Tuesday, February 24, 2009

Is paper shuffling a product?

Posted 2/24/2009

Last night I was visiting with a couple of my very good friends who are soon to move from sunny Scottsdale back to New England. Why they would move from somewhere having 80 degree weather today, to a place where the high today was 35 degrees, I can’t say. Perhaps it has something to do with the clam chowder?

While we were talking about things, the topic of making money came up. One comment was that all the money made by paper shuffling is really not useful; buying and selling stocks, bonds, and the like, while quite lucrative at times (and for certain people) appears to not really “do” anything. Money, she said, should be earned by providing a definite good or service – like selling cars, or cookies, or paying someone to clean your home. [I’m paraphrasing here …]
And it got me to thinking. Is there anything to this idea? I know the US has become more of a “consumer” nation rather than a “producer” nation, and I know this has hurt us economically. Of course, one of the things our government has been “producing” like crazy is credit, and this, too, has led to problems.

To think about whether equity transactions (buying and selling stocks and such) is just paper shuffling, I had to think about where it starts; usually, a small business is put together by some partners, and to raise capital for operations, the partners put in some of their own money, and often raise capital from family, or angel investors, or other sources. In return for this, the investors get equity in the form of stock certificates.

If a company is started with, say, $100,000 initial capital, and there are initially 100,000 shares of stock, then each share is worth $1. It doesn’t usually work this way, though, because the founder’s ideas and the fact that they are doing all the work (often without a salary) lets them value the company for more than the initial capital contribution. So maybe the founders value the company at $1,000,000 and sell the 100,000 shares for $10 each, but only sell 10,000 shares; then they have the other 90,000 shares left to reward themselves later, or to sell for additional capital if they need it.

I don’t see anything wrong with this sort of transaction; it is in furtherance of creating a business which will provide a good or service. The question really comes when one of the initial investors needs money and sells his shares (we won’t quibble over private offerings, restricted shares, and SEC rules here) to a friend for $15. Now the investor has made a 50% return on his money, but there wasn’t really any value added in terms of a product or service, unless you count the due diligence and relationships required from the initial investor; he deserves a return for making those efforts. So while this is starting down the slippery slope, I’ll still give it a pass.

Now let’s expand this view to the New York Stock Exchange. This is the place where millions of shares change hands, and mostly the companies whose shares are traded do not get any benefit from the purchase and sale, unless the company is buying or selling its own shares. As shares rise and fall, so go the fortunes of the employees of the company with investments in stock options or 401k plans, so I suppose you could say that it is in employee’s interest to keep the stock price high; but really it is in the interest of the investors to keep the price as high as possible, so that they can get a return on their investment.

When I buy stock in a company like GE or Johnson & Johnson, there are so many large stockholders that my investment is like a gnat on the butt of a rhinoceros. So I really have no control over what happens with the stock price, and I am generally just along for the ride. When I buy the shares at the exchange, rather than directly from the company, I am buying them because someone else wants to sell at the price I am willing to pay – the company itself is really not involved in the transaction. So this purchase has, apparently, nothing to do with goods or services – I’m buying a rock in hopes that later someone will pay me more for the same rock. Of course I am hoping that I picked a really pretty rock, and that it will stay pretty, because if it gets ugly no one else will want it. It isn’t like buying a service or a product, because all I bought was paper. And, I don’t have the rock. Someone else is taking care of it for me and I trust that they will keep it pretty.

What if I actually buy a rock? As in a gold nugget? I think this is different, because gold has industial and other uses which drives demand. It isn’t just that gold is rare, there are many rare metals (and other pretty rocks); it is that it has use. And if something has a useful purpose, then it is more of a product than a rock. So while you can make money buying gold and holding it (at least over time that seems to work well), in terms of my discussion last night I’m not sure if it qualifies as a product. I personally think it does, because at the least it is a raw material for which there is demand, and it shows up as jewelry and contacts on circuit boards and many other uses.

I haven’t seen a time when a product was sold which was made of stock certificates (especially when the actual certificate may be electronic in form), except for the ones I use for wallpaper in my Hall of Investment Shame.

However I am called back to the fine words of Francisco d’Anconia, as written by Ayn Rand:

"So you think that money is the root of all evil?" said Francisco d'Anconia. "Have you ever asked what is the root of money? Money is a tool of exchange, which can't exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. Money is not the tool of the moochers, who claim your product by tears, or of the looters, who take it from you by force. Money is made possible only by the men who produce. Is this what you consider evil?

"When you accept money in payment for your effort, you do so only on the conviction that you will exchange it for the product of the effort of others. It is not the moochers or the looters who give value to money. Not an ocean of tears not all the guns in the world can transform those pieces of paper in your wallet into the bread you will need to survive tomorrow. Those pieces of paper, which should have been gold, are a token of honor--your claim upon the energy of the men who produce. Your wallet is your statement of hope that somewhere in the world around you there are men who will not default on that moral principle which is the root of money, Is this what you consider evil?

"Have you ever looked for the root of production? Take a look at an electric generator and dare tell yourself that it was created by the muscular effort of unthinking brutes. Try to grow a seed of wheat without the knowledge left to you by men who had to discover it for the first time. Try to obtain your food by means of nothing but physical motions--and you'll learn that man's mind is the root of all the goods produced and of all the wealth that has ever existed on earth.

"But you say that money is made by the strong at the expense of the weak? What strength do you mean? It is not the strength of guns or muscles. Wealth is the product of man's capacity to think. Then is money made by the man who invents a motor at the expense of those who did not invent it? Is money made by the intelligent at the expense of the fools? By the able at the expense of the incompetent? By the ambitious at the expense of the lazy? Money is made--before it can be looted or mooched--made by the effort of every honest man, each to the extent of his ability. An honest man is one who knows that he can't consume more than he has produced.'”

