Law in The Time of COVID: The Ripple Effect in Real Estate

Dean Michael Cahill

In many ways, COVID-19 has changed the way we live for both the immediate future and long-term. Brooklyn Law School Dean Michael Cahill has been sitting down with members of the Brooklyn Law School faculty to discuss the legal ramifications of our response to COVID-19 and what a post-pandemic world may look like.  Here is the link to our discussion of the effect of the pandemic on the real estate market and beyond: https://youtu.be/j9DFBOsU3qw.

Teaching Real Estate Securitization

By U.S. Government Accountability Office from Washington, DC, United States - Figure 1: Securitization of Federally Insured or Guaranteed Mortgages into GinnieMae-Guaranteed MBS, Public Domain, https://commons.wikimedia.org/w/index.php?curid=64986888

Some readers may be interested in a free upcoming program on how to teach real estate securitization.  The program is  co-sponsored by the AALS Real Estate Transactions Section and the New York City Bar Association’s Structured Finance Committee.

You can attend by live stream webcast or in person.  You can attend as much of the program as you have time to attend, and feel free to pop in and out of the webcast.

Law professors and leading practitioners will serve as panelist instructors.  I will be moderating a panel on Servicing & Its Discontents.  It should be a great program for those who teach in this area.

See http://law-u.net/ for the full program and to register or even better, view the PROMOTIONAL VIDEO here.

The Little-Known Escalation Clause

The Wall Street Journal quoted me in Escalation Clauses: A Little-Known Bidding-War Strategy. It opens,

For home buyers locked in a heated bidding war, there is one weapon that may help ensure victory: an escalation clause.

It’s an addendum to a real-estate contract, typically when the offer is made, in which a prospective buyer says, “I will pay X dollars for this house, but if another buyer submits a verifiable bid that’s higher, I will raise my offer in increments of Y dollars to a maximum price of Z.”

These clauses are particularly useful in a competitive real-estate market where homes typically get multiple bids. If a bidding war erupts on a home, the escalation clause will automatically raise the buyer’s offer on the house by the predetermined increment, up to the maximum amount the buyer authorizes. It eliminates the back and forth of offer and counteroffer and helps the buyer avoid paying too much for a house by getting caught up in the frenzy of a bidding war. But they can be risky for buyers who use them.

“A buyer can think of an escalation clause as a ‘have your cake and eat it, too’ clause,” says David Reiss, a Brooklyn Law School professor who specializes in real estate. “But in real estate, as with cake, it is hard to have it all.”

One concern is that the buyer is tipping his hand to the seller by using an escalation clause, Prof. Reiss says.

By indicating the maximum amount he will pay for the house, a buyer is revealing important information—that he’s willing to pay more. For example: Seller lists the house for $1 million. The buyer bids $950,000 with an escalation up to $975,000. The seller can counteroffer at $975,000, knowing that the buyer can both afford it at that price and is willing to pay it.

“Sellers get more money than they ever thought they would have,” says Carrie DeBuys, a real-estate agent with Realogics Sotheby’s Realty in Seattle. In her market, it isn’t uncommon for a seller to receive “10, 15 or 20 offers on a property.”

On the flip side, an escalation clause may not be in the seller’s best interest, explains Prof. Reiss.

Say a house is listed for $1 million, and there are three bidders. Buyer A offers $950,000. Buyer B offers $975,000 with an escalation clause that could go up to $1 million in $5,000 increments. Buyer C offers $980,000. In this scenario, the seller would get $985,000 from Buyer B after the initial offer escalates over Buyer C’s offer. But, had the seller not relied on the escalation clause and instead asked the bidders for their best and final offer, he might have sold the house for $1 million. “We know that the buyer was willing and able to go up that high,” Mr. Reiss says. “Thus, the seller is likely getting $15,000 less in the escalation-clause scenario.”

Trump and the Regulation of Real Estate

I have posted my article, The Trump Administration and Residential Real Estate Finance, which just came out in Westlaw Journal Derivatives to SSRN (and also to BePress). The abstract reads,

An executive order titled “Reducing Regulation and Controlling Regulatory Costs” was one of President Donald Trump’s first executive orders. He signed it Jan. 30, 2017, just days after his inauguration. It states: “It is the policy of the executive branch to be prudent and financially responsible in the expenditure of funds, from both public and private sources. … It is essential to manage the costs associated with the governmental imposition of private expenditures required to comply with federal regulations.” This executive order outlined a broad deregulatory agenda, but it was short on details other than setting a requirement that every new regulation be accompanied by the elimination of two existing ones. A few days later, Trump issued another executive order that was focused on financial services regulation in particular. That order is titled “Core Principles for Regulating the United States Financial System.” It says the Trump administration’s first core principle for financial services regulation is to “empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth.” However, it is also short on details.

