Pity Ota Šik. Šik was a Czech economist who worked in the Novotny and then the Dubček governments during the 1960s. He advocated for a “third way”, or socialism with relaxed price controls and elements of private enterprise. The hard-liner Novotny stymied his efforts. Dubček supported them, and they became an important element of the changes that took place during the Prague Spring of 1968. He was in Yugoslavia on vacation when the Soviet tanks rolled into Prague in August of that year. He was in Switzerland when Jan Palach immolated himself. He spent the rest of his career as an economics professor in Switzerland, although he did return to the Czech Republic after 1989.
Everyone remembers Dubček. We think of Jan Masaryk whenever we push someone out the window. But nobody remembers Šik, although sometimes we do use the noun phrase “a third way”. He pioneered the use of the term.
In this country, in 2015, sections of the Truth in Lending Act (“TILA”) were amended to make it difficult for park owners to finance sales of manufactured homes. Pre 2015, it was common for park owners to “take back paper” from residents who did not have cash saved up to buy mobile homes. This allowed residents who had scratch-and-dent credit to buy their own home. This, in turn, allowed residents to build their credit score and to save money by buying an asset rather than paying rent. The 2015 amendments to TILA limited interest rates that can be charged on mortgages of this type and also imposed burdensome regulatory and reporting requirements on park owners who take back paper. It effectively shut the business down.
The unintended consequences of the New TILA were particularly harsh in New York State. That is because homes manufactured before 1995 do not have titles in New York. Banks will not lend against non-titled homes because without a title, it is impossible for them to record their security interest. This meant that the segment of our population most in need of financing alternatives, i.e. people who can not afford new homes, were cut loose from the only source of home financing available to them.
But it gets worse.
New TILA regulates the issuance of residential mortgage loans. However, it states that it does not regulate leases. Although it does not distinguish between a lease and a mortgage, it does say that lease-to-own products, such as car leases, are not covered by the legislation. So in 2019, when the New York State passed the Nakba legislation, they included legislation that regulates so-called rent-to-own contracts. And the Nakba legislation is nasty. While TILA imposes reporting and regulatory requirements that are enforced with fines. The Nakba legislation, by contrast, includes disgorgement requirements and liquidated damage penalties. You got that right. Someone lives in your park for three years and moves out before they get title to their home (say, because their pitbulls do not comply with park rules). You are required to pay them everything they have paid you, plus a multiple thereof in damages. Most insalubrious.
Semantics is where the rubber meets the road here. If the contract you and your resident entered into is a residential mortgage under TILA, it is regulated by TILA. If it is a rent-to-own contract under the Nakba legislation, it is regulated under the Nakba legislation. There is not a lot of law on how to distinguish a lease from a loan from an option from a rent-to-own contract for these purposes. In other areas of the law, courts and regulators look to the economic substance of a transaction to determine the true owner of an asset when form is manipulated to skirt the rules (full disclosure: I did this for a living, when I was a tax lawyer). Once you determine the beneficial owner of the asset, you can decide whether the applicable transaction is a lease, a loan, or some kind of derivative. The classic case of a transaction whose form does not map on to its substance is a long-term lease with an option for the lessee to buy the asset at the end of the lease term for a nominal amount. The thinking is that, so long as the lessee is economically compelled to exercise the option – i.e., if only a bonehead in the lessee’s shoes would not exercise the option – the lease is more like a self-amortizing loan than like a lease. It becomes more fishy if the lessee has the right to buy the underlying asset prior to the expiration of the lease for a price that tracks what would be the principal amount remaining on a mortgage on the exercise date. If the lessee is responsible for property taxes, repairs and insurance and bears the risk of loss in the case of a natural disaster, it is a mortgage in all but name.
What this means is that, after 2015, a lot of effort went into designing owner-financing products that constitute leases, rather than loans, for purposes of manufactured housing regulation. The two most common such products are rent credit programs and lease-options. Under a rent-credit program, a resident gains credits for each dollar or fraction thereof he or she spends on rent. These credits function like airline points. They are non-transferrable, can not be sold and lapse if the resident moves out of the park. They can be used to offset the purchase price of any home in the park. Under a lease-option, a resident leases a home and gets the option to purchase the home on or after a certain time period.
Rent credit programs should not be treated as loans. No specific asset is identified on Day 1 as the asset to be transferred at maturity. The park pays property tax and buys insurance for the home in which the resident lives. If the resident’s home burns down prior to purchase, the credits may still be used to purchase another home in the park. Burdens, benefits, specific identification – all point to the park, rather than the lessee, as the beneficial owner.
The correct characterization of a lease-option, by contrast, depends on the facts and circumstances of the particular transaction. As discussed above, some lease-options are mortgages in drag. For this reason, well-advised park owners who offer lease-options are careful to retain responsibility for the warranty of habitability; to not take non-refundable purchase payments on Day 1; to make sure that rent payments are the same as payments made by lessees who do not hold options; to make sure the contract is non-transferrable; and to make sure that the option strike price is equal to the parties’ best estimate of fair market value on the expiration date.