This is not his complete speech, which you can easily find on the web if you google a few of the keywords. However it illustrates what I was thinking: that shares of stock, like money, are backed by faith. Money is backed by the faith people have in the issuing government; stock is backed by the faith people have in the issuing company. Both are traded between people and sometimes by the backer.

So if money represents goods and services of the nation, then equities represent the goods and services offered by the issuing company. That is what gives them value; and that is what gives money its value. And, as faith in the USA to meet its obligations and endure waxes and wans, so does the value of the dollar. If a massive crisis arises in Europe, we will see strength in the dollar. If our government is no longer able to meet some of its obligations, or if it prints money like crazy (just as if a company diluted its stock), then we could see the value of the dollar fall.

Just a quick aside: what is meant by “the value of the dollar”? How do you measure your wealth? Locally, we can measure it by looking at how many dollars it takes to buy certain things: a week in a hotel, a plane ticket, a loaf of bread, a six pack of beer. Globally, we should really look at the dollar’s purchasing power on the world market. One way to do this is with the Stable Currency Index, a measure of some stability in terms of various global currencies. By measuring our dollar’s “value” in this way we can get a better picture of what it is worth. Of course, you can also measure it against gold or silver.

I haven’t really addressed the ideas of options (stock options) here, but I think the same thing applies: If equities are the representation of the products and services of a company, then an option on an equity is not that different from an option to buy a home, or extend a lease. In purchasing an option, you are asking the seller of the option to take a risk with his equity, and so they should be paid for it.

I’m still a little conflicted about this, and would love to hear some comments!


Sunday, February 22, 2009

Commercial Landlord Saint Vitus’s Dance

Since commercial tenant defaults will remain on the upswing for a while, I post here the schematic for Arizona landlord action when a tenant defaults and, it appears, cannot cure in an acceptable time frame. This is a compendium of what the landlord can do; in the next post I’ll ruminate on what the landlord should be doing, in these devastating economic times. In the meantime, here are the dance steps.

One: Check for bankruptcy/insolvency status. Always check to make sure that neither the tenant nor its principals are in bankruptcy before taking action. (That’s not easy for the lay person to do competently—you should hire a law firm to help you do this.) If your tenant was a bank, check to make sure that the FDIC has not become your replacement tenant. Most of steps 2-5 below won’t apply if this step discloses that the tenant is under the protection of federal law. On the FDIC front, review www.nylj.com for the Special Section dated Monday, January 12, 2009; the Debevoise & Plimpton attorneys do a nice job of summarizing how to prepare for battle with the FDIC.

Two: Lock ‘em out. Sometimes the only way to find out if there’s a chance you’ll get any rent going forward is to ensure the tenant’s attention is devoted to its most important creditor—you. However, use your noodle, landlord—realize that there are repercussions if you lock out someone with perishable or time-sensitive merchandise or work in progress, and that you may force a tenant to choose the bankruptcy alternative if you close its business through a lockout earlier than would be optimal. Videotape your lockout, with sound narrative, as you inventory the premises. Such tactics increase the odds the landlord will not be defending a conversion claim by either the tenant or an equipment lessor, lender or vendor under an installment contract. Post a notice of the lockout on the door of the premises; and be prepared for the bitter and confused contacts that will follow. See your attorney for further advice on this aspect. If your lease is ambiguous about whether a lockout constitutes a termination, send the tenant written notice contemporaneously with the lockout making clear that the lease is not terminated, and that it remains liable for rent through the date a replacement tenant is found.

Three: Toss ‘em out. The convenient way, financially, is through a forcible detainer action, although there are other, less friendly or summary ways to do that, such as via an action in ejectment. You need counsel to do this; if you try this on your own, remember the adage about having an “idiot for a lawyer.” Forcible detainer actions can lead to an award of attorneys’ fees as part of the judgment of tenant’s “guilt.” Ask your attorney to explain the reach of A.R.S. §12-1178; and realize that you’ll have to file a separate suit to recover “going forward” rent (accruing after the date the defendant is found guilty of forcible detainer).

Four: Cut your losses. Landlords have a common law duty in Arizona to minimize their damages. You have the obligation as landlord to use commercially reasonable, not “heroic,” efforts to relet the vacated premises. There are a rash of Arizona appellate cases that explain, inferentially, what is commercially reasonable. The oldest is Wingate v. Gin (1985); and the most recent is Sakthiveil v. Casler (Filed December 16, 2008). If you have questions after your review of the law, call your attorney. If you don’t act in a commercially reasonable manner, your damages will be reduced by a judge reviewing the circumstances. It also may be a sensible cutting of losses to terminate the lease if the tenant makes clear that it has retained bankruptcy counsel and is preparing a petition in bankruptcy. If a landlord properly terminates the lease according to the notice provision in the writing that announces the termination date prior to the date the petition in bankruptcy is filed, then the leaseshold doesn’t become part of the bankruptcy estate—which means the automatic stay doesn’t “freeze” the landlord from taking action until the lapse of the period when the debtor tenant must assume (with or without assigning it) or reject the lease.

