Equity sharing has long been touted as the magical solution to every real estate problem since the use of caves. If you want more first-time buyers, additional investment or fewer foreclosures then equity sharing is the way to go. Everyone from Mark Cuban to the Urban Institute has latched onto the idea, and now there’s some reason to believe that equity sharing is about to become more popular.
People have always bought together but traditionally there was a problem: Only one owner could write off costs. This meant if you had one owner who lived on the property and a second owner who didn’t only one could deduct mortgage interest and property taxes.
This situation changed in 1981 with the passage of the Black Lung Benefits Revenue Act, the natural and obvious place to find real estate legislation. Now both resident owners and non-resident owners are able to deduct costs from the same property.
The legislation was designed to encourage families to buy together, especially to have parents help children, but the legislation never actually limited equity sharing to relatives. This meant that investors could also get into the equity sharing game.
How does equity sharing work? Let’s say Fred wants to buy a $200,000 condo and Mary wants to invest. Mary puts up the down payment money and gets a percentage of the ownership, say 30 percent in this example but the numbers are negotiable. The condo has 1,000 square feet, so Fred rents 300 square feet from Mary. The money Mary receives is rental income and she can write off 30 percent of the mortgage, property taxes, insurance, HOA fees and repairs. She can also claim depreciation for her share of the condo and benefit from the fact that the property is self-managed and owner-occupied. As to Fred, he gets to deduct 70 percent of the mortgage interest and property taxes. When the property sells Fred and Mary divide the profits and losses as agreed.
Mortgage Credit Certificates
Private equity sharing can be a very much better deal for entry-level buyers than mortgage credit certificates (MCC), a form of government equity sharing. Under MCC programs, borrowers get help from local governments in the form of down payment assistance, lower interest rates and the ability to treat a portion of the mortgage interest, up to 20 percent, as a “tax credit” — a direct tax bill reduction.
Governments finance such help through the sale of tax-free bonds and since governments have better credit than home buyers the result is the ability to get lower mortgage rates, rates which can be passed through to entry-level buyers.
The catch is that MCC programs are a tough bargain. A major purpose of ownership is to benefit from rising values and build equity, but the MCC program can thwart that.
If an MCC buyer moves before nine years then the government can be entitled to 50 percent of any appreciation or 6.25 percent of the loan amount, whichever is less. That 6.5 percent is on top of any interest for the loan. The odds of MCC buyers facing such costs are pretty good given that people move with some frequency and home prices have generally been rising in most areas for the past few years: According to the National Association of Realtors, 36 percent of all owners move in eight years or less and among those aged 18 to 24 the move rate hits 78 percent.
Mark Cuban: Private Homes, Public Ownership
Mark Cuban, the billionaire owner of the Dallas Mavericks and regular panelist on the hugely-popular Shark Tank TV show, said in 2007 that equity sharing could work if there was a public market to buy and sell shares in individual homes. Cuban said that to make this idea succeed you need four basic rules:
First, “the house is appraised by a company approved by the exchange that lists the houses.”
Second, “‘shares’ are set with a Par Value of 10 percent of the appraised value. For a 100k dollar house, there are 10 shares potentially available. However at no point in time can more than 40pct of the “shares” in a home be sold. We don’t want the opportunity for ‘hostile takeovers'”
Third, “the price of the shares will of course be set by the market. In a hot market it will be set above par, in a tough market like today, it will sell below par.”
Fourth, “all proceeds from the sale of shares MUST be used to pay down any debt on the home.
“Despite the best efforts of the residential real estate industry,” said Cuban, “no one ever really knows what their house is worth until you try to sell it. This exchange listing approach will certainly make for better information available for the market, which in turn will also reduce the volatility.”
A substantial benefit of the Cuban plan is that it would allow investors to reduce their risk by diversifying purchases. Instead of putting $100,000 into one home in one market, an investor might be able to have a more-balanced portfolio by purchasing property shares in a number of markets. And, unlike direct real estate ownership, it would be possible to move in and out of the market almost instantly and without major transfer and marketing costs.
Shared Appreciation Mortgages
Shared appreciation mortgages — or SAMs — are a form of equity sharing where the lender discounts the interest rate in exchange for a share of the property’s appreciation.
This sounds pretty good but the SAM concept has some problems. First, with fixed-interest rates today below 4 percent there’s very little incentive for buyers to want such financing. Second, if property values fall the buyer still owes the entire loan amount, hardly a full sharing of risk. Third, and weirdly, it can be argued that if the property’s value rises substantially a regulated lender in some cases might be in violation of the government’s “qualified” mortgage rules.
Make Room for Non-profit Investors
The latest twist on the equity sharing theme comes from the Urban Institute. “What if there were a step between renting and owning?” it asks, and then suggests the development of a pack between entry-level buyers and local community agencies.
Under this approach, says the Urban Institute, “the market cost of the home is shared between the buyer and the entity administering the program, and the program keeps a share of the equity. When the buyer later sells the house, the buyer is able to access a share of the profits, but the house will remain affordable to the benefit the next low-income homebuyer.”
While programs such as MCC financing are designed for those with limited incomes, the Urban Institute plan is not. Instead, it seeks to help those with middle-income salaries, salaries large enough to sustain a reasonable standard of living but not big enough to permit savings.
The Urban Institute says “notwithstanding their modest incomes, shared equity applicants are highly educated: 70 percent have a college degree. Most are in their 30s and working full time for moderate wages in jobs like office administration and healthcare that, though stable, do not pay enough to support buying a market-rate home. And the data show that they have little or no net worth on average.”
The Urban Institute describes a number of equity-sharing programs around the country, each somewhat different. The important point is that all allow buyers to obtain equity from appreciation, a form of savings which can lead to the next step, full real estate ownership.
Of the programs above the Cuban plan is likely the fastest way to capitalize and standardize equity sharing programs nationwide. After all, if corporate shares can be instantly valued, bought and sold then why not interests in private homes?