The sharing economy has taken over. From Uber to Airbnb and now your mortgage. Are you ready to be part of the new “shared” economy? There is a new product that is backed by many Silicon Valley venture funds that allows people to partner with a fund to purchase a home. The new product is termed “shared equity”. The marketing folks are doing a great job… the product name seems very nice “shared”.. who wouldn’t want to share with a Silicon Valley venture fund?
What is the actual product? A homeowner partners with a fund to purchase a house. The fund puts half down and the borrower puts down the other half. For example, if a person only had a 50k down payment this would limit them to a 250k home assuming a 20% down payment. With the partnership, the fund would put up the additional 50k for a stake in the house so now the homeowner could buy double the house. For example, now with 100k to put down, the borrower could buy a 500k home.
Why does someone need this product? Homeowners need this product since they don’t have the additional capital to put down. This will be especially prevalent in higher cost areas where median home prices are high. For example, if someone were buying a home in Boulder, Colorado where the median price is 1m. The borrower might only have 100k in cash and could partner with a fund for the additional 100k.
How does it work? The devil is always in the details. If you partner with a fund they have an equity stake (Ownership interest) in your house. How the fund makes money is on the future appreciation. For example, let’s say a homeowner wanted to buy a 500k home, the homeowner would put down 50k and the fund would put down 50k. Let’s say 3 years later the house sold for 600k. For simplistic purposes assume that the loan amount was still 400k (the loan amount will be less but kept constant to simplify this example). The sales price is 600k minus 400k mortgage leaves 200k equity. The homeowner and the fund would each get back their 50k leaving 100k profit, the homeowner would get 65k and the fund would get 35k. This sounds great but what happens when the numbers aren’t so rosy?
What happens when values decline? Anyone who has been around real estate for over 10 years has first hand experience of what happens when prices go down. It wasn’t pretty. We all know that real estate, or any asset, never moves in a straight line. There are ups and downs along the way. What happens under this scenario when prices go down. Let’s do two scenarios:
- Minor correction prices decline 15%: Let’s use the same scenario above and assume there is a minor correction and prices fall 15%. In this scenario, the sales price of the property would be 425k. There would be a 75k loss in equity. The homeowner would share in the 75k loss with the company so the mortgage company would get 400k, the fund would get 26,250 (35% of the 75k loss). The homeowner would lose their 50k they initially put in and be on the hook to pay the fund 1,250 (26,250-25000 (net after mortgage paid off))
- Actual correction like the last downturn 30%: In many locations prices fell considerably more than 30%, but assume a 30% decline which is plausible in many markets. With a 30% decline the sales price would be 350k. This is where everything gets interesting. Assume the mortgage is still 400k, the lender would take a 50k hit. Under this scenario, the total loss is 150k, the fund likely will try to recoup their 50k from the homeowner. In essence, the lender would take a hit, the homeowner would lose all equity, and the fund would be left with nothing (other than possibly a claim against the homeowner for the loss which is basically worthless)
What are the risks? The primary risk is that the risk itself it “bifurcated” (split) amongst various parties. In a traditional loan a homeowner has 20% at risk typically. The homeowner will be above breakeven as long as prices don’t drop more than 20% or so. In the last crisis, many homeowners “walked away” when their mortgage was underwater. With putting only 10% down, this is a much great probability of someone “walking away” when there is a price correction since the homeowners have less “skin in the game”. From the last recession we found that loan to value was the number one determinant of loan performance. As loan to value increases the probability of default increases. Below I highlighted the risks to each of the five stakeholders:
- Primary Lenders: The primary lender on the property is at heightened risk for default. Instead of having 20% skin in the game, the homeowner only has 10%. This is considered a sub prime loan but not priced/underwritten as a subprime mortgage.
- Homeowner: The homeowner is basically using more leverage. At the end of the day they are “stretching” on a property that they might not be able to afford. Furthermore if there is a loss, they are on the hook to reimburse the fund for the loss which would wipe out their entire equity position in many cases
- Hedge fund: The funds promoting this product are going to take huge hits when the market turns. The model works great in an up market, but when the real estate market corrects, they will lose 100% of their principle since trying to recoup the loss from a consumer that just lost all their equity and their house will be fruitless.
- Mortgage note buyers: Just like many other financial transactions, there is no doubt that this financial arrangement will be sliced and diced. It is basically a future cash flow that can be sold in various “strips”. The buyers of these securities could take large hits down the road.
- You the taxpayer: Fannie Mae/Freddie Mac, the government insurers of mortgages announced that they will buy mortgage notes that have been originated with “shared equity” This ultimately means that the federal government and you the taxpayer will be on the hook for much of the losses.
This is a bad idea! Did we not learn anything from the last real estate crisis? Prices do not always go up! The equity sharing arrangement will be catastrophic in a down market. Not only will homeowners be impacted but taxpayers and fund owners. The equity sharing is basically a sub-prime loan in disguise; the results will be the same when the market turns. The only “sharing” from this program will be the huge losses “shared” by homeowners, lenders, and taxpayers.
I need your help!
Don’t worry, I’m not asking you to wire money to your long lost cousin that is going to give you a million dollars if you just send them your bank account! I do need your help though, please like and share our articles it would be greatly appreciated.
Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).