Five: Sell or toss your tenant’s property. This is a way to recoup some of your lost rent and prepare for re-letting, if a landlord handles it properly. But before you start down that lane, think about three things. Thing one, check for federal and state tax liens that may attach to personal property of the tenant, and that will trump your statutory landlord’s lien rights. Second, review Bates and Springer of Arizona, Inc. v. Frierwood (1973) with your counsel. Since there may well be competition for control of the personal property with equipment lessors, lenders or vendors of personal property retaining security interests, you must perform a search in the records of the Arizona Secretary of State and the County Recorder’s Office where the property lies. Don’t travel either a path of selling what you think is your tenant’s property without knowing whether someone else has a claim on it. Third, resist the temptation to dispose of property that you think is worthless—without input from legal counsel. (For one thing, a tax-liening jurisdiction will be real steamed that you didn’t get the government’s advance consent to the disposal of property as to which it had a lien.) The landlord’s opinions on valuation and resale potential don’t count for much here, especially if the landlord signed a subordination or waiver in favor of an equipment lessor or lender. The text of the lease you signed, on the other hand, does count. Review the text on abandoned property (post-lien termination) with your attorney, along with all other lease-pertinent documents like estoppel certificates, subordinations or landlord waivers.

Last thoughts: I get asked if the landlord can accept partial payments of rent from a tenant in default without waiving rights to proceed against that tenant. The answer is, “what does your lease say?” Often leases recite that landlord may accept any sum of rent without taking that marking a circumstance of waiver, release, accord and satisfaction, and so on. Sometimes, there’s just a generic statement that no covenant or term of the lease can be waived without a written landlord waiver—but understand that occasionally, waiver may be implied from the conduct of the parties. An Arizona case shedding light on the waiver issue is DVM Co. v. Bricker (1983), which says that accepting rent after knowledge of a breach results in landlord’s claim for breach and affirmation that the lease still is in force. Once again, see your attorney for guidance.

Also, I am asked if the landlord can keep the security deposit in payment of delinquent rent. Helloooo—that’s more complicated than first meets the eye. First, review what the parties have agreed to in the lease about the application of the security deposit to delinquent rent. Second, if there’s no discussion in the lease about how to treat the security deposit in a rent default circumstance, review Thompson v. Harris (1969) with your counsel before informing tenant that you are retaining the security deposit to satisfy back rent.

[Note: Saint Vitus’s Dance was the name given to a autonomic nervous system symptoms first described in the 1500s, which presented in the form of “hysterical” physical manifestations like dancing uncontrollably. This became confused with choreomania, a social phenomenon of medieval times, primarily seen in mainland Europe between the 14th and 18th centuries; this involved groups of people, sometimes thousands at a time, who danced uncontrollably and bizarrely, seemingly possessed by the devil. In that day, people of faith supplicated Saint Vitus for succor from the disease. I take the disease seriously; it’s the outward behavior that needs examination.]


Thursday, February 19, 2009

The Last Bastion Against Deflation: The Federal Government
February 19, 2009

This article is part of a syndicated series about deflation from market analyst Robert Prechter, the world’s foremost expert on and proponent of the deflationary scenario. For more on deflation and how you can survive it, download Prechter’s FREE 60-page Deflation Survival eBook, part of Prechter’s NEW Deflation Survival Guide.

The following article was adapted from Robert Prechter’s NEW Deflation Survival eBook, a free 60-page compilation of Prechter’s most important teachings and warnings about deflation.

By Robert Prechter, CMT

Now that the downward portion of the credit cycle is firmly in force, further inflation is impossible. But there is one entity left that can try to stave off deflation: the federal government.

The ultimate source of all the bad credit in the U.S. financial system is Congress. Congress created the Federal Reserve System and many privileged lending corporations: Fannie Mae, Freddie Mac, Ginnie Mae, Sallie Mae, the Federal Housing Administration and the Federal Home Loan Banks, to name a few. The August issue [of The Elliott Wave Theorist] cited our estimate that the mortgage-encouraging entities that Congress created account for 75 percent of all U.S. debt creation with respect to housing. For investors in mortgage (in)securities, the ratio is even greater. Recent reports show that these agencies, which have been stealing people blind by taking interest for nothing, account for a stunning 82 percent of all securitized mortgage debt. Roughly speaking, the government directly encouraged the indebtedness of four out of five home-related borrowers. As noted in the August issue, it indirectly encouraged the rest through the Fed’s lending to banks and the FDIC’s guarantee of bank deposits. These policies allowed borrowers to drive up house prices to absurd levels, making them unaffordable to people who wanted to buy them with actual money. Proof that these mortgages are artificial and the product of something other than a free market is the fact that while Germany, for example, has issued mortgage-backed securities with a value equal to 0.2 percent of its annual GDP, the U.S. has issued them so ferociously that their value has reached 49.6 percent of annual GDP, a multiple of 250 times Germany’s rate, and that is not in total value but only in value relative to the U.S.’s much larger GDP. (Statistics courtesy of the British Treasury.)

Well, the ultimate source of this seemingly risk-free credit still exists, at least for now. When Bernanke & Co. met in the back rooms of the White House in recent weekends, he must have said this: “Boys, we’re nearly out of ammo. We have $400b. of credit left to lend, and we have two percentage points lower to go in interest rates. The only way to stave off deflation is for you to guarantee all the bad debts in the system.” So far, government has leapt to oblige. One of its representatives strode to the podium to declare that it would pledge the future production of the American taxpayer in order to trade, in essence, all the bad IOUs held by speculators in Fannie and Freddie’s mortgages for gilt-edged, freshly stamped U.S. Treasury bonds.

Now, what exactly does that mean for deflation? This latest extension of the decades-long debt-creation scheme has essentially exchanged bad IOUs for T-bonds. This move does not create inflation, but it is an attempt to stop deflation. Instead of becoming worthless wallpaper and 20-cents-on-the-dollar pieces of paper, these IOUs have, through the flap of a jaw, maintained their full, 100 percent liability. This means that the credit supply attending all these mortgages, which was in the process of collapsing, has ballooned right back up to its former level.

