The conventional way of financing property development entangles those involved in a web of debt and conflicting business interests. A new way of organising developments promises better buildings, more affordable rents and a stake in the outcome for everyone.
“It is to be observed, that in common speech, in the phrase ‘the object of a man’s property’, the words ‘the object of’ are commonly left out; and by an ellipsis, which, violent as it is, is now become more familiar than the phrase at length, they have made that part of it which consists of the words ‘a man’s property’ perform the office of the whole.” — Jeremy Bentham, “An Introduction to the Principles of Morals and Legislations” (1789)
We are accustomed to thinking that property is an object — typically, a productive asset — that may be bought and sold, but as Bentham points out above, this is incorrect. Property is the relationship between an individual — the subject — and the asset, which is the object of the individual’s property. So the productive asset of land is not property but rather the object of a man’s property or something that is “proper” to the man. It follows that property is the bundle of rights and obligations that connect the subject individual to the object asset.
The Land Equity Partnerships that I describe in this chapter (I’ll just call them equity partnerships from now on) are an example of the new types of arrangement that can be made when people think of property in terms of rights and obligations rather than ownership.
Land, or perhaps more accurately location, has a value when it is put to use. Its value may perhaps derive from crops that grow on it, or from animals or fish that feed there. It may also derive from its use by individuals to live there, or to conduct business there, or for use as public infrastructure such as transport. This use value then has a value in exchange; individuals are prepared to exchange something of value in return for the use of land at a specific location.
The bundle of rights and obligations relating to land/location is typically recorded in the form of legally binding protocols, although in less-developed nations the rights and obligations relating to land may be a matter of oral tradition. Some cultures are unable to understand that anyone can have absolute rights over land. Others insist that absolute ownership is God’s alone; but the convention in many societies is that the state has absolute ownership of land and that exclusive property rights may then be granted to individuals or to enterprises with legal personality (corporate bodies).
Conventional private-sector property development is transaction based. Land-owners sell land to developers who obtain any necessary permissions, improve or build on the land and sell it to a buyer. Developers typically obtain as much of the development finance as possible by borrowing at interest from a credit institution or investor. Buyers typically finance their purchase with loans secured by a legal charge or mortgage. After a time, they will sell the property to another debt-financed buyer, or find a tenant, and so on through the years.
In most cases a developer has no interest in high-quality standards or energy efficiency because he will not be associated with the site once the development has been sold. He simply wishes to maximise the transaction profit. He will therefore attempt to ensure that any investment in amenities, infrastructure or transport is made by the public sector rather than by him.
A new legal entity
On 6 April 2001, a new legal entity, the Limited Liability Partnership (LLP), came into effect in the UK and, despite the fact that its objective was to protect professional partnerships from the consequences of their own negligence, it made possible a new way of handling and financing property development. Confusingly, an LLP is not legally a partnership. It is, however — like a company — a corporate body with a continuing legal existence independent of its members. Also, as with a limited liability company, members cannot lose more than they invest in an LLP.
An LLP need not have a Memorandum of Incorporation or Articles of Association and is not subject to the laws governing the relationship between investors and the directors who act as their agents in managing the company. The ‘LLP agreement’ between members is totally flexible. It need not even be in writing, since simple provisions based upon partnership law apply by way of default. As a result, an equity partnership set up as an LLP is a consensually negotiated contractual framework for investment in and ownership, occupation and use of land.
An equity partnership (EP) does not own anything, do anything, contract with anyone or employ anyone. In other words, it is not an organisation: it is a framework agreement within a corporate “wrapper.” The EP agreement sets out the relationship between the different stakeholder groups, and each stakeholder group may also have its own specific sub-agreement at whatever level of formality (e.g. an organisational constitution) its members agree. The EP encapsulates the entire property relationship within a corporate entity and related framework agreement.
An EP has a minimum of four types of partner:
- The custodian — who holds the freehold of the land in perpetuity
- The occupier(s) — individuals and/or enterprises occupying the property
- The investor(s) — individuals and enterprises who invest money and/or money’s worth (such as the value of the land)
- The developer/operator — who provides development expertise and manages the EP
Potential partners in an equity partnership
(Source: James Pike)
The landowner may be a private individual or investor, a local authority or a developer. The landowner transfers the land to the custodian, and becomes an investor in the partnership.
