Home equity sharing agreements, which allow property owners to get a lump sum of cash in exchange for a portion of their home’s future appreciation or value, are moving from a niche product to a more popular option for funding a variety of needs.
In July, DBRS Morningstar, the fourth-biggest credit ratings agency in the world, became the first to develop a methodology for assessing home equity investment securitizations. That will allow securitized notes backed by home equity sharing agreements to become more mainstream.
About two years ago, finance company Redwood Trust announced a deal with fintech company Point, which became the first securitization solely backed by home equity sharing agreements. But the first rated securitization of notes backed by home equity investments came this fall, with $224 million in notes backed by home equity agreements originated by Unlock Technologies and issued by Saluda Grade. The transaction shows heightened confidence in the asset class as an option for investors.
Home equity sharing agreements are a way for homeowners to access some of the equity in their home without taking on debt or making monthly payments. But are they a good option for investors looking to leverage their existing equity to expand their portfolio of properties? And do these speculative investments pose a threat to the market in the long term?
What is Home Equity Investment?
Home equity investments, often known as shared equity or shared appreciation agreements, provide homeowners with access to cash in exchange for a portion of their home’s future value or future appreciation above a starting point. These contracts aren’t loans, which means they often come with more lenient credit and income requirements, if any, and aren’t impacted by today’s high-interest rate environment. Homeowners can use the cash to make renovations, pay off high-interest debt, or even buy a second home, all without a monthly loan payment.
However, the agreements are secured by your property and typically come with repayment terms ranging from 10 to 30 years. During that time, you’ll usually have the option to repurchase the company’s share of your home equity for more money than you received initially, or you can pay the company their share when you refinance or sell your home.
If the term ends and you don’t have the money for repayment, some contracts may force a sale. Home equity agreements are also nonstandard contracts, unlike home loans, and may have burdensome stipulations for renovations or other terms that may be difficult to comprehend.
Additionally, most agreements come with closing costs and an origination fee, plus a share of your home’s future appreciation or value that equates to a high APR. For example, Unlock allows you to access 10% of your home’s current value in exchange for 20% of your home’s future value.
Some companies, including Unlock and Splitero, have a cap that protects homeowners from owing too much in the event of rapid appreciation. Splitero uses a shared appreciation model, which means the company shares your losses in the event of depreciation as well.
“In the event your home or property value drops significantly, your investment repurchase amount to Splitero may be less than your initial investment,” says Michael Gifford, CEO and co-founder of Splitero, in a conversation with BiggerPockets. However, the company calculates appreciation from a starting point that is less than the appraised value to account for the risk.
Is Home Equity Investment a Good Option for Real Estate Investors?
To ensure that a home equity sharing agreement is a favorable way to fund an investment property, you’ll want to ensure that the property would generate returns that exceed the cost of accessing your equity. You’d also want to compare your net revenue over the term with the expected net revenue you’d get financing the property with a traditional mortgage, home equity loan or HELOC, hard money loan, or alternative financing arrangement.
But entering into a home equity investment agreement isn’t the same as borrowing, and it comes with other benefits, which means it’s difficult to compare apples to apples with traditional financing options.
Explains Gifford: “Because it’s not a loan, there are no additional monthly payments affected by the rising interest rates or new debt associated with a Splitero HEI. This means it won’t add to your debt obligations or affect your debt-to-income ratio. Splitero HEIs also don’t have income requirements to qualify, which means if your wealth or income is tied up in a property, you can still access it.”
Splitero accommodates both owner-occupied and non-owner-occupied properties.
In other words, it’s an option for investors who can’t qualify for other types of financing. And if not having a monthly payment allows you to use your cash flow to grow your rental property portfolio faster, you could potentially see earnings well above what you owe the originator of the agreement. But you’ll need to crunch the numbers and, given the complexity of these nonstandard contracts, you’ll likely want input from an attorney.
It’s also important to understand that while most companies offer calculators you can use to estimate the price to repurchase your share, these tools are based on assumptions about the market that may not hold true.
The Risk of Home Equity Investment Securities as a Mainstream Asset Class
Securitization of home mortgages began in the 1970s. Most mortgage-backed securities have long been considered relatively safe investments since mortgages are collateralized by real property, and government-sponsored mortgage companies like Fannie Mae and Freddie Mac guarantee payments in much of the secondary mortgage market.
However, home equity investment agreements are typically secondary liens. If the homeowner defaults on their mortgage and the home is sold in foreclosure, the home equity sharing company would only collect after the primary mortgage lender is paid.
Therefore, shared equity securities may be a high-risk, high-reward investment. While real estate tends to appreciate in the long term, the housing boom and subsequent crash of 2007-2008 revealed how typical trends can go awry. Research suggests that housing speculation was partly to blame for the economic downturn, coupled with the packaging of low-quality mortgages, including subprime loans, into securities.
DBRS Morningstar rated the Class A and B notes included in the Unlock HEA Trust 2023-1 as BBB (low) and BB (low), which means that analysis shows the notes to be of “adequate credit quality” and “speculative, non-investment-grade quality,” respectively.
DBRS Morningstar’s rating system may help institutional investors view the asset class as reliable, and it’s possible that the government-backed mortgage companies could go as far as becoming players themselves. Under current regulations, Fannie Mae and Freddie Mac can’t buy mortgages constrained by private transfer fee covenants, which are used to enforce home equity investment agreements, but the Federal Housing Finance Agency (FHFA) is considering permanently removing restrictions on shared equity loans.
The move is intended to support affordable housing by allowing shared equity loans administered by land trusts, governments, and nonprofits to be securitized. These programs typically provide down payment assistance to low-income homebuyers in exchange for a share of the home’s future appreciation or value.
The FHFA not only provided a waiver through 2024 that allows Fannie Mae and Freddie Mac to buy shared equity loans but also removed income limits. The agency is requesting comments on whether to make the waiver permanent for the banks it regulates and whether the income limits should be reinstated. Looser standards could contribute to the rising popularity of home equity investment agreements, but that can also mean speculative danger.
But with the average homeowner in the U.S. now sitting on more than $274,000 in home equity, Gifford doesn’t foresee problems for Splitero, even in an economic downturn, adding: “It would take a never-before-seen, catastrophic event of greater than 50% declines for the average homeowner to be underwater like we saw during the GFC. After such a correction, most homeowners will still have equity in their homes and are unlikely to sell those properties at that time. It is far more likely they will hold on and ride the value of their home back to higher price levels.”
The Bottom Line
Home equity investments may be evolving from a niche product to a mainstream financial tool for property owners. For some, the agreements may be a favorable alternative to taking on new debt. The first-rated securitization of equity-sharing agreements could increase confidence in the validity of the asset class, promoting the growth of home equity investment providers and leading to new, competitive product options for homeowners.
However, because home equity sharing agreements are often costly options for property owners looking to leverage their home equity, caution is advised. Furthermore, the economic consequences of lower-quality securities should not be overlooked.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.