You might think this shift of liability is a magic potion to stave off deflation. But it’s not.

Believers in perpetual inflation will ask, “What’s to stop the U.S. government from simply adopting all bad debts, keeping the credit bubble inflated?” Answer: The U.S. government’s IOUs have a price, an interest rate and a safety rating. Just as mortgage prices, rates and safety ratings were under investors’ control, so they are for Treasuries. Remember when Bill Clinton became outraged when he found out that “a bunch of bond traders,” not politicians, determined the price of T-bonds and the interest rates that the government must charge? If investors begin to fear the government’s ability to pay interest and principal, they will move out of Treasuries the way they moved out of mortgages. The American financial system is too soaked with bad debt for a government bailout to work, and the market won’t let politicians get away with assuming all the bad debts. It may take some time for the market to figure out what to do about it, but as always, there is no such thing as a free lunch. The only question is who pays for it.

The Fed is nearly out of the picture, so the consortium of last resort, the federal government, is assuming the job of propping up the debt bubble. It is multiples bigger than any such entity that went before, because it can draw on the liquidity of American taxpayers and clandestinely steal value from American savers. So the question comes down to this: Will the public put up with more financial exploitation? To date, that’s exactly what it has done, but social mood has entered wave c of a Supercycle-degree decline, and voters are likely to become far less complacent, and more belligerent, than they have been for the past 76 years.

An early hint of the public’s reaction comes in the form of news reports. In my lifetime, I can hardly remember times when the media questioned benevolent-sounding actions of the government. Articles were always about who the action would “help.” But many commentators have more accurately reported on the latest bailout. USA Today’s headline reads, “Taxpayers take on trillions of risk.” (9/8) This headline is stunning because of its accuracy. When the government bailed out Chrysler, no newspaper ran an equally accurate headline saying, “Congress assures long-run bankruptcy for GM and Ford.” They all talked about why it was a good thing. This time, realism and skepticism (at a later stage of the cycle it will be cynicism and outrage) attend the bailout. The Wall Street Journal’s “Market Watch” reports an overwhelmingly negative response among emailers. Local newspapers’ “Letters” sections publish comments of dismay and even outrage. CNBC’s Mark Haines, in an interview on 9/8 with MSNBC, began by saying ironically, “Isn’t socialism great?” This breadth of disgust is new, and it’s a reflection of emerging negative social mood.

Social mood trends arise from mental states and lead to social actions and events. Deflation is a social event. Ultimately, social mood will determine whether deflation occurs or not. When voters become angry enough, Congressmen will stop flinging pork at all comers. Now the automakers want a bailout. Voters have remained complacent about it so far, but this benign attitude won’t last. The day the government capitulates and announces that it can’t bail out everyone is the day deflationary psychology will have won out.


For more on deflation, download Prechter’s FREE 60-page Deflation Survival eBook or browse various deflation topics like those below at www.elliottwave.com/deflation.

What happens during deflation?
Can the Fed stop deflation?
Why is deflation bad?
Inflation vs. deflation
And much more in Prechter’s FREE Deflation Survival Guide.

Robert Prechter, Chartered Market Technician, is the world's foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

Tuesday, February 17, 2009

Common Sense Optional

It’s not my role to substitute my judgment for that of a state’s supreme court (the highest rung of its appellate ladder, except when that phrase is used in New York, where the “Supreme Court” is really the trial court, which itself perhaps explains why I always feel a little lost when I tour that city). But I got a “start”—and this topic for a post--when I serendipitously ran across an opinion of the Rhode Island Supreme Court from 2001 whilst researching an unrelated commercial lease issue. This opinion deals with the enforceability of an option to renew a lease. (Mind you, renewals and extensions of a lease are not technically the same thing, but for the purposes of this post, I’m going to pretend they are, since the modern trend for people in a hurry is to imbed the option to lengthen the term in the body of the lease and, so long as there is timely notice of the tenant’s intention to stay longer, the parties go forward without signing a new lease document. But, I digress.)

For contrast to what’s below, Arizona published two appellate opinions on enforceability of lease renewal options from the mid-1980s, with nothing reported since. In 1984, the Court of Appeals laid down the basic rule that to be enforceable, text in a lease pertaining to renewal must be certain and definite, and a term that the rental rate is “to be subject to negotiation and mutual agreement” does not pass muster. There are some brokerage and stationery-store preprinted forms circulating around Arizona where the parties dutifully fill in the blank about renewal options with such precision as this: “Lessee shall have the right to renew for a 5-year term with 90 days notice, upon renegotiated rental rates.” The temptation to remain loosey-goosey with phrases like “subject to negotiation and mutual agreement” must be resisted if a tenant truly wants to preserve its right to extend the lease term; and it should be promoted, if the landlord wants option rights to be void from their inception. Actually, all such phrases about future negotiation ensure is that the landlord and tenant must confer with a modicum of good faith—surely not that an agreement on renewal rent must be reached.

The Court of Appeals in 1985 ruled in McCutchin v. SCA Services of Arizona Inc. that an option was enforceable when the lease text provided that all the terms of the lease (including the rent price) were incorporated by reference in the event tenant extended; this allowed the court to hold that nothing remained to agree on. Utah’s appellate courts find the same principle to be true: That all terms, including rent, must be specified to permit enforceability; but the rent does not have to be written down as a hard number, if “some mechanism for determining the amount of rent is specified in the lease.” Brown’s Shoe Fit Co. v. Olch, 955 P.2d 357, 363, 366 (Utah App. 1998). The common-sense proposition that such a mechanism cannot be interposed by the court finds this simple expression: “Indeed, the application of the covenant of good faith and fair dealing to the parties’ agreement to agree in this case underscores the reason why open-ended price terms under certain agreements are unenforceable: the parties could negotiate in good faith indefinitely and never agree upon the price term.” After all, if sophisticated landlords and tenants have irreconcilable views of value, how can a judge know what a rent stream is worth?
And yet, it seems that in other jurisdictions, Four Corners states’ jurists may be regarded as wimps, where lease enforcement is concerned.

