Last month Freehold Capital Partners, formerly Freehold Licensing, issued a press release: The Economics of Private Transfer Fee Covenants. The source is identified as Dr. Tom McPeak, Ph.D., an economist who claims that he has "always been fascinated by the allocation of land resources." It was an interesting read, but like most of Freehold's marketing material, it focuses on the theoretical benefits and not the practical, real-world consequences to homeowners. It dismisses opposing views by calling them "illogical" arguments by biased industry groups.
By now you all know what a private transfer fee is, but if you need a reminder here is a list of my previous blogs on the topic.
Freehold Licensing Defends Covenants
To Touch and Concern
Banning Transfer Fee Covenants In Ohio
Freehold Licensing, NKA Freehold Capital Partners, At It Again
Freehold Capital Partners Testifies Before Ohio Senate Committee
First, I'd like to point out the reasons why this whole debate is theoretical. Freehold boasts on its Website that "the owners of an estimated $500 billion in real estate projects nationwide, including some of the largest, most well respected real estate companies in the United States, have partnered with us to restructure the economics of their real estate projects." Despite the bold claims, nobody seems to know who these "well respected" partners are. When I was interviewed for the Washington Post column (yes, I like mentioning that), the columnist told me that he had been unable to identify a single Freehold customer.
"Manhattan-based Freehold Capital Partners declines to identify any clients or participants in its private-transfer-fee program..."
In addition, Freehold touts the benefits of "monetization" of the income stream created by the covenants to provide "much needed liquidity" for development projects. Here is how they describe "the power of monetization:"
Reconveyance Fee Instruments represent a fully-collateralized financial instrument with no meaningful risk of default. These desirable characteristics led one major investment bank to remark, "Reconveyance Fee Instruments represent an ideal securitization vehicle."
In a typical monetization scenario, the Instruments are originated, then aggregated into larger "pools", and securities backed by the pool would then be issued.
Developers originating the Instruments would receive the present value of the future income stream, using the proceeds to reduce debt, install infrastructure and lower the sales price.
Investors acquiring shares of a pool would own a long-term income producing asset secured by a real property interest, and which carried no meaningful risk of default.
I won't spend a lot of time on the claim that there is no "meaningful risk of default," but I think that depends on how you define "default." I believe that there is a real risk that the covenants could be found unenforceable, subjecting investors to a total loss of their investment. But, the most interesting aspect of this plan is the disclaimer that follows.
The is not an offer to sell, buy, market, offer, broker, act as broker-dealer or securitize Reconveyance Fee Instruments. There is no assurance that any particular Instrument will be suitable for sale or securitization or that a public market for Reconveyance Fee Instruments will develop, mature or persist.
We are dealing with a "gee... wouldn't it be nice if..." scenario, here. It is all hypothetical, speculative, and theoretical. Also notice that the "major investment bank" who seems to be in love with the idea is not identified. This isn't the first time Freehold and its supporters have touted support for its product without naming sources. In comments to previous blogs we have seen claims that the product has been blessed by large multi-national, and top-rated law firms... who, again, are unidentified.
At this time Freehold has nineteen attorneys, including numerous attorneys with 25+ years of real estate law practice, an attorney of 20+ years experience that owns a title company, as well as graduates of Stanford Law, Princeton, Yale, etc. The statute has been reviewed by large multinational firms for clients doing projects over one billion dollars in Texas, and those firms, without exception, have concurred with our interpretation.
I am no expert in servitude law by any means, but I did review a legal opinion from a top rated national firm that was retained to evaluate the covenant from an enforceability perspective, and it concluded that the covenant was enforceable.
I have invited both of the posters to share those reports, but I still haven't received anything. In my blogs, I have cited case law that leads me to conclude that the covenants will be ruled unenforceable when they are eventually challenged in court. All I get in response are claims that other brilliant, unnamed attorneys disagree. I'd love to read one of these opinions so I can see how they arrived at their conclusions, but nobody has provided one and I can't find anything published on the topic.