Holds the freehold of the land in perpetuity on behalf of the partners. The custodian is probably a board of independent experts with legal, financial, property and construction expertise. The custodian sets up a Charter of Co-operation between equity partners.
The developer may be the owner of the land, or he may have set up an agreement with the landowner, or he may be brought in as an investor to contribute his expertise to the development. He may also be the contractor.
The manager is appointed by the custodian to manage the development, its maintenance and transfers of investors. The manager is likely to be a property management company with valuation and property transaction expertise.
The local authority
The local authority zones and grants planning permission, which adds value to the land. It also imposes obligations such as Part V and charges for infrastructure services.
It may be the owner of the land. If not, it may be an investor to maintain a say in the development on behalf of its tenants under the Part V requirements or other community interests.
The investors would include the site owners. They could also include the bank or the housing finance agency funding the local authority, or the bank funding the developer. Once the development is completed and fully let, it would be an ideal, low-risk investment for a pension fund or other investment fund, which could buy out the equity shares held by the landowner, and/or the local authority, the developer and the contractor if they wished to sell.
The contractor may be brought in as an investor by the custodian, the local authority or the developer. He would be expected to invest at least part of his profits from the contract to align his interests with those of the other partners.
The development will require insurance once it is occupied. This is normally obtained by the manager. The insurance company providing the insurance could be an investor in return for preferential rates.
The community of individuals who occupy the properties on the land. While the majority of occupiers will be residents, equity stakes can also be built by enterprises operating on the land, e.g. a local shop or hairdresser. The occupier rents the property at an affordable basic rent. This should be sufficient to cover interest charges due to the investors. The occupier has a right to pay an additional amount to purchase equity shares in the development. Once the income from these equity shares is equal to the rent being paid, the occupier effectively owns the dwelling but not, of course, its site. This feature enables them to buy their dwellings over the years without taking out a loan. Occupiers vacating their dwellings receive the full value of any equity shares they hold.
How an equity partnership works
Landowners invest the agreed value of their land/location in the partnership in exchange for “equity shares” which are millionths of the flow of rentals to be paid by the occupiers when the development is complete. This gives the landowner a share in any development gain. While not every development goes to plan, the partnership model ensures that everyone involved has an interest in ensuring that it does. If the land invested does not have planning consent, the local authority can invest the value of that consent, hoping to receive a greater return on its equity shares than it would conventionally.
The custodian becomes steward over the land in perpetuity, with rights of veto over land use, and also safeguards the EP’s purpose and values as expressed in the EP agreement. The custodian may be an individual, a board of independent experts with legal, financial, property and construction expertise, or a public body such as a local authority.
Investors then invest “money’s worth” or money to allow the development to be carried out, and in return they receive a proportionate number of equity shares. Once the development is complete, the occupiers pay an agreed rental in money or “money’s worth” of services for the use of the capital that has been invested in the location. This capital rental is set at an affordable level initially and may rise according to an agreed index of inflation. The occupiers also make a payment or provision for the maintenance/ depreciation (and possibly heating) of the building. The developer/manager manages the development or use of the building in return for equity share in the rentals. If an occupier pays more than the affordable rental, he invests automatically in equity shares, and thereby acquires a stake in the property in which he lives. Once he has acquired enough shares, the income which he derives from them cancels out the capital rental he has to pay.
The pool of rentals created by development is shared out amongst the holders of the equity shares in proportion to their holdings. This form of EP is essentially a Real Estate Investment Trust (REIT). REITs have become extremely popular recently because rents flow through them without tax having to be paid by it. Instead, any tax due is collected from the shareholders.
Investors, who have seen their income dwindling as interest rates spiral towards zero, should be extremely interested in an investment such as this. Equity shares offer a reasonable, index-linked return based on property. There is a very low risk that the return will not be paid since affordable rentals are by definition more likely to be paid. Equity shares are a perfect investment for risk-averse investors such as pension funds and sovereign wealth funds. In particular, this investment is perfect for Islamic investors since no debt or interest is involved.
Capital rental to develop five eco-houses
A landowner invests land in exchange for a 20% equity share in the rentals from the developed property. A provider of eco-friendly and energy-efficient wooden buildings is prepared to sell five units at a cost of €200,000 plus a 10% equity share since he is investing part of his profit margin. The occupiers-to-be dig the foundations and provide other non-skilled labour. In return they receive a 10% equity share. In addition to the €200,000 spent on the houses, a further €100,000 is used to purchase heat pumps, a wood-chip boiler and pay for other investments in energy efficiency.
