Capital Improvement Options for Indexed Resale Formulas
Revised: December 22, 2014
One of the common concerns about index based resale formulas is that they create no incentive
for homeowners to invest in improving their homes – the formula will generate the same sales
price regardless of any improvement that they make. There are a number of different approaches
that CLTs that use these formulas have taken to address this concern. Some CLTs rely on the fact
that homeowners will be motivated to make improvements even if they do not receive any credit
at resale simply because they live in their homes and want to benefit from whatever improvement.
Others develop complex systems for reviewing, approving and assigning a value to improvements
that homeowners make and provide language in their ground leases that allow the CLT to
approve a credit for improvements which increases the resale price of the home. Below are three
alternative approaches to this question with varying degrees of complexity. While these three
alternatives provide a sense of the variation there are many many other alternatives in use.
A. Very Simple Open Ended Option
This very simple language gives the CLT the option, but not the obligation, to approve any
improvements for whatever reason and to add the value of those improvements to the formula
resale price. The homeowner, under this approach, has no right to credit for any improvements –
approval is entirely at the discretion of the CLT. This approach has the advantage of being short
and fairy clear but it makes it very hard for homeowners to know in advance what kind of
improvements will be approved. This version also allows for depreciation of the improvement so
that a kitchen remodel that is initially worth $20,000 will add less to the resale price in each
future year.
Add to Section 10.10:
CALCULATION OF THE FORMULA PRICE: The Formula Price shall be equal to
Lessee’s Purchase Price, as stated below, plus a) an indexed increase in Lessee’s’ equity,
plus b) a Credit for Capital Improvements, if applicable, as stated below.
Indexed Increase in Lessee’s Equity: … [Insert existing index language]
Credit For Capital Improvements. Value for Added Improvements shall be permitted
only if the Added Improvements were: 1) made by the Lessee and approved by the
Lessor pursuant to the terms of this Lease, and Lessee and Lessor had agreed to the
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following in writing: a) the original value of the Added Improvements; (b) an
amortization plan to depreciate the value of the Added Improvements over the estimated
life of the Added Improvements; and (c) that the Added Improvements will not make the
total value of Improvements and Added Improvements unaffordable to a Low Income
Resident.
B. Capital Improvement Policy Outside Lease
This approach still leaves it up to the CLT to decide whether to approve any improvement and to
establish the value but it provides more of a formal process for this approval and references a
specific Capital Improvement Policy which the Land Trust Board would adopt and could freely
alter from time to time which would, presumably, provide more specific guidance about what
kinds of improvements are allowed and how to apply for approval. This version also includes
language allowing for a reduction in the resale price in the event of excess damage to the
property. This approach still gives the homeowner no formal right to make improvements but the
Capital Improvement Policy could assure approval for certain types of improvements. Some
CLTs adopt a policy that assigns a specific maximum value for a list of potential improvements.
10.10 CALCULATION OF THE FORMULA PRICE: The Formula Price shall be equal to
Lessee’s Purchase Price, as stated below, plus a) an indexed increase in Lessees’ equity,
plus b) a Credit for Capital Systems Replacement , if applicable as stated below, plus c) a
Credit for Capital Improvement, if applicable, as stated below, minus d) a Penalty as
determined below for Excessive Damage, if applicable.
Indexed Increase in Lessee’s equity: …[insert existing index language]
Credit for Capital Improvements: Eligible Capital Improvements are only those
improvements approved in writing by Lessor in accordance with Lessor’s Capital
Improvements Policy as revised from time to time. To qualify for an Eligible Capital
Improvement Lessee must submit to Lessor in advance of performing any work a request
for approval, along with plans and specifications for the proposed work, and contractor
bids or other cost estimates and any other items required by Lessor’s Capital
Improvements Policy. Lessor and Lessee shall mutually agree on the maximum value of
any improvement prior to the commencement of construction. Lessor shall have an
opportunity to inspect to insure completion and satisfactory workmanship prior to issuing
a final letter stating the Approved Value of an Eligible Capital Improvement.
Lessor shall be under no obligation to approve any capital improvement and shall consider
whether the proposed improvement increases the utility and functionality of the home and
the impact of the Capital Improvement on long-term affordability prior to its consent.