But, at least Dr. McPeak's article supporting the economics of the covenants is not anonymous. What does he have to say about them?
From a typical developer's perspective, a private transfer fee represents an alternative to putting 100% of development costs onto the shoulders of first-time buyers. In addition, if the future income stream could be sold off, much needed liquidity would be brought to the project. In return, the developer can lower the sales price, pay down bank loans, and even restart failed projects (creating jobs).
From the buyer's perspective, the willingness to pay a fee in the future in return for a lower initial price will result in lower acquisition costs, reduced carrying costs, and reallocation of the savings (i.e. does the buyer pay down high interest credit card debt with the savings). In addition to the quantifiable savings, a buyer may consider intangible issues such as the portion of the transfer fee that goes to non-profits, and whether the Buyer can qualify for the lower priced home (with a transfer fee) but would be unable to qualify for the higher priced home (without a transfer fee). All of these variables go into the decision-making process and both buyer and seller make an economic decision based upon their respective perceptions of the market value of the trade. If these perceptions match, a bargain is struck and the transaction is Pareto-efficient.
The assumption is that the seller will lower the sales price.
Why do I think this is all theory and not a realistic view of the practicalities of the real estate market? Well, for starters, Dr. McPeak states that "if the future income stream could be sold off, much needed liquidity would be brought to the project." Clearly, Dr. McPeak has been sucked in to the the "gee... wouldn't it be nice" world of Freehold. Unfortunately, it doesn't seem that this "monetization" is even possible yet.
Next, he states that "The assumption is that the seller will lower the sales price." He then continues to say that "this assumption is well-founded because economic theory suggests that buyers armed with the facts will not pay the same for a home with a transfer fee as they will pay for the same home without a transfer fee." While I agree, it is still but a "theory," as he admits.
Finally, Dr. McPeak goes on to criticize those who do not support Freehold's position.
It would be illogical to argue otherwise. (Having said that, the illogical nature of this argument does not appear to have prevented organizations from making the argument.) As is often the case, economics lies at the heart of the decision. Realtors apparently see transfer fees as a threat to commissions and the title industry see transfer fees as a potential liability for which they will be held responsible. Each entity is responding in an economically predictable way by protecting its own interest.
I have to ask the question that should be on everyone's mind right now? Is Dr. McPeak biased? Because these arguments so closely mirror the Freehold comments posted on Source of Title, I have to wonder if he was paid for his opinion. But, even assuming he was not, I cannot accept the premise that Realtors and title agents are biased just because they have a vested interest in the real estate transactions. Isn't it possible that these organizations are concerned because they really understand what is at the heart of the real estate deal and they know that based on their experiences that these covenants are just plain bad news for consumers and the real estate market in general?
Now let us turn to the real world, practical consequences of a private transfer fee covenant. Just because Dr. McPeak correctly points out that "buyers armed with the facts will not pay the same for a home with a transfer fee as they will pay for the same home without a transfer fee," it doesn't lead to the conclusion that the buyers will be armed with the facts.
Even if we assume that everything goes as it should and the title commitment discloses the covenants, you have to consider when the title commitment is provided to the buyer, if ever. If we look at the transaction chronologically, here is what typically happens in the real world.
- Seller lists the home with a Realtor. The Realtors do not do title searches, thus would not be aware of the covenant at this time.
- Realtor find a buyer, who views the home and decides whether or not to make an offer. Buyers do not do title searches, thus would not be aware of the covenant at this time.
- A price is agreed upon and the contract is signed, contingent on financing. Whether the financing will be approved will likely depend on the appraisal. Again, the buyer is likely still unaware of the covenant.
- Buyer applies for a mortgage with the bank. Banks do not do title searches, thus would not be aware of the covenant at this time.
- Bank orders the appraisal. Appraisers do not do title searches, either. Hmmm... what if the appraiser is unaware of the covenant? The appraisal will be based on comps, some of which may be in the same development, others may be nearby (where there is no covenant).
