The Second Coming of Shared Appreciation
Equity sharing, a fledgling concept that never managed to gain traction as a loss mitigation strategy during the housing crisis, is being reincarnated as an alternative to home equity loans and other second-lien mortgage products.
Real estate finance company EquityKey began offering homeowners cash in exchange for a share of the future price appreciation of their homes earlier this year. The founders of the San Diego-based company say they're acquiring "appreciation rights" from homeowners seeking to tap into their homes' future equity. Unlike a traditional mortgage where a borrower makes monthly payments and is charged interest, a homeowner in a shared appreciation agreement doesn't owe any money until the house is sold, with investors earning a return based on how much the property appreciated.
"We view ourselves as an alternative to debt," said Jeff Nash, a managing director and co-founder of EquityKey.
EquityKey typically pays 6% to 17% of a property's current appraised value in exchange for a share of its future appreciation. For example, a property currently appraised at $750,000 would have appreciation rights valued at $45,000 to $127,500, according to an EquityKey brochure. When the property is sold or ownership is otherwise transferred, the homeowner is obligated to turn over 30% to 75% of the equity gained during the term of the agreement.
Future appreciation is based on the Standard & Poor's Case-Shiller 20-city home price index, not the actual value or sales price of the subject property. Relying on the Case-Shiller index provides a neutral third-party to determine appreciation rather than using subjective appraisals, but limits EquityKey to the 20 cities listed in the localized index.
While EquityKey is targeting its product to homeowners that have significant equity in their homes, the concept of borrowing against the future appreciation of properties has previously taken other forms. Affordable housing agencies often provide homeowners down payment assistance programs by structuring shared-appreciation mortgages as second-lien loans that aren't due until the home is sold or the first mortgage is refinanced.
In the throes of the housing crisis, the concept of offering distressed borrowers principal reductions in exchange for a share of future equity was seen by some as a way to mitigate the "moral hazard" of loan write-downs.
While serving as a senior vice president at mortgage technology and services vendor ISGN, Bill Garland spearheaded a partnership in 2010 with another equity-sharing firm, EquityRock, to launch an equity sharing initiative aimed at providing principal reductions to distressed borrowers.
"I think this an interesting product," Garland, now an industry consultant based in San Diego, said of EquityKey's new venture — though he's not involved with EquityKey or its management.
For homeowners whose properties have appreciated, equity sharing is a way to tap into that capital without taking out a second lien or selling their property, he added.
"If the house goes up in value, you know that 40% or 50% of it is not yours," Garland said. "If house prices crash, which is unlikely, you are protected on the downside."
EquityKey was founded in 2005 and sold to KBC Financial in 2006. That first venture was cut short in 2008 by the housing crash and the steep drop in house prices.
Many of those early participants sold their homes and "that was a great trade for them," Nash said. But the bulk of those 2006 to 2008 agreements are still on the books. "They didn't sell during the downturn and we are standing in the background, hoping the properties continue to appreciate."
Nash and his co-founders reacquired the company in 2009. After getting recapitalized with new investors, the relaunched EquityKey closed its first transaction in May. The product is currently available in Los Angeles, San Francisco and San Diego. EquityKey wants to expand into Florida and New York City next.
The shared appreciation product generally fits well with owners who have been in their home for a while and want to lock in future appreciation and receive immediate cash, said Nash. There are no restrictions on how homeowners can spend the proceeds.
Homeowners must have at least 20% equity in their homes to be eligible for the EquityKey agreement. But the product is also attracting newer homeowners who want to pay down their first or second mortgage, increase cash flow and "reduce what is often a very leveraged exposure to house prices," Nash said.
The company uses mortgage brokers, insurance agents, financial planners, real estate agents and certified public accountants to sell its product. "We only target financially sophisticated homeowners and ask them to be counseled by their financial advisors," Nash said.
Financial advice is needed to understand this product that can be a blessing or a curse.
First, the homeowner needs to understand that they are entering into a seven to 10-year commitment to own the house so the property (a first or second home) has an opportunity to appreciate. "We view our investment in your property as a long-term one," the EquityKey CEO said.
The ultimate investors of the appreciation rights are insurance companies and pension plans that are looking for house prices to rise 3.5% to 4% a year over 10 or 20 years. To ensure investors can realize a projected gain for their committed capital, there is an early termination provision in the share appreciation contract, and a lien is placed against the property.
In a worst-case scenario, a homeowner that terminates an agreement early would forfeit all the proceeds from selling the appreciation rights and pay a penalty that covers origination costs and an investment return.
In an example scenario where EquityKey paid $129,000 in exchange for 75% of the future appreciation, the owner would have to pay between $158,000 and $204,000 as a minimum early termination settlement, depending on when the agreement is extinguished. In other words, the owner would pay back all the proceeds from selling the appreciation rights, along with a $30,000 to $75,000 penalty.
On the other hand, EquityKey takes the loss if the Case-Shiller index declines and there is no price appreciation over the contact period. The owner can sell the house and walk away with no obligation to the investors.
In a normal real estate environment where home prices rise by 3.5% to 4% a year, the minimum settlement amount (and the entire early termination provision) is rendered meaningless between the third and fifth year, according to EquityKey.
There are also several exceptions built into the shared appreciation agreement. "With respect to sudden and unforeseen life changes, we allow homeowners to transfer the agreement to their heirs or to a new home in the event there is a triggering event in the first three years," Nash said. "We're worked hard to build a contract that protects the interests of both parties in a fair and balanced fashion."
The homeowner can also refinance to lower the interest and take additional loans on the property with EquityKey's approval. "The structure of your new loan must satisfy our guidelines and the loan-to-value ratio generally cannot exceed 65%," the brochure says.