Nothing in this section shall prohibit Lessee from making an improvement which does not
qualify as an Eligible Capital Improvement. However, only Eligible Capital
Improvements, authorized in advance and approved after completion by Lessor, may be
included in the calculation of the Purchase Option Price, as set forth herein.
Excessive Damage: Excessive damage is defined as damages beyond normal wear and
tear. Such excessive damage may be described as, but not necessarily be limited to holes
in walls, damaged or neglected floor coverings and Capital Systems, severely degenerated
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interior or exterior painted surfaces, damage resulting from neglected Capital Systems, or
missing essential household fixtures that were originally a part of the edifice.
Determination of excessive damage value will be at the sole discretion of the Lessor
and/or its agents. Lessee may appeal excessive damage value determinations to the
Lessor Board of Trustees within 7 days of the determination.
C. Appraisal Based Valuation
This approach incorporates a full system for valuing improvements into the lease itself and gives
the homeowner a stronger right to receive a credit for any improvement that they make as long as
it costs more than $5000 and improves the “functionality of livable space.” It is still possible for
the CLT to disallow certain improvements but this approach removes the burden of deciding how
much a specific improvement is worth by relying on appraisals instead. The advantage of using
appraisals is that there is less potential for conflict with CLT homeowners and less administrative
work for CLT staff. The main disadvantages are that appraisals will cost the homeowner’s a
significant amount of money and that the value they generate may not ultimately seem fair.
This approach also includes a credit for Capital Systems Replacement (which is quite different
from Improvements). Under the other models, homeowners are responsible for replacing all of
the systems (roof, furnace, etc) that were there when they bought the house and receive no credit
for this investment when they sell. This model offers a 100% credit for replacement costs
whenever a homeowner replaces more than 50% of any of the specific systems listed. This can
be tricky to implement, but it avoids the situation where someone avoids replacing the roof
because they plan to sell soon – passing the cost on to the next buyer. This credit would allow the
seller to make the repair when it was needed and get credit at sale. This credit can cause serious
problems for long term affordability because all of the major systems will eventually need
replacement, and under this approach, each replacement will increase the resale price of the home
permanently. When used along with an Area Median Income Index this will quickly result in the
home becoming unaffordable. However, with a less generous index (1% or 2% fixed increase or
even CPI Index) it is possible that incomes will increase faster than the resale price even with this
replacement credit. An alternative to this credit would be to collect a replacement reserve as an
additional fee each month and allow homeowners to draw funds from this reserve for replacement
of these major systems. If the reserve is managed by the CLT, a homeowner that makes no
repairs will build up a fund that can be used by the next owner when the major systems all require
replacement. However, any monthly reserve contributions will lower the homeowner’s
borrowing power, increasing the amount of initial subsidy that will be needed to make a given
home affordable.
10.11 CALCULATION OF THE FORMULA PRICE: The Formula Price shall be equal to
Lessee’s Purchase Price, as stated below, plus a) an indexed increase in Lessees’ equity,
plus b) a Credit for Capital Systems Replacement , if applicable as stated below, plus c) a
Credit for Capital Improvement, if applicable, as stated below, minus d) a Penalty as
determined below for Excessive Damage, if applicable.
Indexed Increase in Lessee’s equity: …[insert existing index language]
Credit for Capital Systems Replacement: For the purpose of qualifying as a Capital
Systems Replacement, only the roof, plumbing, foundation, electrical, heating, cooling
unit(s) and sewer line systems shall be considered Capital Systems and at least fifty percent
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(50%) of the Capital System must be replaced. In order to receive a credit for Capital
Systems Replacement, Lessee must consult with Lessor prior to replacing a Capital System
and agreement must be reached between Lessee and Lessor regarding the scope and cost of
the proposed Replacement. Lessee shall be responsible for obtaining any permits required by
law for the proposed work. Said agreement must be signed, duly notarized and retained by
both parties and shall become a legal attachment to the Lease. Replacement of less than fifty
percent (50%) of a Capital System will be considered a repair and the cost of such repair
shall not be eligible for credit under this section. Provided all conditions of this paragraph
are met, 100% of Lessee’s documented cost of a qualified Capital System Replacement, not
including costs which were or could have been paid with insurance proceeds, shall qualify
for the Credit for Capital Systems Replacement. Credit shall not be given, however, for the
cost of installing materials that are deemed above standard construction grade. The cost of
upgrading to higher than standard construction grade materials and associated labor costs
will be discounted to industry standards.