- Bank orders title work. Finally, the title company will do a title search, and they should, admittedly, find the covenant. Of course, this assumes that they do a full search, something that is not always done.
If the buyer is getting an owner's policy of title insurance, he may be provided a copy of the title commitment. But, it still isn't clear if this will be sufficient to disclose the fee to the buyer. It may just include language such as "subject to Conditions, Covenants, and Restrictions filed at..." Even if the title agent used more specific language, like "subject to a transfer fee covenant filed in the Conditions, Covenants, and Restrictions filed at...," this is still unlikely to alert a buyer to the fee. After all, how many people would understand what a transfer fee covenant is?
If the buyer does not get an owner's policy, they are most likely just out of luck, unless a diligent title agent points the fee out at the closing. But, by this time, they are AT THE CLOSING! Would they even be permitted to renegotiate the price at this late stage of the transaction? Presumably, they have already obtained financing and the contingency does not apply.
So, it seems quite likely that the buyer could get all the way through the closing without any actual knowledge of the fee and the price paid for the home would not be a "lower sales price" that accounts for the covenant. Even if someone, somewhere along the line provide a copy of the covenant to the buyer, it is unlikely that an ordinary purchaser would understand it. It reads something like this:
"Within, and for the benefit of, the subdivision and the Lots therein, Declarant has created a master subdivision plan, set aside parkland and common areas, and constructed streets, drainage and other improvements, (jointly and severally "Improvements"), which a party taking possession of any Lot stipulates all and singularly benefit said Lot. In consideration therefore, the Owner of any Lot in the development ("Owner"), by acceptance of a Deed therefore, whether or not it shall be express in the Deed, and for the foregoing benefits and other good, valuable and independent consideration, receipt of which is acknowledged by acceptance of the Deed, and as a covenant running with the land, is deemed to covenant, agree and shall be obligated to pay Declarant or assign(s), upon each transfer of title to a Lot in the Subdivision, a "Conveyance fee" equal to one percent of the Gross Sales Price of the Lot (including any improvements thereon). No Conveyance fee shall be levied upon the transfer of a Lot (a) by the Declarant; (b) by a Builder; (c) by a co-Owner of a Lot to a person or entity who was a co-Owner of the Lot immediately prior to such transfer; (d) by a Grantor to any entity wholly owned by Grantor; provided, upon any subsequent transfer of any ownership interest in such entity, a Conveyance fee shall become due; (e) by an institutional lender pursuant to a mortgage that is superior to Declarant's lien or upon foreclosure of a mortgage that is superior to Declarant's lien; (i) for transfers made on or before the first occurrence of (i) Jan. 1, 2010 or (ii) completion of improvements on ninety percent of the total Lots within the subdivision (g) if the Lot being conveyed is unimproved. For purposes hereof, the term "Builder" refers to a person or entity who purchases a Lot in the Subdivision from Declarant for the purpose of constructing a residential dwelling thereon and who is regularly engaged in the business of constructing homes for sale to individuals, and the term "Gross Selling Price" of a Lot shall mean the total consideration paid by the purchaser of the Lot, as is (or ordinarily would be) indicated on the title company's closing statement or, if a contract for deed or similar instrument, as indicated in the contract for deed or similar instrument, including consideration paid for all improvements on the Lot."
You could even make it bold and in all capital letters and the practical consequences to the consumer would be lost on most buyers - especially when this is only a part of a multi-page legal document.
But, even if we give the benefit of doubt to Freehold and assume that everyone will be aware of the covenant from the beginning (say a very knowledgeable Realtor is familiar with the development and discloses it to all parties), including the appraiser... how will the appraiser account for the covenant in determining the value? Appraisers mostly rely on comps. A special adjustment would have to be made for the covenant. Unfortunately, the amount of the future transfer fee is unknown; it will depend on when the home is next sold and how much it has changed in value at that time. Surely, an economist, such as Dr. McPeak, could devise a formula to precisely account for the covenant. However, appraisers are not economists and I think it would be a challenge for them to do so.
