A Proposal for Homeownership & Community Wealth-Building through a new type of Co-Op Housing

“Tenancy-to-Equity”

Significant trends have affected the real estate industry in the past decade yet ownership and governance structures of multi-family housing remains predominately unchanged. A new hybrid co-op model, “Tenancy-to-Equity”, can provide flexible pathways to ownership with gradual wealth building and community involvement. The Tenancy-to-Equity approach is a realistic solution for renters, affordable housing developers, for-profit developers, and community organizations.

Tenancy-to-Equity models could be established in existing residential buildings and in new developments. In a Tenancy-to-Equity co-op, residents buy co-op shares assigned to their apartment from the initial developer or owner. The Tenancy-to-Equity model is authorized under Washington D.C. law (the city used here as an example) and can be pioneered anywhere.

The Problem

Lack of access to homeownership burdens residents with renting costs and leaves less money for food, health and consumer goods. Inadequate homeownership opportunities also negatively affect the U.S. economy. Morgan Stanley estimated that the lack of access to homeownership has cost nearly 800,000 jobs and $400 billion in tax revenue. Morgan Stanley says housing discrimination has taken a huge toll on the economy, CNBC, Nov. 13, 2020.If adopted on a wide-scale, Tenancy-to-Equity would create benefits beyond the immediate benefits to renters.

Tenancy-to-Equity through a co-op avoids the predatory stigma sometimes associated with rent-to-own models and installment sales contracts. Tenancy-to-Equity need not have the fees and interest that are generally attached to existing alternative acquisition models.

Tenancy-to-Equity — A Flexible Co-op Model

Co-ops Generally

Co-ops are used in multi-family residential buildings nationwide in non-profit and for-profit contexts. Prospective members (residents) apply for admission and are screened by the governing co-op board. Buying the shares in the co-op allocated to a residence buys membership and ownership. Shares are generally determined by the apartment’s size relative to the building’s total size. Co-op members must pay their share of expenses, including property taxes, operating expenses and capital expenditures. Co-op boards generally appoint property managers, another cost paid by members.

In a limited-equity co-op, (“LEC”) the co-op share price can be set by a fixed formula to restrict or eliminate speculative gain from the property and its shares’ appreciation. See generally Local Housing Solutions, Limited-Equity Cooperatives. Tenancy-to-Equity co-ops combine aspects of traditional co-ops, the limited equity co-ops and traditional tenancy.

Tenancy-to-Equity Co-ops — Governing Law

Washington D.C.’s legal framework provides a representative example of how Tenancy-to-Equity co-ops would be authorized across different local jurisdictions. The D.C. Code, Title 29, Chapter 9, General Cooperative Associations, the (“Co-op Code”) is a permissive authorizing legal framework for Tenancy-to-Equity. The Co-op Code requires at least five incorporating members or at least two incorporating organizations. Co-op Code § 29–903 (2020). Properties with fewer than five apartments would not be well-suited for Tenancy-to-Equity because smaller buildings do not require as extensive management and generally do not entail significant community involvement.

Residents’ rights to flexibly achieve equity will be defined and described in a Tenancy-to-Equity Co-op Agreement (“TtE Agreement”). TtE Agreements incorporate that co-op’s Articles of Incorporation, also known as a charter. The powers of all co-ops flow from the charter (governed § 29–906) and through bylaws passed by the co-op board. Charters may permit non-profits, community organizations and individuals to be co-op members. § 29–923. Charters should specify all parties’ roles and state whether any community organizations will have temporary or permanent membership.

Every charter requires a statement of purpose. Non-profits and community development corporations (“CDC’s”) can use their discretion to align the co-op’s purpose with specified public benefits. This could be similar to a public-benefit corporation’s charter. For example, a Tenancy-to-Equity co-op’s charter could state its purpose is to “provide and maintain a co-op association with opportunities for community residents to flexibly achieve homeownership through flexible and forgiving share purchase programs, regulated share prices, and opportunities for community engagement and empowerment”. Community-conscious or community-driven statements of purpose would guide future board members and residents. Even if a community organization is not the initial developer, community organizations can seek to influence a charter, perhaps by mandating specific share purchase flexibility details or shares set-asides for extremely low-income groups.