Credit for Qualified Capital Improvements: Only the addition, or reasonable
improvement to the functionality of livable space (e.g. bedrooms, bathrooms, basements,
attics, porches, decks) or the addition of a garage (either attached or detached) shall be
considered a Qualified Capital Improvement and a minimum of $5,000 in cost must be
incurred. In order to receive credit for a Qualified Capital Improvement, and prior to
commencing construction, Lessee must consult with Lessor and agreement must be reached
between Lessee and Lessor regarding the scope of the proposed construction and its
qualification for credit under this section. Lessee must submit to Lessor a) detailed plans for
the proposed construction, b)an itemization of the expected costs for the proposed
construction, c) copies of any permits required by law for the proposed construction and d) a
Pre-Construction Appraisal of the Leased Premises and the Improvements conducted by a
mutually acceptable and duly licensed appraiser. The Pre-Construction Appraisal shall be
conducted by analysis and comparison of comparable properties as though title to the Leased
Premises and Improvements were held in fee simple absolute, disregarding the restrictions of
this Lease on the use of the Land and the transfer of the Improvements. The PreConstruction Appraisal shall state the contributory value of the Land and the Improvements
as separate amounts and shall further state an estimate of the value of the Improvements
assuming that construction is completed in conformance with the submitted plans. Copies of
the Appraisal are to be provided to both Lessor and Lessee. Agreement must be reached
between Lessee and Lessor regarding the scope of the proposed construction and a
reasonable timeframe within which construction shall be completed. Said agreement must be
signed, duly notarized and retained by both parties and shall become a legal attachment to
the lease. Except for Capital Systems Replacement, other construction on the Residence
shall be considered maintenance rather than capital improvement and the cost of such other
construction shall not be eligible for credit under this section. Provided all conditions of this
paragraph and the agreement between Lessor and Lessee described herein are met, 100% of
the value added by a qualified Capital Improvement, not including any costs which were, or
could have been paid with insurance proceeds, shall qualify for the Capital Improvement
Credit. The value added by a Qualified Capital Improvement shall be determined as follows:
Within thirty (30) days after completion of construction, Lessee shall submit to Lessor a
Post-Construction Appraisal, which may be a brief update of the Pre-Construction Appraisal
prepared by the same appraiser or a Post-Construction Appraisal conducted by another
mutually acceptable and duly licensed appraiser establishing the market value of the
Improvements after completion of the construction, with the difference between the PreConstruction Appraisal and the Post- Construction Appraisal being the value of the Credit
for the Qualified Capital Improvement. If the Lessor objects to the Post- Construction
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Appraisal within twenty (20) days of receipt of the Post-Construction Appraisal, and the
parties cannot agree as to the value added by the Qualified Capital Improvements, then the
dispute shall be resolved by Arbitration, as provided in Article 13. If the Lessor does not
object to the Post- Construction Appraisal or the value added by the Qualified Capital
Improvements within twenty (20) days of receipt of the Post-Construction Appraisal, then
the difference between the Pre-Construction Appraisal and the Post-Construction Appraisal
shall be the amount of the Credit for Qualified Capital Improvements for the improvements
so appraised. Said Credit for Capital Improvement shall increase 1.5% annually begining on
the anniversary date of completion of the Qualified Capital Improvement.
Credit shall not be given, however, for the added cost of installing materials that are deemed
above standard construction grade. The cost of upgrading to higher than standard
construction grade materials and associated labor costs will be discounted to industry
standards.
Excessive Damage: Excessive damage is defined as damages beyond normal wear and
tear. Such excessive damage may be described as, but not necessarily be limited to holes in
walls, damaged or neglected floor coverings and Capital Systems, severely degenerated
interior or exterior painted surfaces, damage resulting from neglected Capital Systems, or
missing essential household fixtures that were originally a part of the edifice. Determination
of excessive damage value will be at the sole discretion of the Lessor and/or its agents.
Lessee may appeal excessive damage value determinations to the Lessor Board of Trustees
within 7 days of the determination.
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