Since Trump signed these two broad executive orders, his administration issued two sets of documents that fill in applicable details for financial institutions. The first is a slew of documents that were released as part of the Office of Information and Regulatory Affairs’ Current Regulatory Plan and the Unified Agenda of Regulatory and Deregulatory Actions. The second is a series of Treasury reports — titled “A Financial System That Creates Economic Opportunities” — that are directly responsive to the core principles executive order. While these documents cover a broad range of topics, they offer a glimpse into how this administration intends to regulate — or more properly, deregulate — residential real estate finance in particular. What is clear from these documents is that the Trump administration intends to roll back consumer protection regulation so that the mortgage market can operate with far less government oversight.

The Impact of Tax Reform on Real Estate

Cushman & Wakefield have posted The Great Tax Race: How the World’s Fastest Tax Reform Package Could Impact Commercial Real Estate. There is a lot of interesting insights in the report, notwithstanding the fact that ultimate fate of the Republicans’ tax reform is still a bit up in the air. Indeed, C&W estimates that there is a 1 in 5 chance that a bill will not pass this year.

Commercial Real Estate

C&W states that history

suggests that tax law changes by themselves are often not key drivers for transactions or for investment performance. However, there is likely to be a period of transition and market flux as investors restructure to optimize tax outcomes with implications for the underlying asset classes. Corporations are likely to separate the real estate aspects of their businesses. (2)

The commercial real estate industry is largely exempt from the biggest changes contained in the House and Senate bills. 1031 exchanges, for instance, have not been touched. C&W sees corporations being big beneficiaries, with a net tax cut of $400 billion over the next 10 years; however, they “anticipate that the tax cut will be preferentially used to return capital to shareholders or reduce debt, rather than to increase corporate spending.” (2)

Residential Real Estate

C&W sees a different effect in the residential real estate sector, with a short-term drag on home values in areas with high SALT (state and local tax) deductions, including California, NY and NJ:

The drag on home values is likely to be largest in areas with high property taxes and medium-to-high home values. There is also likely to be a larger impact in parts of the country where incomes are higher and where a disproportionate proportion of taxpayers itemize. Both versions of the tax reform limit property tax deductibility to $10,000. While only 9.2% of households nationally report property taxes above this threshold, this figure rises to as high as 46% in Long Island, 34% in Newark and 20% in San Francisco according to Trulia data.

The Mortgage Bankers Association (MBA) estimates that 22% of mortgages in the U.S. have balances over $500,000, with most of these concentrated in high costs areas such as Washington, DC and Hawaii—where more than 40% of home purchase loans originated last year exceeded $500,000. This is followed by California at 27%, and New York and Massachusetts at 16%. (6)

C&W also evaluated tax reform’s impact on housing market liquidity and buy v. rent economics:

The median length of time people had owned their homes was 8.7 years in 2016—more than double what it had been 10 years earlier. Now that interest rates have begun to tick upward from their historic lows, the housing market may face a problem called the “lock-in” effect, where homeowners are reluctant to move, since moving might entail taking out a new mortgage at a higher rate. This leads to the possibility of decreasing housing market liquidity in high-priced markets.

All things considered, the doubling of the standard deduction and the cap on the property tax deduction is likely to have the largest impact on the buy vs. rent incentive, especially as it seems likely that there will be minimal changes to the mortgage interest deduction in any final tax reform bill. (7-8)

Investing in Homes

photo by Pictures of Money

TheStreet.com quoted me in Investing In Your Home Remains a Sound Financial Decision for 2018. It reads, in part,

Homeowners are still pouring money into their homes as renovations and upkeep are generating a large portion of sales for Home Depot as demand for purchasing homes rose in September and the three massive hurricanes in the U.S. boosted revenue.

Home Depot’s third-quarter sales surged in the aftermath of a robust hurricane season that spanned from Texas to Puerto Rico, increasing demand from homeowners who faced immense rebuilding as homes were destroyed by relentless floodwaters.

The Atlanta-based home improvement retailer reported an impressive 7.9% increase in comparable-store sales in the third quarter, which exceeded the Wall Street estimate of 5.8%. Home Depot also beat on earnings, reporting $1.84 a share, 2 cents ahead of forecasts. The company’s total revenue was $25.03 billion, up 8% from the same period last year.

