The financial burden of purchasing or developing land and housing is enormous, and it is a burden that we have most commonly shared with risk-loving developers that require a high return on investment and large banks that supply the financing. But banks are usually beholden to the financial bottom line of their shareholders, and not to the financial well-being of our communities. It just makes more sense to share the financing burden with individuals and organizations that are more interested in and committed to the economic health of our communities. Government and nonprofit grants and subsidies are sometimes available, but there are rarely enough. That leaves us with an important task: To develop more ways for community members to share in the financing of housing purchases and development.
Our communities are full of capital that could be harnessed to finance housing, but a good amount of that capital is used to finance companies traded on Wall Street, by means of typical individual investments and retirement funds. The question becomes: What incentives and legal structures will lead individuals, local businesses, and organizations to move their money and invest in, lend to, and donate to support housing purchases and developments in their communities?
In some cases, housing could simply be financed by the residents themselves – if a group of people pools funds to buy an unsubdivided multiplex, the cost is generally much lower than if they each purchased their own homes. Purchase of raw land is similarly much cheaper, and residents have the option to “finance” their housing with “sweat equity” if they build dwellings themselves. Furthermore, individual residents that have greater access to capital than other residents can finance a larger share of the purchase and either own a greater share or be compensated over time by co-owners.
Resident financing, however, will not always be an option, so it’s necessary to create structures for bringing in outside capital. As they say, “you can’t get somethin’ for nothin’,” which requires that we create legal relationships that reward the people and organizations that share in the financing of our housing. The reward could be a share of the management, a share of the monetary appreciation, a share of the rental income, a commitment to serving a social or environmental purpose, or other financial or social returns. Here are some common arrangements:
- Loans: The most common type of exchange is one where people receive a loan and agree to repay it with interest. The widespread use of such a financing arrangement, particularly without significant regulation of lenders, can result in real estate bubbles and undermine efforts to stabilize economies. Purchasers are bound to repay loan principal along with substantial interest, regardless of fluctuations in the market value. There are bound to be losers in this system, as not every borrower will be able to earn enough to repay principal plus interest. Nevertheless, loans are and will continue to be an important piece of the financing picture, and it’s important to ensure that they are designed so that both lender and borrower succeed and thrive. This could mean setting more dynamic repayment terms, more flexible default remedies, and/or structuring a more reasonable return for the lender. Most importantly, the financial return on loans should ideally be poured back into the community. If we create local loan funds and credit unions, the interest we pay on loans will simply be re-invested into our communities, which builds wealth within the local market.
- Investments: Ideally, a financing arrangement will allow residents and financiers to share both the risks and benefits of property ownership. When people invest in housing, the incentive is usually a share of the appreciated value, a share of the rental income, and/or a share of the control. Of course, there need to be boundaries constructed around the control by and returns to non-resident investors, to ensure that decisions about the property are not solely driven by a financial bottom line. Equity sharing 1 and shared-appreciation mortgages are common arrangements for investment; through either arrangement, a lender or co-owner is granted the right to share is some portion of the property’s appreciation [or depreciation], usually realized at the time the property is sold or refinanced.
- Donations: Housing arrangements that build in strong commitments to social and environmental purposes will also be able to access grants and donations as a source of funding. Housing or land that is purchased or supported by nonprofits generally comes with strings attached. In the case of housing, the mandate may be to use a legal structure that ensures that the housing remains affordable for future residents. In the case of open space, funders may mandate a commitment that land be preserved and stewarded for the benefit of ecosystems. In the case of agricultural land, funders may mandate that land be perpetually used for agricultural purposes and not sold to developers.
Note that community financing of housing often implicates securities laws, and anyone seeking to create an avenue to lend or invest in housing should thoroughly investigate them. However, when a loan or investment is adequately secured by an interest in the real property or by a deed of trust, such an arrangement may not be considered a security.
Implications of Financing
Large institutional lenders make loans with a variety of strings attached, and can sometimes prevent groups from managing property in the way they desire. For example:
- Due on sale clause: Most mortgages come with a “due on transfer” or “due on sale” clause, which accelerates the loan and requires payment in full upon the transfer of an interest in the property. The Garn-St. Germain Federal Depository Institutions Act 2 lays out a list of transfers that are allowed and that may not trigger the loan acceleration. This includes transfers to living trusts, transfers to joint tenants upon the death of one tenant, and a transfer to make a spouse or child an owner. One listed exemption is “the granting of a leasehold interest of three years or less not containing an option to purchase,” 3 which begs the question of whether a lease for longer than three years or a lease with purchase option could trigger the clause. As mentioned earlier, notices of long term leases and purchase options should generally be recorded in public records to provide notice to the public of such a right. Recordation, however, could result in notice to the lender, who may choose to accelerate the loan. Whether the lender actually accelerates it is another question, as many lenders are content to let things like that slide.
- Access to fractional finance: Co-owners of multi-unit properties are sometimes able to obtain fractional loans, which means that each co-owner is responsible for a separate loan that is secured by that owner’s interest in the property. Most lenders are hesitant to make such loans, and when they do, they typically must review and approve a co-ownership agreement to ensure that the rights and responsibilities are sufficiently described and divided, to ensure that the lender is protected in the event that it must foreclose on one owner’s fractional interest. These loans may incur higher interest rates that conventional loans.
When fractional financing is not available, TIC co-owners often share responsibility for a single mortgage, which means that TIC Agreements must contain a significant number of provisions to ensure that one owner’s financial troubles do not put everyone else’s interest at risk.
- Residential versus commercial finance: A downside to purchasing a property as an LLC or corporation, as opposed to a TIC, is that the financing available for such a purchase is more likely a commercial loan than a residential mortgage, which generally requires that the purchasers make a significant down-payment (often 30%). Lack of access to optimal financing leads some people to avoid formation of an LLC or other entity, even when most other factors indicate that it would advantageous to do so.