Now (after first mentioning it 500 words ago) consider the opinion in Saunders Real Estate Corporation v. Landry, 769 A.2d 1277 (Rhode Island Supreme Court, April 27, 2001). The lease contained the following provision concerning a renewal term:

“(b) For any extended term of the lease, the Tenant shall pay a monthly
rent which shall be the fair market rental value for the Premises as of the
date of the commencement of such additional five (5) year period(s) as
determined solely by the Landlord in its bona fide business judgment
and in good faith taking into account all relevant factors bearing upon
such rental value for comparable space within the central business
district of Providence, Rhode Island, including, without limitation, size of
premises, location, and visibility and exposure; however, in no event will
the minimum monthly rent be less than the minimum monthly rent in
Section 1.2 and as adjusted by Section 3.1.” (Emphasis added)

In 1964, this same court had held unenforceable a renewal clause in a commercial lease, when the rent for the extension term was to be determined solely by the landlord (oddly there, the State of Rhode Island was one party to the lease—hmm, I forget which side?). But here, the court said that while (i) sole determination by the Landlord, even using “bona fide business judgment” was not enforceable, nonetheless (ii) the minimum rent that had been agreed to for the initial term’s last 12 months was definite, so, being objectively ascertainable, it would be enforced as the renewal rent. Wow--hitting the floor smarts! (To be fair to the court, I cannot tell if it held “upward adjustment clause” was to be incorporated during the renewal term, which was a CPI adjustment provision with specifics omitted from the opinion text. I wonder how inflation or deflation, one of which is en route, would affect these Rhode-nt litigants in the present economic times.)

If Rhode Island’s “initiative” seems modest, contrast it with the temerity of Alaska’s appellate bench some years before Landry was decided:

“With respect to the second point, that the lease was not renewed because the parties failed to agree to a rental amount, it is our view that the trial court committed an error of law.

Courts are no longer reluctant to supply lease terms when parties who, at the time of contracting agreed to set or renegotiate particular terms in the future, are unable to reach agreement. This is particularly true when the amount of rental is the term left to future agreement. City of Kenai v. Ferguson, 732 P.2d 184, 187 (Alaska 1987). Agreement on the rental amount was not a condition precedent to renewal. If the parties could not agree on rental terms, and could not agree on a method to resolve this question, the court could have resolved the issue for the parties, or as our court said in Kenai, ‘The courts will declare the terms upon which the parties fail to agree.’” Berrey v. Jeffcoat, 785 P.2d 20 (Alaska App. 1990).

Leasing parties, eschew stirring the judicial imagination in the Last Frontier, unless you hunger for valuation by fiat! This jurisprudence summarizes the so-called “minority rule”—that since the agreement to permit a renewal is consideration for making of the lease in the first place, it should be enforced by intervention of the court to establish what the future rent rate will be. In this same vein is Cassinari v. Mapes, 91 Nev. 778, 542 P.2d 1069 (1975), which upheld a renewal provision even though the monthly rental would not be certain at the date of renewal; the Nevada court said it was appropriate for it to establish the amount if the parties cannot agree, “since economic conditions are ascertainable with sufficient certainty to make the [renewal] clause capable of enforcement.”

This concept of “complete the blank” for the rent figure appears a spillover from the Uniform Commercial Code Sales article, where if one studies the current price of gizmos in comparable marketplaces for a few hours, one can infer the final price, per gizmo unit, that commercially reasonable parties would expect to pay and receive for the goods on the delivery date. But the time for ordering, manufacturing and delivering most gizmos is relatively circumscribed. Contrast that, please, with a lease renewal period that (being measured in years) can span the peak[s] and trough[s] of an entire real estate cycle. Improved properties and brake linings—never shall the twain meet. The thought that rental property is fungible, coupled with a fondness for judicial determination of rental value, seems hubristic indeed.

Ah, savor our Wild West! Mr. President Obama, search no more for a Commerce Secretary—select one among our appellate bench activists! For the rest of us facing 2009 with some angst, draft your lease renewal option provision so any reasonable person may ascertain the benchmarks, indices or other formulaic approach undergirding renewal term rent computation. Further, make an experienced, neutral appraiser’s valuation of fair market rent the “default solution” in the event the parties cannot reach an agreement on price—unless you’d prefer a judge (who never protests, methinks, his or her personal residence’s ad valorem valuation) calculating rent for the extension period of your commercial lease.


Wednesday, February 11, 2009

Rights of Passage, or, What’s Yours is Mine, Too

First, a visual.

Your screen (you may want to use the wallpaper with that green hills background) is a 100-acre parcel owned by Kong. (Okay, if you use the wallpaper, you’ll have to visualize a 15 foot-wide, mostly linear creek that divides the two parcels about equally into two, 50-acre tracts.) While Kong owns the land, he accesses it only from the far western (left side) edge of the property. In 1993, Kong sells the left “half” to Dolt; and in 1995, he sells the right “half” to Pope. Pope and Dolt are neighbors, separated only by the creek, but they don’t see each other much. Pope starts a cattle ranch on his piece, but Dolt’s tract is vacant most of the time; Dolt uses it for a retreat during the pleasant-weather months of the year, and builds a cabin far back from the public road that runs along the tool-bar portion at the bottom of your screen.