TtE Agreements must reference the total number of authorized shares per the charter. § 29–906(9). The charter must recite the shares’ fixed par value. Id. TtE Agreements will specify the number of shares allotted to the particular residence that the prospective resident will lease and hopefully own. Disclosures regarding the total shares authorized and share costs can assure prospective residents that they are buying a valuable and meaningful interest because the total share authorization and issuance will reflect the building’s number of units. Residents will be assured by the co-op agreement and charter that the total share number has not been, nor can be diluted by additional share issuances. The Co-op Code permits allocating votes based on the proportionate share of ownership in the co-op or on based on one vote for each unit. § 29–902(3)(ii).

Charters, or an alternative agreement, would specify when the co-op’s board of director’s power shifts from the initial governing party to a board composed of residents, potentially also with a community organization. The Co-Op Code authorizes boards to exercise a wide range of powers: to make bylaws for management of the co-op’s affairs and exercise any power granted to businesses corporations as long as it is consistent with the Co-op Code. § 29–905.

The charter or bylaws will need to clearly describe how the costs associated with operating the building will be paid, managed, and possibly shared, before the co-op gains full governance and management capacities. However, the initial developer may need to remain a minority shareholder or retain some form of ownership to provide management services, likely through a property management company, to ensure a smooth transition. It is critical that residents understand the details and responsibilities of building management and have the necessary capacity.

Tenancy-to-Equity — Community & Resident Involvement

Community organization membership and support are essential to encourage local participation. Community organizations are also needed to explain Tenancy-to-Equity’s benefits. A community organization seeking a controlling interest in a co-op board should consider legal risks, including joint and several liability, as well as economic risks. For example, community organizations could be liable for the co-op’s debts. Similarly, the co-op association would be jointly and severally liable for the transfer taxes owed upon the transfer of a co-op interest. § 42–1103(c). Community organizations could be granted equity interests. Alternatively, community organizations could serve as voting member(s) without any equity interest. § 29–906(9) (authorizing voting power interests without ownership).

During the leasing process, prospective tenants would have opportunities to opt into Tenancy-to-Equity by signing a TtE Agreement. The initial governing party or leasing agent should require that the resident consult an attorney to ensure they understand the TtE’s Agreement’s terms. Each resident’s TtE Agreement will state the minimum quantity of shares to be purchased to achieve membership and voting rights (which two rights could have different thresholds).

After signing a lease and TtE Agreement, residents initially pay rent under traditional tenancy- yet with opportunities to purchase shares or a portion of a share. When unexpected expenses arise, or during unemployment, those who purchase shares ideally would not be penalized. A charter may impose a reasonable time limit for residents to purchase shares. Any time limit should conform with the co-op’s community benefit mission and should provide sufficient flexibility. If the initial governing party is unsatisfied by the total share acquisition amount, the initial governing party could transfer its interest to a more patient organization that is satisfied with ongoing rental payments and without assurance of capital gain-like exit on investment.

Despite many possible variations, generally residents shift from paying rent, to paying only those costs traditionally paid by co-op members. The TtE Agreement will state whether rental payments decrease proportionately with the number of shares purchased, or whether rental premiums are eliminated once a certain number of shares are purchased. For example, once a resident has acquired over 50% of the shares allocated to that apartment, the charter or TtE Agreement can mandate that residents no longer pay rent. Co-op costs could be phased in as residents acquire over 50% of the shares allocated to that unit.

Charters can be adjusted to reflect acquisition and development costs through a higher cost-per-share. Cost-per-share and allotments-per-residence can vary to reflect apartment quality and other benefits. Tenancy-to-Equity can provide payment flexibility by creating more shares per apartment and by allowing residents to accrue shares (equity) in smaller increments. For further share acquisition flexibility, a co-op board could create a system where residents could deposit any amounts at any time, which payments are automatically are applied to sequential share purchases. The Co-Op Code does not permit transfer or issuance of shares unless the par value has been paid in full. § 29–925. Thus, shares would need to be transferred and issued only upon full payment for that share. Id. Whenever the par value of a certain quantity of shares has been deposited, shares could be automatically transferred and assigned, with notice of the transfer provided to the resident. This could be similar to an online rent portal where tenants pay rent electronically, except with additional share purchase (and partial share purchase) options.