Appraisals can vary from appraiser to appraiser; perhaps even by more than the amount of this future transfer fee. I believe that it would not take long before the difference in valuation would be lost anyway. This would make it likely, in my opinion, that homeowner's will be paying as much for the home with the covenant, as they would without. At that point, this just becomes another fee... that will burden the property for 99-years.
Another practical consideration is the effect that this covenant will have on the homeowner's ability to sell the property. Even if we assume that everyone will be aware of the covenant and the value of the home can be precisely determined, surely there are still many homeowners that will not understand the complexities of the covenant and the impact on the value of the home. It would be quite logical for buyers to shy away from homes burdened by the covenant just because of the nature of the burden. Homeowners may not understand how the transfer fee has been accounted for in the appraisal; how it will impact their ability to sell the home in the future; or even how much it would cost them when they want to sell. This likely means that it would be more difficult, and take longer, to sell a home with this kind of covenant burdening the title.
We just don't need to create a condition that will hamper future real estate transactions. The real estate market has already been damaged enough. Of course, the developer doesn't care about that... once they sell the home, they get their money, especially if Freehold is able to monetize the covenants.
And, where would these covenants ever end? I spent about $30,000 remodeling my home a few years ago. Now that prices have declined, could I agree to take a lower sales price and force future owners to pay me a 1% every time the property sells for the next 99 years? Could the next guy do the same thing? And, the one after that? I just can't imagine the complexity of dealing with multiple private transfer fees on the sale of a home. Imagine trying to place a value on a home encumbered by three or four private transfer fees to different individuals. At that point, comps go out the window. But, logic tells me that if the developers are permitted to add such a convoluted encumbrance to their projects, savvy individuals could do the same thing. And once they get the idea, they will.
Lastly, I think the cumulative impact of missed covenants is also an important concern. Eventually, a private transfer covenant will be missed - things do get missed no matter how diligently the parties work. That is one of the reasons we have title insurance. What happens if the fee isn't paid on a transaction? It becomes a lien against the property and would have to be paid on the next sale. So, here is what that would look like.
Assume that the home sells for $300,000 and nobody paid the $3,000 fee to Freehold. Freehold has stated that they favor not holding the title company liable, and that there would be a lien for the $3,000 that will have to be paid next time around.
So, on the first sale, the covenant went undetected and the buyer presumably paid the full fair market value without taking the covenant into consideration. If we assume that the covenant should have a 5% impact on the sales price, the buyer paid about $15,000 more than he should have.
Next, assume that five years later, the house has appreciated to $347,782.22 (a modest 3% per year). When that homeowner sells the property, and the lien and covenant are discovered, he will owe $4,831.53 for the covenant that was missed ($3,000 plus 10% interest per annum). Furthermore, he will have to reduce his sales price by $17,389.11. This represents the amount that the home is worth with the covenant, $330,393.11 (the same increase of 3% per year based on what the home should have sold for last time - $285,000).
Lastly, he will owe $3,303.93 for the transfer fee he is responsible for when he sells the property.
Thus, when a fee is missed, the next owner suffers a heavy loss. In the example above, the cost to the homeowner totals $25,524.57... or, $22,220.64 more than the 1% fee that Freehold calls a "de minimus fee." If this seller purchased an owner's policy when he bought the home, he might be covered - if there wasn't a generic exclusion for "Conditions, Covenants, and Restrictions" in his policy. If he doesn't have an owner's policy, he is most likely out of luck. The question is, do we really want to allow these covenants when they could subject an unsuspecting homeowner to this kind of loss?
This is where the theoretical world of economists diverges from the real world. Real estate professionals understand the practicalities of the real estate market and they seem to uniformly agree that these covenants are bad for everyone, except the developers and Freehold, of course.
Freehold is attempting to create value where non exists. They state, "when a property owner 'unbundles' the various property rights it usually results in the parts being worth more than the whole." But, as we all know, when you are told that you can make money for doing nothing, it is probably too good to be true. I think that is the case here.