Scenario 1: Pope figures that he’s got a little more pasture land at his disposal if he moves his fence west across the creek--about 50 feet from its left bank. He puts up a three strand, barbed-wire job with support posts, and puts a concrete bridge acros the creek in 1996, so the cows can cross over. He never talks to Dolt about his activities, and keeps a few head of cows grazing across the creek for the next decade, that meander up to the fence line now and then. In 2007, he sues Dolt in a declaratory judgment action seeking to quiet title, meaning establishing his outright ownership of the land inside his fence line. You all know the result. That’s what adverse possession is about.

Scenario 2: Pope decides in 1997 that cattle-raising isn’t his métier. (I fancy the notion of a cowboy having a métier.) And, he’s not fond of barbed wire either; it’s a bad aesthetic for him, so he takes down his fence. A year later, he decides to grow cotton on his land, but to get the maximum benefit from the creek water, he grows his crop from stem to stern, planting right up to the bank and covering his 50 acres so that he can’t access his fields (except between tight rows of the crop, which would get mangled by tires) by driving onto his property from the public road. So, he rents a grader in 1998 and blades across the east boundary of Dolt’s dirt adjoining the creek bed a path that’s wide enough for a single vehicle, thereby connecting the public road to the bridge across the creek. Pope puts pea gravel on the pathway at first, but lets the spinning of tires and occasional rainfall wash the gravel mostly away, and the drive “improvement” turns into a mess, though the vegetation where he drives stays mashed-down. A vacationing Dolt at first uses the driveway to get to the creek for fishing on his bank-side, but eventually Dolt tires of Pope’s indecision about his agricultural pursuits and Pope’s spendthrift ways, and all the dust stirred up by Pope’s pickup, too, so he erects a picket fence across the gravel driveway. Pope sues for trespass and to quiet title in 2008; Dolt counter-sues for the same relief. Who wins, and how? And what does the winner have, actually?

Easements, other than those established by an express grant, are a weird construct in Arizona’s law. There’s at least four ways a landowner can establish an easement involuntarily (as to the fee title holder) here: By implication via prior, existing use; by implication via necessity; by prescription; or, rarely, by estoppel (where usually an irrevocable license is found to exist by the court, rather than an easement). Let’s begin with some thoughts on the two types of implied easements.

An easement created by implication arises from an inference of the intentions of the parties to a conveyance of land. The factors determining the implication of an easement, according to the Third Restatement of Property (Servitudes) at §2.11, et seq. are these:
a. whether the party claiming easement rights was the conveyor or the conveyee of the land through which the easement is claimed;
b. the terms of the conveyance;
c. the consideration given for it (if any);
d. whether the claim is made against a contemporaneous conveyee (meaning if two parties got their lands at about the same time from the original overall owner);
e. the extent of necessity of the easement to the claimant;
f. whether reciprocal benefits result to the conveyor or conveyee;
g. extent to which the manner of prior use was or might have been known to the parties.

Here is an illustration of each type of implied-in-law easements:

Easement implied from a prior use: In the case of Van Sandt v. Royster, the easement is implied on the basis of an apparent and continuous (or permanent) use of a portion of the tract existing when the tract is divided. It is also called a "quasi-easement." This is imposed by a court to protect the probable expectations of the grantor and grantee that the existing use will continue after the transfer. In truth, this is an implied reservation, not an implied grant. This is an implied reservation because she reserved a right for her own property when she sold the other property. It would have been an implied grant, if she would have remained on the "quasi servient tenement" and sold the "quasi dominant tenement."

Easement by necessity: In the case of Othen v. Rosier (1950), the plaintiff and defendant own tracts of land which were formerly part of one larger parcel. To reach a public highway, the plaintiff had to cross over another's property, and used a road that ran over the defendant’s property, that he kept in repair. Because of drainage issues that had water encroaching, the defendant erected a levee, which made the road muddy for weeks on end. The plaintiff filed suit for injunction, to compel the plaintiff to eliminate the levee. But the court found in favor of the defendant, asserting that the roadway was not a necessity at the date of the division of the parcel by the original grant deed. So, in the necessity scenario, such an easement is implied when the court finds the claimed easement is necessary to the enjoyment of the claimant's land and that the necessity arose when the claimed dominant parcel was severed (separated by ownership) from the claimed servient parcel.

In Arizona, the case of Tobias v. Dailey, 196 Arizona 418, 422, 998 P.2d 1091, 1095 (App. 2000) is a “necessity case” that arose under the state’s private condemnation statute, but the court of appeals ruled that the landowners failed to show that they lacked an adequate alternative outlet to their parcels.

Here are the essential elements of an easement by prescription in most jurisdictions:

1. Open and notorious use of the land of the other (that is, it’s visible--the user isn’t sneaking around)
2. Adverse and under claim of right (that is, the user knows that he wasn’t originally vested with the right to use the other’s land, and that he wouldn’t be welcome to use it if the owner were asked for permission)
3. Exclusion of the owner; in Arizona, however, this is not a requirement for a prescriptive easement, so long as the claimant is not staking his claim on the basis of being a member of the general traveling public but rather as an individual making somewhat consistent use of the easement tract, see Ammer v. Arizona Water Company, 169 Ariz. 205, 209, 818 P.2d 190, 194 (App. 1991). (As a matter of fact, this issue of exclusion strikes me as the single biggest “difference maker” in understanding the distinction between adverse possession and prescriptive rights in Arizona.)
4. The passage of 10 years of continuous use, see Harambasic v. Owens, 186 Ariz. 159, 160, 920 P.2d 39, 40 (App. 1996).