Cost-per-share may be lower if there is a CDC or other non-profit involved, and if the Tenancy-to-Equity developer is an experienced affordable housing developer. The Co-Op Code permits multiple types of shares in a co-op association. § 29–906. Charters can permit shares with special voting rights, governance rights or veto powers. For example, charters can stipulate that a non-profit developer or CDC retains voting rights despite not owning shares. These groups could exercise their rights for the purpose of furthering the co-op’s community wealth-building purpose, e.g., setting reasonable share re-sale restrictions, or approving a new resident who has been a long-time community resident. Special shares could also be granted for the purpose of overseeing Tenancy-to-Equity co-ops and providing real estate and management expertise.

The charter could permit granting a limited number of shares to residents for non-equity contributions, such as job training, landscaping, gardening or any activity improving the building and community. Turner Impact Investing, a social impact fund, provides rent reductions to tenants who provide “sweat equity” that benefits the building. Laura Kreutzer, Investor Bill Ackman and NBA’s Chris Paul Back Housing Fund, Wall Street Journal, Dec. 7, 2020.

Advocacy & Development of Tenancy-to-Equity Buildings

Providing residents with opportunities to gradually obtain equity ownership may help the developer receive the necessary community support to receive local governmental approvals. Community organizers and groups should use tax-benefits and leasing benefits as talking points to encourage Tenancy-to-Equity adoption. Community organizations should also highlight the “best-of-both-worlds”: developers receive rent payments while gradually receiving share purchases, a gradual exit of the investment, reducing uncertainty.

Tenancy-to-Equity buildings can be established through various methods. In one scenario, an initial developer voluntarily decides to structure its newly completed building for lease-up with a Tenancy-to-Equity structure and co-op in place. Alternatively, a developer could decide to lease an apartment without Tenancy-to-Equity and convert the building’s management to a new co-op structure where existing tenants and new residents could opt into Tenancy-to-Equity. It is possible that a Tenancy-to-Equity co-op board may not be created until the building is further stabilized or leased.

Non-profit developers (with lesser need for immediate profits) could create Tenancy-to-Equity developments for new developments or existing buildings. There is no realistic way to compel developers to participate. However, tax, leasing and community benefits can attract a range of participants. Additionally, increased interest in supporting disinvested communities, in part resulting from 2020 social and justice movements, and broader demand for impacting investing vehicles can catalyze investments in Tenancy-to-Equity.

Further, governmental affordable housing production funds could be allocated to Tenancy-to-Equity developments. Tenancy-to-Equity buildings also could be entitled to density bonuses (permitting a larger building than what the zoning permits as-of-right).

Following the developer’s paydown of any construction loan and awarding of any Low-Income Tax Credits (permitting LIHTC purchasers to reduce tax liability), loans for affordable housing are typically converted into long-term fixed rates. Since returns on the developer’s equity will be gradual and uncertain given the flexibility to residents, the mortgage principal should ideally be paid down when share purchases occur. The Tenancy-to-Equity developer likely will not be able to easily obtain Fannie Mae and Freddie Mac loans as the loans have strict criteria (in part due to later securitization). Thus, financing could be more expensive for Tenancy-to-Equity developers. A more flexible long-term loan structure will likely be needed. For example, a balance sheet loan with a revolving component (to provide a cushion to pay unexpected expenses) could provide flexibility in pay-downs.

The residential building developer or initial governing party, e.g., a community organization, may choose whether to lease exclusively to those interested in gaining equity through the co-op, or whether to also lease to those only seeking traditional tenancy. For example, someone may only be working in the area for one year, or a young couple may know they need to upsize in a few years to support a family.

If the co-op’s control of the board of directors has not yet shifted to community groups, the developer or initial governing party will have more control over the leasing process. The charter and negotiations with community groups should clearly delineate if and when control and management of the building’s leasing and TtE Agreement signings will shift to the co-op board and any community groups. For example, the co-op board and any community affiliates could be empowered to control leasing once 25% of the total issued shares have been purchased by residents, after a period of time. There should be adequate training and information to ensure that the new residents and board is prepared to maintain and manage the building. Better management increases the values of the residents’ ownership. It may be difficult to ensure that the residents are leased to community members. A community organization would be instrumental in steering pre-existing residents to the community.

