Innovation in real-estate finance: equity-sharing as a financing alternative for homeowners
George Brighten is an Intern at Social Enterprise Associates. He is a rising junior at the University of Pennsylvania, where he studies Political Science and Public Policy.
With the annual number of foreclosures at a concerning level, equity sharing - where a homebuyer and an investor buy a property together and share ownership - is an innovative alternative to conventional debt financing for homeowners. In these agreements, the homebuyer is an active participant, taking on mortgage, tax, insurance and other such obligations, while the investor is a passive participant who is exposed to the fluctuations of the housing market. In short, the homeowner relinquishes a portion of his assets in exchange for reduced liability.
Equity sharing is by no means a recent development. In the past, the concept has been applied to debt financing in affordability-oriented mortgages. Many homeowners have taken advantage of Shared Equity Mortgages (SEMs), which were developed in the 1970s and initially known as Shared Appreciation Mortgages (SAMs). In a SEM agreement, the lender provides a portion of the down payment in return for partial ownership of the home. Proceeds from the sale of the home are shared proportionally to ownership between the borrower and lender.
Demand for equity sharing, however, has shown slow growth. In the early 2000s, most homeowners preferred cheap and easy debt financing and once home equity began to plummet due to the sub-prime crisis, lenders and the government favored the traditional responses of lower interest rates and extended maturities.
Only when the housing bubble burst and housing values plunged in 2007 did the shortcomings of these more familiar refinancing alternatives become apparent. The frantic deleveraging that followed dealt a further blow to housing values, constricted credit and even homeowners with strong credit ratings struggled to find lenders. Although credit standards have since eased and the worst foreclosure numbers are behind us, the U.S. homeownership rate fell to a 15-year low in the first quarter of 2012 indicating public skepticism of debt financing and the need for alternatives.
Equity sharing is now receiving more publicity. However, a lack of flexibility, transparency and simplicity has limited the appeal of these methods to both lenders and homeowners, and enhancements are few and far between.
FARJHO and SwapRent
Enter FARJHO and SwapRent, two non-debt financing alternatives created by California based Investors Ally. Short for Flexible and Reversible Joint Home Ownership, FARJHO is an improved method of shared-equity based home-ownership that allows tenants and real-estate investors to co-own properties under a legal entity such as a Limited Liability Company (LLC).
One of the co-owner members will rent the property from the LLC as his primary residence and by allowing him to build on his minority stake ownership in the co-owned LLC as his individual financial situation permits, FARJHO can help him become a homeowner. To the other members, a FARJHO structure can provide a positive yield on their investments. An aspiring homeowner or a joint property investor can initiate a FARJHO structure.
SwapRent, on the other hand, is a consumer-oriented online real-estate derivative instrument that allows FARJHO LLCs or other such structures to manage the investment value of a property by way of ‘own-rent switching', where a homeowner switches between owning and renting a property. This transaction enables homeowners and investors to shift their exposure according to fluctuations in the real estate market. These two instruments can be used in isolation or combination.
FARJHO and SwapRent are based on the notion that the ‘shelter- (or use-) value' of a property should be separable from its ‘economic- (or investment-) value' but they are different from traditional equity sharing methods (like SEM and SAM) in many ways. Most important, by way of member level debt financing FARJHO and SwapRent eliminate the possibility of foreclosure and protect occupants against eviction.
Although SEM and SAM incorporate a shared equity component they are still conventional property-level debt financing methods. If tenants lose their monthly income stream, they are likely to be evicted or their home foreclosed. However, under a FARJHO structure, if the homeowner were to lose his monthly income capacity he could exchange (in a SwapRent transaction) some of the upside potential of his property in return for an investor's capital to help pay his monthly mortgage amount and thereby avoid foreclosure.
Benefits of innovative equity-sharing arrangements
There are several important benefits of such instruments for the real-estate market, at both the individual and community level:
1. Satisfy a critical need in the real-estate market for alternatives to conventional finance. At present, many people are faced with an ever-growing quandary: while many are unable to or wary of taking on further collateralized or mortgaged debt, their need for stable housing requires that they do so. Innovative equity-sharing arrangements allow these people to bypass conventional finance.
2. Have the potential to expand the accessibility of housing for homebuyers of modest means. In the case of FARJHO, the tenant can build on his minority stake ownership as his financial situation permits (by way of SwapRent transactions) and eventually become the homeowner.
3. Could broaden the opportunities for investors to diversify beyond the traditional stock and bond markets. Single-family residences could be made an investable asset class and SwapRent transactions could become the basis of a tradable equity market for home ownership.
4. Don't require financial expertise. A high level of knowledge of derivatives or capital market instruments isn't necessary.
5. Reduce the risks of homeownership. Such instruments could increase neighborhood stability and outmode common practices like debt financing and foreclosure.
6. Higher quality, lower risk mortgage portfolios for lenders. By attracting less credit-worthy homeowners, these instruments could help to increase the average credit-worthiness of lenders' mortgage portfolios.
A revived economy?
Equity-sharing agreements are not perfect. Many argue that it isn't the form of tenure that expands the accessibility of housing for homebuyers but the type of housing and the level of subsidy available. However, by expanding the choice of financing available to the real-estate market, lenders can tap a market traditionally closed off by conventional debt financing. By doing so, they create the potential to revitalize the U.S. economy at the local level, while at the same time easing the suffering of struggling homeowners.
Granted, at present investor interest in the U.S. real estate market may be limited due to its recent ugly past. But time, along with a successful track record of these instruments in pioneering counties, could lessen such anxiety, increase investor activity and meet homeowner demand.
Equity sharing is not a new solution. The instruments that constitute this solution have proven effective elsewhere, creating, for example, the liquid stock markets that drove the development of venture capital markets. Perhaps in a similar fashion these instruments can create a liquid residential home equity market, propelling the recovery of housing markets and helping the two million U.S. households who face foreclosure each year to remain in their homes.
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