Using REITs to Find a Joint Solution to the Foreclosure Crisis
By Jesse M. Keenan, Managing Editor, Housing.com
The emotional violence of having the American Dream turn into the American nightmare is not unfamiliar to the psycho-social upheaval associated with wars or natural disasters. The imagery of war comes to mind on the topic of what a foreclosure does to a neighborhood. Specifically, if one recalls the rather generic footage of bombers carpet bombing a particular urban location or forest—there was very often concentric shock waves which emanated from ground zero just micro-seconds before the fireball explosion at its core. This action and reaction is precisely what a single foreclosure can do in terms of a negatively resonating crater. The collateral damage is exponential in the case of cluster concentrations. Millions of homeowners become upside-down on their mortgages as a direct consequence of this spiraling phenomenon. The tragedy of the innocent is always the driver of justice and change—justice being a proxy for equity.
In this case, the notions of equity and change coexist through the development of a Community Growth Corporation (the “CGC”). The CGC is a conduit by which mortgage lending institutions, REO servicers, local governments, renters and homeowners can collaborate on the stabilization and advancement of their neighborhoods. As these participants invest in the CGC, they promote neighborhood stabilization and jointly invest in the future financially sustainable growth of a community. This entity is a for-profit corporation which elects under the Internal Revenue Code to be treated as a Real Estate Investment Trust (REIT). One of the key facets of a REIT is that it must be more than one hundred (100) shareholders who receive at least ninety percent (90%) of the annual taxable income of the entity. As such, the stock of the corporation would be divided into two classes of membership. The first class of membership would be made up of the governing local jurisdictions and REO lenders (the “A Class”). The innovation herein rests with the capitalization of the CGC. The local government would contribute land, development expertise, and land use entitlements to the entity, which are collectively valued on a per square foot basis on par with that of the private market. In turn, REO lenders would exchange, under a IRC §1031, the properties for an interest in an Tenant-in-Common (TIC) operating partnership (OP), often a limited liability company (LLC), which would be purchased in whole by the CGC (“Up-REIT”). Under IRC § 721, neither the TIC nor the REO lender would recognize any gain on the sale. In effect, the capital gains associated with many of these properties—which are already booked on a relatively marginal value—would be deferred. In order to capitalize the CGC with operating capital, Class A shares would also carry certain cash call obligations.
Aside from obligations, the A Class shares would contain restrictions on the election of trustees so that both the local governments and the REO lenders each had equal right to elect an even number of trustees. The odd number of trustee(s) which are otherwise designated as the tie breaking trustees would be from the second tier (“AA Class”) of shareholders. As a collective, the AA Class shareholders would serve as the crucial mediator between the REO interests and that of the local governments. This democratizing element mitigates the risk of losing control to the tyranny of the majority, or in this case, the REO lenders who may not otherwise always act in the best interest of the community in the furtherance of their broader portfolio strategies.
This AA Class of shareholders would be made up of both renters and homeowners, who subject to shareholder restrictions, would reside in a proximate location to the defined situs of the CGC. This defined territory should extend beyond random jurisdictional boundaries to be consistent with the economics of neighborhoods. Home and property owners would be able to also exchange their interests in their properties to the CGC. In return, the owners would be able to select from either shares-only or a combination of shares and use rights. The license fees for the use of the property would be indexed to inflation to promote stability and predictability. In the case of distressed owners, the household and the REO lender would get a distributive share of the TIC/OP equal in proportion to the debt and equity associated with the property. In the case where there is no homeowner equity, the household would be compensated with incremental TIC interests as their rent is inflated at a quicker pace (than inflation) to compensation as a yield on rents for the loss of principal. The homeowner gets stability and the opportunity to recreate equity through bumps in rent; or, they can choose to remain as renters of the CGC on multiyear leases without the corresponding tax and credit benefits. Once a distressed homeowner/renter builds up enough TIC credits, i.e., twenty (20%) of the assessed value, or before the expiration of some point in time in the future, the distressed household can purchase back their unit, or, technically redeem the TIC credits, from the CGC at a certain imputed discount rate over and above the defaulted mortgage principal. If necessary, and if it is in the best interest of the CGC, defaulted principal may be reduced on the books in favor of a shared appreciation covenant recorded against the property. Short-sales would be limited in any given year to a fixed percentage of the portfolio which is at the discretion of designated fiduciary managers of the trustees.
For certain non-distressed households, such as the elderly, the exchange would also entail stock in addition to use rights in a newer, smaller more efficient unit. These use rights may or may not be subject to rent depending on the equity in the home. These efficiencies would allow the homeowner to live more narrowly within their means which mitigates risk to both the consumer and the CGC. This risk mitigation is also a hedge against energy inflation which conversely increases default risk on otherwise obsolescent units of late vintages. These efficiencies also translate into a greater percentage of disposable income which have the potential to either bolster local consumer economies or increase savings rates—which again mitigates default risk.
Homeowners are not the only households to participate in the CGC, as renters of CGC units may also be eligible. Renters can earn TIC credits in subsidiary assets of the CGC through inflation in rents above and beyond inflation, capital payments or certain home or capital improvements. For instance, repairing the roof or the construction of photovoltaic panels on the roof, e.g., would equate to a certain allocation of credits. Again, the renters would be required to create a certain percentage of equity in credits prior to being able to redeem the credits for the purchase of the property from the CGC at a limited dividend above the debt/equity differential on the books at the time of the exchange. In this sense, renters enter a new classification of tenure which bridges renting and owning. Regardless of the individual of circumstances of the shareholders, the par value of the shares via the credits based on the net asset value (NAV) of the property subject to the TIC allow some measure of liquidity in the market. This provides a buffer for those households who would otherwise be penalized by the necessity of the obligations of a highly mobile labor market.
As the CGC takes title to all of the various properties either directly or indirectly through the acquisition of the TIC entities, the CGC would leverage the value of the properties, often including foreclosed homes, to undertake independent development, renovation and compensate users for capital improvements. With the recent advent of more liberal REIT operating rules, the CGC can begin to offer services which mitigate physical waste and partially lessen the burden of the local governments. Likewise, CGC can achieve operating efficiencies through purchasing materials, energy, water and other consumer commodities in bulk. Through economies of scale, the CGC can act as a leader in changing consumer consumption to conform to the broader notions of energy conservation consistent with a new order of ethically engaged citizenry. However, at the end of the day, the core function of the CGC is to provide a tax efficient conduit for capital in the mitigation of the spiraling effects of the foreclosure crisis. As the community grows and prospers, then the equity created is distributed to those shareholders who worked hard to dig out the community from the craters of the cluster bombs of foreclosure.