Additionally in Arizona, if the use is open and obvious (the courts say that the owner must have “notice,” but that has been construed to include constructive notice where the adverse use is obvious), there is a presumption in favor of the claimant that the use is adverse, see Harambasic above; it then becomes the burden of the owner to prove that the use was permissive. But proof that the use was expressly or impliedly with permission of the fee title owner will defeat a claim, and no number of years of use will lead to a prescriptive easement, see LaRue v. Kosich. (What constitutes an implied grant of permission is a whole ‘nuther discussion, I suspect; a recent Court of Appeals case, Spaulding v. Pouliot, 218 Ariz. 196, 181 P.3d 243 (App. 2008) stands for the proposition that when the claimant uses the tract acknowledging its use “in subordination to the owner’s title”—whatever that means—such an acknowledgement will support a finding of permission, even if it never were expressed.

The Spaulding court said this: “if a use is shown to have begun with the owner's permission, any subsequent use is presumed to have remained permissive. That is, a use that begins permissively cannot "ripen into a prescriptive right" by the mere passage of time. Consequently, in order to overcome the presumption of continued permissive use, the party claiming the easement must show that, despite the initial permissive nature of the use, his or her later actions indicated to the owner that the use had become hostile and under a claim of right.”

So, how does that work? Suppose Dolt had said to Pope when the latter first put down the driveway, “Yo, Pope, thanks for the improvements on my land--and hey, feel free to use that sucker all you want, ‘cause I’m sure enjoying the ease of takin’ the truck over by the creek, and I aim to drive along that path every time I’m in the neighborhood.” Does Pope now have to “fence off” the 1998 driveway along its west side, to prove that he’s not using it “in subordination to” Dolt’s title? Is it enough only to tear down Dolt’s picket fence and proceed with Pope’s use? How about if everyone in the county starts using the driveway to get to the bridge to fish the creek?

An easement by estoppel is the rarest bird. Perhaps that’s because it’s like a consolation prize for someone deserving but who cannot claim prescriptive rights. In a 2006 Ohio case, Kienzle v. Myers, 167 Ohio App. 3d 41, 2006-Ohio-2765, the Ohio appellate court said this: “While permissive use may prevent an easement by prescription from arising, in another context an owner's grant of permission for land use may act as an inducement for another to act, especially when the permission granted is for an act not easily undone.” Twenty-one years after Myers had installed a line, counsel for the Kienzles sent a letter to appellants advising them that the Kienzles had "decided to terminate the revocable license" by which Myers' sewer pipe crossed the Kienzle property. The letter directed appellants to "make other arrangements" within 30 days. Subsequent letters from the Kienzle family threatened to "cap" the sewer line absent certain concessions from Myers.

Another example of easement by estoppel is Holbrook v. Taylor, decided by the Kentucky Supreme Court in 1976. There, for years Holbrook tacitly was given permission to use a road which ran across the defendant's property. In reliance upon this, the plaintiff made improvements on his land, like a building of a home. The court found for Holbrook, holding that the right to use a roadway over the land of another can be established by estoppel. This is not, remember, an easement by prescription that fundamentally is acquired by adverse possession. Holbrook had received permission, however desultory, to use the property, so the use could not be ruled adverse. In this case, an irrevocable license was formed by estoppel and it has the potential to last forever or be used "to extent necessary to realize upon his expenditures." The irrevocable license formed here is the equivalent to an easement by estoppel—and evaluating the respective hardships to the relying party and the “permissive” party likely is the determining factor in a court’s decision.

So, what does the prevailing claimant for an easement or irrevocable license get from a court, more often than not? It’s a useful question because--more often than not--a court forgets to indicate that aspect of the outcome, especially if the use is ill defined, such as when a road bed washes away. Courts that do speak to the matter seem intent upon realizing the Jagger-Richards unified theory:

You can't always get what you want, no!
You can't always get what you want (tell ya baby)
You can't always get what you want (no)
But if you try sometimes, you just might find
You get what you need
Oh yes! Woo!

Did I wake you up? [Sorry] So, what you probably “get” is what the community standards are for the dimensions of the type of pathway (driveway, utility line right of way, etc.), often established by building or development codes, plus any access needed to maintain the easement tract. If Pope wins his 2008 case, whatever a private drive minimum width (curb cut and pavement) is in that community will be what is granted, probably—if for no other reason than concern for public safety. And that is what you need, just in case there’s a zoning enforcement authority in the jurisdiction of the dispute. But will Pope win?


Thursday, February 5, 2009

Arizona Residential Landlord Follies

So I’m noticing that there’s a lot of folks with second homes or “investment properties” listed for rent in our fair state. Since many of our citizens didn’t count on putting these places up for rent but rather for resale, there are a fair number among us who didn’t read up on the rules in Arizona pertinent to residential landlords. Here’s some things you have to know about--and to do--if you are renting property in Arizona and want to avoid mixing it up with the authorities at the county and city levels:

First, register your property with the appropriate County Assessor’s Office: In Maricopa County, the Assessor will permit registration on-line, at this address: http://www.maricopa.gov/assessor/residential_property_form.aspx. You must do this for the purpose of identifying your property as rental residential (which is Legal Class 4 property, instead of the owner occupied Class 3 designation), and, additionally, so its maintenance condition can be monitored by community authorities if necessary. See ARS Sections 33-1901 through 33-1905. Caution: Yavapai County, to choose one example, is on the prowl to make sure that all residential rentals are identified. There are hefty and recurring fines imposable by the authorities if you fail to register your rental house, be it free-standing or attached. A.R.S. § 42-12052. Don’t forget to designate a statutory agent on that registration form; the community intends to serve that person with a notice in case it decides to land on a landlord for violating building codes or the slumlord legislation.