As 40% of the rental income has been allocated, 60% is left to pay for ongoing maintenance and management and to give a return on the €300,000 money investment. Let us suppose that a 10% share goes to maintenance and 50% goes to pay the investors. A 4% initial return on investment requires a capital rental of €24,000 in the first year. It would be divided as follows.
- Management and maintenance charge is 10% or €2,400
- The former landowner receives 20% i.e. €4,800
- The building manufacturer receives €2,400
- Investors receive €12,000.
The occupiers pay €4,800 per house per annum gross initially. This is reduced by €480 (their equity share), to give an affordable rent of €360/month each.
Capital rental and land rental to reconstruct seven local authority dwellings
Seven existing properties are in municipal ownership. Two of them are to be converted into three units of 1-bed each, while the other five will each be converted to give a 1-bed unit on the ground floor and a 2-bed unit on each of the two floors above. Accommodation for, say, 20 people in eleven 1-bed flats and five 2-bed flats will result. A common space and shared facilities will also be provided at ground level and ground-source heating and other energy-efficient features will be installed.
Each of the seven sites on which the dwellings stand is valued at €100,000. The current value of the two buildings to become 1-bed units is put at €125,000 each and the five other buildings at €100,000. The redevelopment cost is €70,000 per building or €490,000 so the total cost of the scheme, allowing €10,000 contingencies, is €1,950,000.
The municipality puts in half the value of the land (€350,000) and 20% of the value of the buildings (€150,000) in return for equity shares. The remaining €1,450,000 is contributed by an investor prepared to accept an initial 3% return or €43,500 per year. This capital rental would be inflation-linked and would therefore provide a real asset-based return of 3% to the investor regardless of movement in interest rates. The 20 occupier members would pay €2,175 each per year in rent, or just under €42 per week.
In addition to the capital rental, the equity partnership members agree to include a land rental payment in their EP agreement. This rental is a pre-distributive mechanism internal to the EP and utilises two separate parameters: an income pool and a land-use pool.
(i) Income pool
Assume a contribution to a ‘pool’ at the rate of 5% of income.
5 members on €50 per week state benefits pay in total €12.50
5 members on €100 per week pay in total 25.00
5 members on €150 per week pay in total 37.50
5 members on €200 per week pay in total 50.00
The outcome is a total income pool of €125 per week, which is then divided between the 20 members giving a dividend of €6.25 each. This gives a net rebate to those earning less than €125 per week and a net contribution by those earning more. This is intended to subsidise the capital rental payments for those least able to afford them. The contribution rate could be higher or lower than 5%.
(ii) Land-use pool
The land occupied by the EP members would be assessed using Land Rental Units (LRUs). In the example, five properties each occupy three units of land, while the other two are bigger and occupy five units — a total of 25 LRUs. The members agree a value payable per LRU by the occupants of each property into a pool. Again, net-value transfers (payments or receipts) result from those enjoying above-average land use per person to those with below-average land use.
A comparison with conventional refinancing
EPs may be used to refinance existing secured debt through “unitisation.” Take a €1bn nominal value portfolio consisting of 5,000 25-year mortgage loans averaging €200,000 and paying interest at 6% per annum. On average, each borrower must currently repay €1303.77 per month or €15,645.24 pa for the life of the loan.
Under an EP arrangement, a capital rental could be set at an “affordable” level, say, an average €500 per month or €6,000 pa. This would be index-linked. The total rental income would be €30m in the first year and would rise with inflation. The 5,000 properties would be “unitised” into (say) a million “units” or “millionths”, each consisting of one millionth of the economic interest/”ownership” of the relevant properties. A unit would bring an income of €30.00 in the first year, rising with inflation thereafter. What would the market price of these units be?
i) At €1,000 per unit the initial return is 3%, and the proceeds €1bn which refinances the debt at 100% of nominal value;
ii) At €750 per unit the initial return is 4%, and the proceeds €750m or 75% of the nominal value. And so on.
It will be seen that the absence of debt repayment dramatically reduces financing costs.
Improved affordability and sustainability
The problem in most urban areas is not the affordability of housing but rather the affordability of land, since construction costs are relatively uniform. In essence the issue relates to land rental values, since a land purchase price is simply the capitalised net present value of future land rentals. The issue of supply relates primarily to planning, land use and an absence of incentives to bring land into use. The use of a land rental will tend to incentivise occupiers to bring land into productive use.