Resident Departure & Re-Sale

If a Tenancy-to-Equity building is located in an area where property values are forecasted to appreciate, residents will want to sell their shares for more than the purchase price. It would initially be the incorporating party’s decision as to whether the residents would be permitted to sell their shares for more than the initial share price. If the co-op board is controlled by residents rather than community organizations, it is more likely that the residents will create more permissive re-sale bylaws, allowing residents to sell at market rates.

Strong share price restrictions could conflict with the Co-Op Code. The Co-op Code states the co-op’s purpose may be “for the primary and mutual benefit of the patrons of the association, or their patrons, if any, as ultimate consumers.” § 29–904. If the charter indefinitely limits share re-sales to the initial fixed share prices, residents could challenge the charter for not being for the primary benefit of the association and its patrons because the restriction would be benefitting outsiders in the community at the expense of co-op members who cannot fully realize the benefits of their investment.

Residents who have acquired shares and depart before becoming a co-op member should be required to return those shares for their acquisition cost. The charter or bylaws could determine whether there are any reasonable fees associated with a resident’s departure after having acquired a certain number of shares. The ability to sell a minor fraction of the shares allotted to an apartment, may be valuable to some (particularly if there are not re-sale restrictions). However, fractional selling would lead to additional complexity in managing the co-op. Community organizations could serve as the manager of returned shares and be granted power over the leasing and TtE Agreement signing processes.

Property Taxes

Tenancy-to-Equity properties could be subject to various property tax exemptions and should seek to minimize tax liability. Tenancy-to-Equity co-ops predominantly rented to low-income residents should apply to that jurisdiction’s local assessor or other governing governmental office for annual and one-time property tax exemptions. Tenancy-to-Equity incorporators should seek assurance that residents will receive existing tax benefits for lower-income homebuyers, specifically for co-ops.

Other organizations and individuals involved in Tenancy-to-Equity buildings could seek exemptions or assurances that Deed Recordation and Transfer Taxes would not apply upon transfer of any type of co-op interest to community organizations and in circumstances when apartments are rented in partial or full-compliance with that localities’ low-income household requirements. When not exempt from transfer taxes, Tenancy-to-Equity co-ops would need assurances from the local jurisdiction that the Deed Recordation and Transfer Taxes will only be levied when residents become co-op members after crossing share purchase thresholds.

Tenancy-to-Equity also provides residents property tax deferral, helping to make homeownership more affordable. Residents can contribute equity towards homeownership before becoming subject to Deed Recordation and Transfer Taxes, and before incurring property tax liabilities. However, instead of incurring these homeownership costs, residents will be paying some amount of rent. Further, cost-per-share lock-ins pursuant to TtE Agreements and charters could lead to lower principal amounts and property values upon which property taxes are assessed.

Residents obtaining financing for their share purchases (e.g. through a traditional mortgage, but perhaps with periodic disbursement to residents instead of an initial full disbursement) should seek guidance from the lender and from the IRS that the interest is eligible for the Home Mortgage Interest Deduction. See 26 U.S.C. § 163(e).

Property tax related exemptions and assurances would need to be pursued on case-by-case basis depending on the jurisdiction. No form of governmental taxation seems unworkable for Tenancy-to-Equity.

Leasing & Tax Advantages

Tenancy-to-Equity provides a new method and edge for lease-up. When a prospective tenant is choosing between a standard rental building and one offering the opportunity to achieve equity, many will select the building that offers an opportunity to gain wealth and no longer pay rent. However, a truly affordable building does not need a competitive edge because rents are below-market and are in high demand. To the extent investment and development is needed or wanted Tenancy-to-Equity can be a compelling incentive.

Tenancy-to-Equity provides tax advantages over existing ownership and sale structures. Tenancy-to-Equity’s tax benefits may be more compelling considering the President Biden Administration’s proposed increase of the capital gains rate to 39.6% on income above $1 million and proposed corporate tax rate increase. The gradual purchase of shares allows owners to defer capital gains taxes (to the extent shares remained unpurchased) and report income over multiple years under the installment sales method. 26 U.S.C § 453. This reduces the amount paid in the highest marginal tax bracket and preserves income for other investment. However, Tenancy-to-Equity reduces the amount of capital that can be re-deployed elsewhere.