Second, if applicable in your community (and most cities collect this type of tax), acquire a transaction privilege tax license (and then, get ready to pay tax on your residential rental income). Phoenix, for instance, assesses city tax at the rate of 2% of the gross revenues from residential rentals, if you’re an eligible taxpayer. You’re eligible to pay tax to Phoenix (you lucky dog) on a rental property located within the city limits if you have three or more residential units rented or available for rent within the State of Arizona. (Your registration with the County Assessor enables cities positioned like Phoenix to determine if you own enough residential units to be eligible for taxation.) You can read all about Phoenix’s requirements for transaction privilege tax (amount owed and when due, forms and exemptions, etc.) at this Web address: http://phoenix.gov/PLT/resrent.pdf . You can’t goon the system by describing tenant payments as something besides “rent”; any dollars collected under the residential lease is subject to the 2% Phoenix tax. My hunch is that the other cities around the state that collect this tax have the same view—hand it over, buddy.

Third, while you should read the entire landlord-tenant statutory scheme in Title 33, chapters 10 and 11 of the Arizona statutes, there’s one thing you must be familiar with: How you treat the tenant’s security deposit, if you can get one in these times. A.R.S. Section 33-1321(C) is a provision you want to know backwards and forwards. You have to give the tenant a chance to note what is physically missing or dysfunctional within the premises; and you have to give the tenant written notice that tenant has the opportunity to go through the “exit walk-through” at the conclusion of the lease, if as the landlord you intend to keep all or a portion of the security deposit. (There is an exception to this requirement if you are reasonably in fear of your tenant, for example, if she has threatened you physically or he turns out to be a drug kingpin—then, you can skip the “joint” visit to the premises.) You should use a standard form for the tenant to describe in writing what’s wrong with your rental at the outset of the lease term; then, that checklist can be compared to how the place is surrendered at the end of the term. If you don’t handle this correctly, and follow the process and the timing in subsection 1321(D) regarding the return of the deposit or describing the purposes to which the landlord is applying the deposit, you could be liable to the tenant for twice the amount of the security deposit (subsection [E] of § 33-1321) if the tenant decides to press the issue in court.
Fourth, everyone in the business of renting places will tell a landlord to get a security deposit and the first and last months’ rent from a prospective tenant; that way, if the tenant skips without paying rent for the last piece of a month he/she is in your place, the landlord will get made whole. It’s sounds like great advice; alas, it’s not permitted under the landlord-tenant statute, nor is getting a security deposit that’s more than 1.5 times the monthly rent installment, unless the tenant volunteers to pay an additional amount [see subsection (A) of ARS § 33-1321]. And, if you’re going to charge a cleaning or pet or similar deposit that you have no intention of refunding at the end of the lease term, no matter what, you’d better tell the tenant that in the lease, and in a way that’s unambiguous [per subsection (B)] or the landlord has to give back the deposit that you thought was nonrefundable.
Finally, the landlord has to give the tenant a copy of the lease with all the blanks filled in and fully signed by each of the parties. It’s the biggest folly of all to neglect this simple task, because community property law may make the landlord’s rights unenforceable and because the statues say that you must deliver a copy of the lease.

Tuesday, February 3, 2009

Real Estate Investing in Today's Market

Recently a very good friend of mine approached me, he had found a really good deal in real estate, here in the valley. This friend is a very savvy investor, and probably has forgotten more about commercial real estate than I will ever know. I have the utmost respect for him, and I appreciate that he often calls me to see if I want to participate in various projects.

This time he called because he had found a project he could buy very cheaply, and it would immediately cash flow at more than 5% -- and the structure was only about 50% occupied, and he was sure that he could get the rest occupied pretty easily; after all, it is making a great return now, and so he can lease the rest of the space at a substantial discount and still do very well.

In most market conditions I would agree with him, and I would very likely participate with him. But the same thing that is affecting most private equity is also affecting my check writing hand: the unknown. We are in uncharted territory here, with interest rates at historical lows, the US going through an almost unprecedented deflationary cycle, and continuing incredible decisions by the government, reacting almost in a panic.

So I thought, what would I do if I had a bunch of money burning a hole in my pocket? Where would I most likely invest it? I usually take a long term view; I invest for the 20 year return, usually, not for the quick turn. But my philosophy is a little different today. Because my crystal ball broke about 6 months ago, I am looking for investments offering high liquidity and acceptable returns. Cash in the bank is hard to beat, except maybe US treasuries are safer (maybe!) That merry-go-round is sure to stop sometime soon.

So I turned to the equities markets. There are some interesting stock plays, in particular Canadian oil & gas trusts, that I like a little better than commercial real estate in Phoenix. I like oil, because the world continues to need lots of it, and the price is apparently controlled, to a great extent, by a small middle Eastern group dedicated to keeping the price high. Plus, I think we are past peak oil (meaning we are on the declining side of the availability curve). We won't run out anytime soon, but new discoveries are more rare and more costly to develop. Lots easier to drill a gas well in Texas than in the Arctic, aside from government regulations.

If you google "Canadian oil trust" you will find all sorts of things. One in particular is paying a 20% dividend right now. So I can place an order and get it filled immediately, and get a 20% return. If I need the cash in a month, I can place another order and get the cash 5 days later. Try that with real estate! Sure, I have the risk that the price of the equity will fall -- but I have the same risk in the real estate, and I don't have the liquidity!

I work in real estate every day. I used to buy and sell properties for my own portfolio fairly regularly; however in this market I am content to get a commission. The rewards are far lower than direct investment, but then so is the risk. So for now you'll find me being more of an agent and less of an investor. At least until I get that crystal ball fixed.