 Home Depot’s third-quarter earnings rose 15% from a year ago and its comparable sales in the U.S. increased at a 7.7% clip.

“Though this quarter was marked by an unprecedented number of natural disasters,” said CEO Craig Menear in a statement, “the underlying health of our core business remains solid.

The company was able to raise its fiscal 2017 guidance due to its stellar earnings and now estimates comp sales growth of 6.5% and earnings per share of $7.36, which reflects its $8 billion buyback program this year.

Home Depot shares rose 2.7% to $168.06 on Nov. 14.

 Interest from first-time home buyers remains strong and home sales rose in September — new home sales increased to a seasonally adjusted rate of 667,000, which is up 18.9% month over month and 17% year over year.

*     *     *

“When an individual buys a share of stock they can monitor the value of the investment on a minute-to-minute basis,” Johnson said. “People can see the fluctuation in value. With real estate, however, no one is quoting you a price instantaneously on your real estate purchase. Absent a market price, people tend not to worry about the value of their real estate purchase and assume that it is very stable in the short run.”

Millennials tend to be conservative with their investment choices and are “drawn to this seeming stability in the value of residential real estate,” he said.

Nevertheless, purchasing a home can often be a very poor financial decision and potential home buyers need to be aware of the additional costs and potential pitfalls.

“People fall prey to the stories of individuals realizing substantial gains by buying a home and selling it at a much higher price years down the road,” Johnson said.

Noble laureate economist and Yale University professor Robert Shiller had made a compelling case that real estate, especially residential homes, are a much inferior investment when compared to stocks. He found that on an inflation-adjusted basis, the average home price has increased only 0.6% annually over the past 100 years.

The stock market’s average return on a large stock index such as the S&P 500 has been about 10% while inflation has averaged around 3% from 1926 through 2016 while the inflation adjusted return of the stock market over the past 90 years has been approximately 7%.

The rate of homeownership still remains much lower than the 1998 rate of 9.5% and the rate has remained stable since the commencement of the financial crisis — hovering around 5% since 2008.

So should you own or rent?

Renting can be a better deal for many consumers, depending on the city and region, said David Reiss, a law professor at Brooklyn Law School in N.Y.

“This is a better question to ask yourself than whether owning is a sound investment choice because you are going to need to live somewhere no matter what,” he said. “It is not too helpful to look at national numbers to answer this question – you should look at the figures in the communities you are considering living in.”

Manafort Indicted for Real Estate Fraud

Special Counsel Mueller

Paul Manafort and his protege, Richard Gates III, were indicted on a variety of charges, including conspiracy, failure to file requirement financial reports and the making of false statements. The indictment was signed by Special Counsel Mueller. A number of the allegations involve real estate transactions. Here are the highlights (lowlights?) of the allegations that document how money can be laundered through real estate:

Manafort used his hidden overseas wealth to enjoy a lavish lifestyle in the United States, without paying taxes on that income.  Manafort, without reporting the income to his tax preparer or the United States, spent millions of dollars on luxury goods and services for himself and his extended family through payments wired from offshore nominee accounts to  United States vendors.  Manafort also used these offshore accounts to purchase multi-million dollar properties in the United Sates.  Manafort then borrower millions of dollars in loans using these properties as collateral, thereby obtaining cash in the United States without reporting and paying taxes on the income.  In order to increase the amount of money he could access in the United States, Manafort defrauded the institutions that loaned money on these properties so that they would lend him more money at more favorable rates than he would otherwise be able to obtain. (para 4)

More than $75,000,000 flowed through Manafort and Gate’s 15 offshore accounts. They also had 17 US corporations through which some of these funds flowed as well. In order to avoid paying taxes on this money, Manafort and Gates made millions of dollars in wire transfers to pay “for goods, services and real estate.” (para. 15) Manafort spent more than $12,000,000 on personal items including home improvement services, clothing, cars and housekeeping. He also bought four properties for over $6,000,000.

After Manafort bought these properties, “he took out mortgages on the properties thereby allowing Manafort to have the benefits of liquid income without paying taxes on it. Further, Manafort defrauded the banks that loaned him the money so that he could withdraw more money at a cheaper rate than he otherwise would have been permitted.” (para. 33) He did this by wrongfully claiming on a loan application that an investment property was owner-occupied (banks generally give you a more favorable interest rate if the property is owner-occupied). He was also able to borrow more money by claiming that part of the proceeds of a loan would be used to fund a renovation when in fact he did not intend to use the funds for that purpose.

The allegations in the indictment provide a nice case study of how real estate is used in money laundering.