In a 1031 exchange, no gain or loss is recognized on the sold property if the seller invests the sale’s proceeds for like-kind investment or productive real property within 180 days of the sale. 26 U.S.C. § 1031(a). Tenancy-to-Equity practically prohibits opportunities to defer capital gains taxes by transferring their old basis to the new property through 1031 exchanges because proceeds will not immediately be available for reinvestment. Community organizations not seeking redeployment of capital and non-profit without financial constraint do not face these limitations and may be better suited for Tenancy-to-Equity ownership generally.

Conformance with Affordable Housing & Landlord-Tenant Laws

The Tenancy-to-Equity hybrid structure makes compliance with the panoply of affordable housing laws and programs complex. Compliance with the full-range of a localities’ housing programs and laws will need to be examined. Tenancy-to-Equity proponents may need to engage in informational campaigns with policymakers to ensure the Tenancy-to-Equity co-ops receive the benefits they are entitled to. For example, Tenancy-to-Equity buildings’ required leasing to lower-income residents can ensure compliance with inclusionary ordinances. Ultimately, a campaign can lead to cost-savings and helpful partners.

Under landlord-tenant law, upon membership, residents would no longer be classified as tenants. Tenancy-to-Equity may lead to uncertainty arising from the application of landlord-tenant law when residents are part renter, part owners. To avoid uncertainty, the charter should require that residents receive all applicable tenant protections when residents own some but not all shares allocated to an apartment. Once residents become co-op members, the remedies for non-payment would be those available to co-ops to pursue non-payment and related remedies under contract and real property law. Charters or bylaws will need to resolve which party will be responsible for non-payment of rent and co-op payments from i) non-shareholding residents; ii) residents owning some shares but not yet co-op members, and iii) full co-op members. For example, the charter could provide that once 75% of the total issued shares have been purchased by residents, the co-op board is responsible for all of the building’s expected and unexpected costs.

Real Estate Technology

Tenancy-to-Equity co-ops will entail administrative expenses and complexity, particularly in managing and tracking residents’ rental payments, equity contributions and equity interests. Fortunately, software and businesses to track investments and modernize the real estate industry have proliferated. From 2016 through November 2020, real estate technology firms have raised over $19 billion dollars in the U.S. alone (excluding We Work related fundraising). Crunchbase Pro Database, (last visited Dec. 28, 2020). There are currently over 1,750 venture capital backed real estate technology in the U.S. Id. Real estate technologies could partner with CDCs and Tenancy-to-Equity co-op boards to provide custom solutions. For example, Carta provides simple tools for equity investment management. Carta tracks equity interests for a range of organizations. Carta’s mission statement states: “We’re on a mission to create more owners. With over 14,000 companies, more than 800,000 investors, law firms, and employees on our platform, and a commitment to transparency and equality….” Software companies can furnish portals wherein residents could track share purchases and the remaining capital required for membership rights, voting status, and full-equity status. Technology companies can help facilitate this unprecedented finance structure and minimize administrative costs.

Conclusion

There is little reason for real estate ownership and tenancy to be as rigid as it is today. There is a great need for more flexible pathways to ownership. Relatedly, there is a high interest in investments in communities that have positive social, racial and economic impacts. This need and demand can be fulfilled through Tenancy-to-Equity co-ops. Enthusiastic community organizations, affordable housing developers, traditional real estate developers and social impact funds, all can create Tenancy-to-Equity properties, thus building community-wealth in areas needing it most. Washington D.C’s permissive Co-op Code and similar frameworks nationwide are legal foundations for residents to share the benefits of ownership through transparent and accommodating Tenancy-to-Equity co-ops.

Adapted from a proposal written for Professor Anthony Cook’s Community Development Seminar, Georgetown University Law Center, December 2020.

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Aaron Reuben

Aaron is an Associate at Paul Hastings LLP. J.D. from Georgetown Law. NYU alumnus. San Franciscan.