The use of the EP allows land-owners to invest the value of their land and to receive an agreed share of the rental value of the developed land. Similarly, local authorities’ participation in EPs allows them to invest the value of planning consents, and to use their resulting share of the rental value of developed land to cross-subsidise affordable property rentals. If local authorities were to specify that development could only take place within an EP framework, then the result could be a major increase in development of affordable housing. This might require legislation. In fact, the structure is similar to the use of statutory Development Corporations in the UK, except that land-value capture is addressed consensually within the EP framework, rather than adversarially within a statutory framework.
In the UK, the statutory “right to buy” in the public sector has seen a transfer of housing from the public to the private sector. The EP gives occupiers both an indefinite “right to rent” and a “right to invest” in the co-owned property in which they live.
They may not only buy equity shares conventionally, but also acquire them as “sweat equity” through:
- self-build or partial self-build;
- carrying out maintenance to agreed standards, to be monitored by the EP operator member.
As occupiers acquire equity, then their net capital rental obligation gradually falls so when their investment reaches a level at which the notional capital rental income equals their capital rental obligation they are, in economic terms, the owner, although the land remains in custody. Moreover an investor/occupier may flexibly release equity at any time simply by selling equity shares.
Governments that give rental subsidies, grants or subsidised loans for property merely increase rents or the price of land. The EP model takes land ownership out of the equation by putting the land into the ownership of a custodian, and the land price therefore cannot become inflated because it is never sold again.
Where landowners are reluctant to give up ownership, it is possible for them to retain ownership as the custodian member. In that case, the EP agreement essentially operates as an evergreen lease of indefinite duration — that is, the occupier is entitled to use of the land for as long as he pays the rental. The measure of control, such as restrictions on use, retained by the owner would affect the amount and nature of the return they could expect through the EP, in their other stakeholder role as an investor of the value of the land.
An EP improves affordability by drastically cutting long-term financing costs because:
- there is no return of capital, as there would be with debt, since the capital value is unitised into tradable equity shares in the EP, just like the units in a unit trust;
- the return on capital bears no relationship to interest rates. It gives an index-linked return reflecting the risk of property-based investment.
Stakeholders’ participation means that the need for development finance is minimised. For example, the land is not bought with loan finance but invested in return for equity shares.
In the EP model the developer/operator is a service provider, rather than an intermediary, and need neither risk equity capital nor put his business at risk by obtaining secured loan finance. His interests lie in minimising the total cost of occupation over time, because this will maximise the rental revenues and therefore the value of the units that he gets in return for his services, expertise and time committed.
Similarly, any contractors responsible for design and construction can be given the option of being paid in equity shares instead of money. Even if they chose money, they would be expected to take their profit in units so that their stake in the outcome was aligned with the interests of the other stakeholders. As a result, it is in the interests of all stakeholders that the buildings are constructed to high standards of quality and energy efficiency, since to do so minimises the total cost of ownership over time. The result is a genuinely sustainable development.
There are three key areas to which attention must be given in order to set up an equity partnership: the availability of the necessary legal form; the taxation regime; and the regulatory regime.
The legal form
The enabling legislation is the recognition of an “open corporate” enterprise. This is a new type of legal entity, which is a corporate body with no stipulations about what its governing agreement should be, and only simple default provisions based upon partnership principles about its governance. In the UK this was achieved in two pages of legislation and one page of default provisions. The other (relatively few) provisions in the UK legislation dealt with technical matters relating to taxation and limitation of liability. Anyone wishing to set up an EP in the Republic of Ireland could do so in Northern Ireland under the British legislation until equivalent legislation is passed by the Dail.
If open corporates are permitted, then limitation of liability could be available subject to payment of a bond (as in Jersey); an insurance premium; or a provision into a default fund. However, since an EP is a framework agreement linking all stakeholders and the EP doesn’t actually do anything, there is no need for limitation of liability because no-one outside the EP can be adversely affected by it.
An EP is “tax transparent.” It does not pay tax on any capital gains or income that flow through it. Its members pay instead according to their personal or corporate liability.
Statutory provisions that protect investors in relation to the actions of financial services intermediaries are unnecessary in relation to an EP, because any financial services take place within the EP framework and are subject to the EP agreement.