However, there appears to be a third way. That is a lease with an American-style option.
Options offered under lease-option arrangements tend to be what are called on Wall Street ‘European-style’ options. That means that they can be exercised only on their expiration date. American-style options can be exercised any time from the date of issuance until expiration (‘Bermudan-style’ options can be exercised at one or more dates between issuance and maturity). A third kind of seller financing for manufactured housing is for park owners to offer lessees American-style options to purchase their homes. These arrangements create an incentive for lessees to purchase their homes, and they are clearly neither mortgages nor rent-to-own contracts for TILA or Nakba purposes.
Here’s how that would work. Let’s say a park owner purchased a home for $25,000, including transaction costs. She wants to get a 10% mark-up on it, so she will sell it for $27,500. She finds a buyer who is approved by the park but who can’t scrape together the money to buy the home up front. Lot rent is $420 a month and apartments in town rent for $900. Under a mortgage-in-drag lease-option arrangement with a European style option, the lessee would pay $1,380 to the owner for seventy-eight months and then buy the home for a nominal amount. That is equivalent to a no-money-down mortgage with monthly payments of $480 and an interest rate of 10%, in addition to a lease of $900 per month.
An alternative would be for the owner to lease the home to the resident for fair market value, i.e. $900 per month, and enter into an American-style option to purchase the home for, say, $25,000. The option expires in three years. The lessee has the right to exercise the option at any time from the date of signing to the maturity date, three years hence. Regardless of the date of exercise, the strike price remains the same, i.e. $25,000. Amounts paid as lot- and home rent do not reduce the strike price. Assume further that the owner tells the lessee that rental payments will increase annually (in New York, these increases are limited to 3% or, in an inflationary environment, 6%). How does this affect the rights and liabilities of the owner and the resident?
Let us count the ways:
- The arrangement is, unambiguously, neither a mortgage nor a rent-to-own transaction. Mortgages and RTO transactions are both installment-sale transactions. As such, both share one crucial feature, i.e. the longer their term, the greater the number of principal or rent-to-own payments are applied to the purchase price and, hence, the lower the eventual purchase price. By contrast, in the American style option transaction described above, the purchase price remains constant regardless of exercise date. Lease payments do not reduce the strike price. In fact, the longer the lessee takes to exercise her option, the more she will pay under the arrangement, because she will not receive a rebate for pre-exercise lease payments;
- There is an incentive for early exercise. The sooner the lessee exercises, the sooner she will be rid of lease payments. This incentive is strengthened, if the lessee is informed that monthly payments will increase each year; and,
- The arrangement might work for some residents, but not for all. For example, if a prospective resident expects to inherit a slug of money in four to six months, they can lease the home until they come into their fortune. If the home can qualify for bank financing but the resident needs a few months to work on her credit score, this can give her a place to park while she sets things right. However, this will likely not meet the needs of a resident who does not expect a slug of money to come in shortly who wants to buy an unfinanceable home.
(Note that, although American-style publicly traded options can be exercised prior to maturity, that almost never happens. This is because every option’s price consists of either one or two components. The first component is intrinsic value, and the second component is option value. Options that are in-the-money (i.e., calls whose strike price is lower than the underlying’s value, or puts whose strike price is greater than the underlying’s value) have intrinsic value equal to the difference between the strike price and the value of the underlying. Option value is everything else. At-the-money and out-of-the-money options only have option value. In-the-money options have both option value and intrinsic value. Option value reflects the probability that the option will expire in the money or farther in the money. Option value is why tradable American-style options are almost never exercised. The holder of an American-style option who wants to cash out will almost always sell their option, rather than exercise it, because by exercising it, the holder would give up option value, while if they sell it, their counterparty will pay them for it. Rare exceptions to this include options on stocks pregnant with dividends that more than offset option value, and options that are so deep in-the-money as to have no real option value. This does not apply in the case of American-style options on manufactured housing, because these options are nontransferrable.)
I am afraid that I do not know more about Mr. Šik. He consulted with the post 1989 Czech government but did not hold any official post after he fled in 1968. He died in 2004. We all know how Jan Palach met his end. Jaromir Jagr, whose grandfather died in a communist prison in 1968, wore the number ‘1968’ throughout his NHL career, but he was eventually traded to a Russian team, and played in the former Soviet Union for several years. That is like Fidel Castro shaving his beard for a Schick commercial, mutatis mutandis. But thanks in part to Mr. Šik’s third way, private enterprise is alive and well in the former Czechoslovakia. A friend of mine even runs a successful wood turning and education company, based in Prague. Readers are encouraged to buy his products or sign up for a craft course, courtesy of the Third Way.