive buyer knows that once a pro-sale vote is secured, it’s increasingly likely that a second or third vote will also go their way even if the terms of the deal are worse for owners.

This makes it essential that at the earliest possible point of discussion a reasonable and substantial amount of earnest money be required by owners who occupy their units as a demonstration of good faith from both the potential buyer and an association board dominated by absentee owners/investors.

Very Few Large Section 15 Condominium Deconversion Sales Fail

While it’s not yet clear what the outcome will be for ESG Kullen’s offer to purchase the 2 East Oak Street building, history suggests that a deal will ultimately be struck. There are substantial fixed costs required to investigate, evaluate, price and present large real estate transactions like this. Investment groups are beholden to other investors and banks who provide the capital needed to execute these transactions and to profitably manage the property as a rental building.   To put an offer on the table to a condominium association and not be very certain of the outcome would cost tens of thousands of dollars and lost confidence on the part of outside investors.

If you have any questions about a possible Section 15 sale for your condominium building, please feel free to reach out to my firm, Brown, Udell, Pomerantz and Delrahim, Ltd., or contact me directly at gudell@bupdlaw.com