Build-to-Rent Deals: Navigating the Legal Issues
Structuring transactions in this emerging asset class presents challenges that developers and investors should consider, advise attorneys from the law firm of Goulston & Storrs.
There are not enough homes to rent in America. Higher home costs, increased debt loads and a desire to maintain freedom and flexibility have led the newest wave of house hunters to single-family rentals. Investors are amassing large stocks of single-family homes, once owned by individuals, to cater to this new generation of renters.
Single-family rental is the fastest growing segment of the U.S. housing market. With an estimated 16 million single-family rental homes in the country, the sector currently comprises approximately one-third of all U.S. rental properties and 66 percent of the rural rental market. By 2030, the number of single-family rentals is expected to almost double. However, residential construction has been slow for almost a decade, and the existing single-family housing stock is far below projected long-term demand.
The combination of limited supply, a desire to achieve scale quickly and the prospect of reduced maintenance, is leading investors to funnel significant resources towards a burgeoning new asset class: “build-to-rent” communities. As a result, new residential neighborhoods are springing up across the country, entirely for rent and not for sale. From an operational standpoint, the developments often function like high-rise apartment buildings. On-site managers coordinate leasing and maintenance. Some projects even feature luxury amenities like tennis courts, swimming pools, fitness centers, dog parks, and community plazas. But whereas high-rise apartments stack vertically, the detached, single-family rental homes sprawl horizontally, mirroring the layout of other suburban neighborhoods.
This emerging asset class presents a number of legal challenges and also opportunities that developers and investors need to consider as they structure their “build-to-rent” transactions. In particular, investors should be aware of issues relating to construction warranties, closing conditions, homeowners’ associations, leasing arrangements and unique financing features.
As with the purchase of any new home, investors must understand the terms, conditions, scope and duration of construction warranties and the extent to which the seller or a third-party contractor is providing them. Generally, investors acquire homes from homebuilders who may engage third-party contractors. In any case, investors should obtain a covenant that homes will be built in accordance with provided plans and specifications, as well as warranty and surety coverage for materials and workmanship, piping and wiring, and structural defects of homes. It is imperative that parties confirm that contractors’ warranties are fully transferable from sellers to investors. Since warranty laws vary by state, it would be prudent to engage local counsel for this review. For example, in Minnesota, there is a statutory three-paragraph warranty required for all construction contracts. In New Jersey, homebuilders must enroll in a state-approved warranty plan. In Georgia, there is more flexibility, but all warranties must be in writing, identify duration, assign manufacturer warranties, describe claim procedures, and response options.
The purchase of homes yet to be constructed requires special attention to the transaction’s closing conditions. Parties must decide whether homes will be acquired piecemeal or after completing construction of the entire community and whether the homes will be acquired as they become “habitable,” as evidenced by a certificate of occupancy or only after they are leased. At a minimum, closing conditions should include the delivery of all necessary closing documents, the issuance of a title insurance policy and a permanent certificate of occupancy for each home. In addition, investors should have the right to inspect each home prior to each closing to verify compliance with construction plans and specifications. Because each home constitutes a disparate asset, investors may have an additional opportunity to obtain certain “kick-out” rights. Investors in a larger single-family rental portfolio may choose to exclude certain homes from a deal if there are incurable problems, like title defects, leasing restrictions in an HOA, discussed more fully below, or even casualty or environmental issues. In the same vein, investors also may be able to negotiate for “post-closing seller repurchase” obligations for some or all of these types of issues. Other closing conditions will reflect the structure of the particular deal and may require adjustment based on local law and custom.
If the homes to be acquired belong to one or several homeowners’ associations, investors must conduct additional due diligence. While part of the HOA diligence can be addressed through seller representations and warranties in a purchase agreement, typically, investors also will want to obtain a clean estoppel certificate directly from the HOA. In addition, in reviewing the HOA documentation, investors should specifically confirm that there are no leasing or other material restrictions that would undermine the purpose of the investment. Finally, investors need to confirm during the diligence period that their title company is willing to insure the home without any specific restrictions from the HOA.
If investors are buying many, but not all, of the homes in an HOA, investors should confirm that they will have an opportunity to control the HOA upon turnover or at least that the HOA’s governing documents cannot be amended without the investor’s prior consent. If investors are building or buying an entirely new community and there is no HOA, investors should consider whether the benefits of creating an HOA to be owned and controlled entirely by the investor outweigh the costs and administration. These benefits include the limitation of liability, administrative and organizational ease, and potentially, increased liquidity for some or all of the homes.
Leasing Arrangements & Maintenance Obligations
Once the community is acquired, investors should define the extent of their responsibility as landlord through carefully crafted leases. These leases need not be the same as in a multifamily property. Given the independence historically associated with single-family living, tenants of build-to-rent communities may be more open to taking on certain maintenance responsibilities and might even prefer solving mundane issues on their own. Adoption of property technology such as video or chat software that assists tenants fixing minor, common problems themselves can facilitate the hands-off approach. The benefit of the upfront-spending by landlords to install property technology or crafting obligation-shifting lease provisions could result in long-term property management cost savings. However, the enforceability of lease terms that push responsibilities traditionally belonging to landlords onto tenants should be analyzed under applicable state and federal law prior to taking effect. In any event, all of these options are more readily available in newly built-to-rent communities.
There are numerous new and creative financing opportunities for buyers and builders of single-family rentals, ranging from warehouse facilities to securitized pools. In any financing, borrowers need to consider the mechanics for getting to a closing involving a large portfolio of assets and the practicality of operating such a portfolio while being subject to a loan. Once a pool of assets is identified, the borrower will need to engage with lenders in a due diligence process (including title review). This process requires consultants who have experience with this asset class. The business terms of any such financing (including the guaranties that will be required) will depend on the collateral pool and whether the assets will be subject to a mortgage or deed of trust or if the borrower will deliver equity pledges (or both). On an ongoing basis, the loan documents will need to provide flexibility for the renovation of “fixer uppers,” adjustments upon stabilization, a release mechanism for homes that are to be sold and/or a replacement mechanism for replacing homes with new ones during the term.
As demand for this new asset class continues to grow, many want to address emerging social, economic and political issues, including the ways renters conceive of community, impacts on local school operations, local commerce, taxation and city politics. Meanwhile, investors, owners and operators will need to how to navigate the particular legal issues in order to continue to ensure that supply can meet the demand.
Zev D. Gewurz is a director & co-chair of the International Investors Group at Goulston & Storrs in Boston. Yuanshu Deng is a director & group leader of the firm’s Real Estate Banking & Finance Group. Dan Lasman is an associate at the firm.