The impact on Home Equity Contracts and
US Residential Real Estate
The Kingsbridge Alternative Strategies Fund, LP
offers investors the opportunity to participate in the innovative emerging investment asset class of Home Equity Contracts.
Home Equity Contracts
are structured residential real estate option purchase contracts, with protected downside participation and accelerated upside participation, that are secured by a performance deed of trust on U.S. Residential Real Estate.
The following article explains how the coronavirus is currently impacting demand for Home Equity Contracts, as well as the wider US housing market, and how they are likely to be impacted going forward.
We observe that demand for Home Equity Contracts is stronger than ever at present, and that the geographical distribution of active Contracts held in Kingsbridge’s Alternative Strategies Fund is predominantly in those metro areas not considered to be economically vulnerable as a result of the virus.
We then account for the changes being implemented to the origination process due to COVID-19,
- Noting that a patch-work approach is being taken by Originators largely in response to directives that consider real estate a non-essential business.
- We observe that the resultant move towards greater digitization is helping to prevent significant disruption to that process.
- Structural changes are also being made to the Home Equity Contract, such as raising the Contract’s discount rate to accommodate for the increased likelihood of a drop in house price.
We also look at the wider US housing market, noting that its response to the unfolding economic shock is likely to be significantly more subdued and short-lived than what the market experienced in the 2008 crisis. This is mainly due to
- The strong housing market and healthy economy immediately prior to the outbreak of the virus in the US
- The crucial role that homes are playing in sheltering and protecting people during this pandemic, which in turn is preventing the widespread selling of homes.
- A moratorium on foreclosure activity by government mortgage organizations, major states and financial institutions are also helping to contain the fallout on this occasion.
Finally, we note the support to the housing market being provided by the Federal Reserve through low mortgage rates and the Fed’s recent market interventions to purchase over $250 billion of mortgage-backed securities. Whilst the accommodative monetary environment should help homeowners with refinancing options once the economy recovers, Home Equity Contracts may well offer more flexibility to homeowners, and will benefit investors as home prices appreciate.
With COVID-19 having brought almost the entire global economy to a halt, virtually every country has suspended its economic activity to some degree, in an attempt to “flatten the curve” and contain the devastating impact of the virus.
With that in mind, we want to provide you with an update on exactly how this pandemic is affecting Home Equity Contracts – the principle constituent of our Alternative Strategies Fund, as well as the wider owner-occupied residential real estate market in the US.
Coronavirus and Home Equity Contracts
Strong demand, low geographical risk
Given the pronounced economic shock that is now transpiring, it should perhaps come as no surprise that demand for Home Equity Contracts is currently very strong. Indeed, one of the Home Equity Contract’s most appealing features is the utility it offers both homeowners and investors during times of economic hardship.
The lack of any monthly payment requirement, coupled with the long duration of the contract (usually either 10 years or 30 years) which means that the homeowner is not under pressure to repay the lump sum immediately, means that demand for liquidity from a non-debt solution is now significantly elevated.
The evidence on the ground from some of the main Contract originators bear this out, moreover. Indeed, one originator is observing that homeowner demand for the Contracts has “never been stronger,” and anticipates a further strong surge in demand over the coming 6-12 months. This pent-up demand may ultimately improve the selection of contracts going forward.
You may also be wondering about the currently active Home Equity Contracts in Kingsbridge’s fund portfolio, and whether they are at risk from this downturn. Thankfully, the geographical distribution of the Contracts is predominantly concentrated in areas not deemed to be economically vulnerable to the fallout from the virus. According to research published by Brookings on March 17th, of the nation’s largest metro areas, Las Vegas is the most exposed, followed by Orlando, New Orleans, Honolulu and Oklahoma City. With the exception of Orlando, none of Kingsbridge’s Home Equity Contracts are located in such high-risk areas.
Origination continues on a more “patch-work” basis
Whilst homeowner demand for Home Equity Contracts remains undiminished during this turbulent period, the extenuating circumstances have forced originators into adopting a different, more “patch work” approach to the origination process. Some are taking a pause while directives prohibiting non-essential business remain in place, and are waiting until the market opens up once more. As explained by the National Association of Realtors:
“If real estate services are considered an essential service under the order, REALTORS® may be able to continue to conduct real estate business, which is the case in several states, like Illinois, Wisconsin and Connecticut, where real estate services are considered an “essential service” in the state’s shelter-in-place order. However, this is not always the case. Several states, including New York, Pennsylvania, and Vermont, do not consider real estate to be an essential service, thereby limiting the continued conduct of real estate activities to actions that may be accomplished remotely.”
As far as origination is concerned, therefore, the process can still be continued in those states that are allowing for digital processing of Home Equity Contracts.
But this migration towards digitization does not necessarily translate to a slowdown in activity. On the contrary, there was a massive 191% increase in the creation of 3D home tours between the average number created in February and the first weeks of March, according to home listing site Zillow. Prior to the coronavirus, moreover, those listings that included a 3D Home tour were saved by users 50% more, with the homes selling 10% faster on average.
And even when it comes to completing deals and signing documentation, originators can use remote online notarization in order to circumnavigate the ongoing restrictions. Such notarization enables the relevant parties to appear before the notary using audio and video technology, as well as to sign documents using an electronic signature, without having to meet in person. Remote notarization was already gaining traction across the country last year after the National Association of Realtors passed policy supporting this legislation in November 2018 as part of a move towards total electronic home closing. And with the pandemic necessitating such an option, it is likely to prove even more popular than ever before.
With sharply slowing economic activity, the growing threat of falling house prices has also prompted some originators to make accommodative changes to the structure of the Home Equity Contract. Specifically, investors are being afforded greater downside protection through a larger discounted purchase price, meaning that they will remain in-the-money on the Option should prices fall by a greater amount than a typical Contract has previously permitted. A larger discount rate also means that investors can begin to enjoy upside participation from a lower discounted purchase price than is normally the case.
