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.

Addressing NYC’s Affordable Housing Crisis

photo by Hromoslav

The NYC Rent Guidelines Board (of which I am a member) held a public hearing as part of its final vote on rent adjustments for the approximately one million dwelling units subject to the Rent Stabilization Law in New York City. My fellow board member, Hilary Botein, and I submitted the following joint statement at the hearing (also available on SSRN and BePress):

The Rent Guidelines Board determines rent increases for New York City’s 1 million rent-stabilized apartments. We must weigh the economic conditions of the residential real estate industry; current and projected cost of living; and other data made available to us. To make our decision, we reviewed reams of data and multiple analyses of those data. We also held five public hearings at which we heard hundreds of tenants speak, sing, chant, cry, and demonstrate. These hearings are among the only opportunities that tenants have to speak publicly about their housing situations, and they made clear the extremity of the housing crisis in the City, and that it will get worse without significant intervention.

Tenants who came to the RGB hearings are not a representative sample of rent-stabilized tenants in New York City. But they told us a lot about the state of housing in the City.  We felt that it was incumbent on us to respond to what we heard, even where it did not relate directly to the jurisdiction of the Board.

New York City cannot expect any meaningful housing assistance from the federal government in the near term. Our observations therefore focus on state and municipal actions that could address some of the issues that regularly cropped up at our hearings.

There is a desperate need for affordable housing that is pegged to residents’ incomes. Housing is deemed “affordable” when housing costs are 30 percent of a household’s income. There is no guarantee that rent stabilized housing remain affordable to a particular household, and there is no income eligibility for rent stabilized housing.  This aspect of rent regulation explains its durable political appeal, but makes it an imperfect vehicle for meeting the needs of low-income tenants.

Mayor de Blasio is protecting and developing hundreds of thousands of units of affordable housing through the Housing New York plan announced at the beginning of his term. More recently, his Administration announced a program to create 10,000 deeply affordable apartments and a new Elder Rent Assistance program.  But more can be done to help low-income tenants.

The Senior Citizen Rent Increase Exemption (SCRIE) and Disability Rent Increase Exemption (DRIE) programs have proven their effectiveness in “freezing” the rents of more than 60,000 low and moderate income rent-stabilized households. The state should create and fund a similar program for low-income rent stabilized tenants who pay more than 30 percent of their incomes towards housing costs.

State laws governing rent stabilization must be amended. Three elements of the law particularly penalize low-income tenants in gentrifying neighborhoods, and were behind the most distressing tenant testimonies that we heard. They are not within the RGB’s purview, but change is critical if the law is to operate as it was intended to do. The state legislature has considered bills that would make the necessary changes. First, owners can charge tenants a “preferential” rent, which is lower than the legal registered rent for the apartment. Preferential rents are granted most often in neighborhoods where the rent that the market can bear is less than the legal rent. This sounds like a good option for both tenants and owners, and perhaps that was its original intention. But now, as neighborhoods gentrify and market rates increase, the prospect of increasing a preferential rent with little notice has become a threat to tenants’ abilities to stay in their apartments. Preferential rents should be restricted to the tenancy of a particular tenant, as was the law before a 2003 amendment. Owners would then be able to increase rents for those tenants no more than the percentages approved by the Board.

Second, owners can tack on a 20 percent “vacancy increase” every time an apartment turns over. This increase incentivizes harassment, and should be limited to situations of very long tenancies, to keep owners from actively seeking to keep tenancies short.

Third, owners making what is termed a Major Capital Improvement (MCI) – a new roof, windows, or a boiler, for example – can pass this expense on to tenants via a rent increase that continues in perpetuity, after the owner has recouped her or his expenses. We also heard allegations of sketchy capital improvement applications that were intended to increase rents without improving the conditions in the building. The state legislature should review how MCIs work in order to ensure that they are properly incentivizing landlords to invest in their buildings to the benefit of both owners and tenants.

New York City needs a repair program for broken gas lines. We heard from tenants who had not had gas in their apartments for more than a year. We understand that fixing gas lines is particularly complicated and expensive, and that gas leaks raise serious safety concerns, but it is unacceptable for families to go for more than a year without gas, and we are concerned about fire safety issues resulting from people using hot plates. The city needs to step in and make the repairs.

We have a housing crisis. Low income tenants, who live disproportionately in communities of color, experience this crisis most acutely. We will not find systemic solutions within the housing market. All solutions require a lot of money, and we cannot count on anything from the federal government. But it is imperative that our state and local governments act, or New York City’s already burgeoning shelter system will be forced to take in even more people. Since the 1970s, New York City has been a leader in committing public resources to housing its low income residents, and that legacy must continue.  The Rent Guidelines Board cannot solve the housing crisis, but other arms of the New York State and City government can work together to reduce its impacts on low-income households.

The Lowdown on Blockchain & Real Estate

There is a lot of hype out there about the impact that blockchain technology will have on the real estate industry. There is no doubt that blockchain will be revolutionary over the long term, but its impact in the short term is much more limited. Spencer Compton and Diane Schottenstein have written an article for Law360 (unfortunately, behind a paywall), How Blockchain Can Be Applied To Real Estate Law, that provides a nice overview of where blockchain stands today in the real estate industry. It opens,

Real estate transactions are steeped in traditions that have hardly changed over hundreds of years. Today, as computer-based property recording systems are prevalent in our cities but roll out at a snail’s pace in rural areas (often hindered by strained municipal budgets), and e-signatures are little used (due to legitimate fears of fraud), arguably the real estate closing process has lagged in its use of computer aided technology. Yet other aspects of real estate ownership have been transformed by the internet: smart home technology to remotely control heating and lighting and monitor security; Airbnb which increases the value of real estate ownership and disrupts the hotel industry; and the real estate brokerage community’s design/photographic/communication technology to list and virtually show properties. Now add to our brave new world blockchain, a cloud-based decentralized ledger system that could offer speed, economy and improved security for real estate transactions. Will the real estate transaction industry avoid or embrace it?

What is blockchain?

Blockchain is best-known as the technology behind bitcoin, however bitcoin is not blockchain. Bitcoin is an implementation of blockchain technology. Blockchain is a data structure that allows for a digital ledger of transactions to be shared among a distributed network of computers. It uses cryptography to allow each participant on the network to manipulate the ledger in a secure way without the need for a central authority such as a bank or trade association. Using algorithms, the system can verify if a transaction will be approved and added to the blockchain and once it is on the blockchain it is extremely difficult to change or remove that transaction. A blockchain can be an open system or a system restricted to permissive users. There can be private blockchains (for ownership records or business transactions, for instance) and public blockchains (for public municipal data, real estate records etc.). Funds can be transferred by wires automatically authorized by the blockchain or via bitcoin or other virtual currency. Transparent, secure, frictionless payment is touted as one of blockchain’s many benefits.

The article goes on to answer the following questions:

  • How does a blockchain differ from a record kept by a financing institution or a government agency?
  • How is a blockchain transaction more secure than any other transaction?
  • How widely is blockchain used?
  • How blockchain is being used to record real property instruments?
  • How might blockchain affect the role of title insurance companies?

If the impact of blockchain on the real estate industry has mystified you, this primer will give you an overview of where things stand today and maybe tomorrow too.