The appraisal process could prove more challenging in the current climate, however. Although in-home appraisals are considered an essential business in all US states except for Michigan and Pennsylvania, shelter-in-place and social distancing orders may well compel a slowdown in obtaining home valuations.
And without the normal volume of pricing information available, the overall liquidity of the housing market could take a hit, which in turn may cause a short-term dip in valuing homes. This dip should, however, be short-lived – as the recovery sets in and liquidity improves once more, valuations are highly likely to experience a substantial upswing to make up for any current defensiveness.
On the whole, originators are keen to be able to solve as many problems for homeowners as is feasible at present. This is undoubtedly a time when more homeowners will need access to liquidity, and as such, originators are striving to be as solution-oriented as possible, whilst continuing to maintain a favorable position from a regulatory standpoint.
Coronavirus and US Residential Real Estate
Given the substantial economic contraction that now looms, one might be wondering whether the resultant impact on US real estate performance will be similar in magnitude to that experienced during the Great Financial Crisis of 2008.
But a handful of key factors that are supportive of today’s situation vis-à-vis 2008 strongly suggests that the impact will be significantly more muted – and more short-lived – this time around.
The US housing market is fundamentally strong
Perhaps most importantly, it is worth reminding ourselves just how robust the housing market was in the first couple of months of the year, immediately before the virus’ outbreak within the US. With the economy firmly into a record-breaking 11th straight year of expansion, house prices were experiencing solid gains right up until March.
“Before the onset of the pandemic, the quickening of home price growth during the first two months of 2020 highlighted the strength of purchase activity,” notes Dr. Frank Nothaft, chief economist at leading property analytics provider CoreLogic. “In February, the national unemployment rate matched a 50-year low, mortgage rates fell to the lowest level in more than three years and for-sale inventory remained lean, all contributing to the pickup in value growth.”
Dr. Nothaft’s comments followed the release of CoreLogic’s most recent monthly analysis, which shows that house prices in February rose nationally by 4.1% on average from February 2019, and by 0.6% from January’s levels. National property database curator ATTOM Data Solutions also recently released its February 2020 US Foreclosure Market Report, which shows that the total US property foreclosure filings (default notices, scheduled auctions and bank repossessions) had fallen to just 48,004. This is the lowest number ever recorded, with ATTOM data going back to April 2005.
Will foreclosure numbers spike once more during this current period of economic turmoil? One might have initially presumed so, given that almost 17 million Americans have filed for unemployment benefits in just the last three weeks alone, thus raising the likelihood of a wave of borrower defaults being triggered. But thankfully, relief has come in the form of numerous government agencies – and in turn, commercial lenders – that have decided to suspend foreclosure activity. This is in stark contrast to the events of 2008, when banks foreclosed on thousands of homes.
Fannie Mae, Freddie Mac and the Department of Housing and Urban Development (HUD), as well as major states including New York and California are allowing homeowners to delay their loan payments without incurring fees. They are also preventing delinquencies from weakening homeowners’ credit ratings. The government has mandated that lenders and mortgage providers comply with these requirements, and as such, several banks have already announced suspensions of their foreclosure activity, ranging from 30-90 days.
Homes provide ideal protection against COVID-19
The somewhat unique nature of this particular economic shock also suggests that a housing crash in the same vein as 2008 will not materialize. Specifically, the potentially life-threatening risk posed by COVID-19 has prompted a number of state and local directives such as “shelter in place” and “safer at home” to come into effect.
By isolating people at home and discontinuing all non-essential outings, such orders aim to stem the spread of the virus.
As such, occupying one’s home for the purpose of shelter is of the highest priority for everyone for the time being. Consequently, it has become much more unlikely that homeowners will want to sell their most fundamental form of shelter and protection during such a vulnerable time. And this trend is clearly playing out, with sellers observed to be pulling their homes from the market in droves. According to a report covering six San Francisco Bay Area counties from residential brokerage Compass, for example, the number of active home listings pulled off the market saw a massive jump from 16 as of the week ending March 16th, to 250 just one week later.
“The decline in confidence related to the direction of the economy coupled with the unprecedented measures taken to combat the spread of COVID-19, including major social distancing efforts nationwide, are naturally bringing an abundance of caution among buyers and sellers,” Lawrence Yun, chief economist for the National Association of Realtors recently noted. “With fewer listings in what’s already a housing shortage environment, home prices are likely to hold steady.”
Will housing demand remain similarly subdued? Possibly in the near-term, given the uncertainty that accompanies the threat of an approaching recession or marked slowdown. But much of the evidence gathered thus far reveals the opposite to be true, and that appetite for buying homes remains strong. Real estate brokerage Redfin, for instance, saw a 494% spike in requests for agent-led video home tours at the end of the second week of March. The following week, 18.9% of tour requests on Redfin’s website were specifically for video-chat tours, a whopping 94 times more than at the beginning of the month.
Fed intervention helping to support the mortgage market
The prevailing low interest rate environment should also continue to stimulate demand. Last month saw the average fixed 30-year mortgage rate fall to a record low of 3.29%. Rates are highly likely to remain at or near historical lows for much of rest of the year as the Federal Reserve attempts to jump-start the economy and stimulate a recovery. The Fed also purchased $68 billion worth of mortgage-backed securities in the third week of March, before buying a further $183 billion soon after to help support lower rates for homeowners and potential homebuyers.
Such moves should enable homeowners to refinance their homes once the economy starts to recover, thus potentially allowing them to reduce their outstanding monthly mortgage payments. That said, such an option may extend the life of the loan for the homeowner, which may not be ideal for those looking to sell their homes before any savings from a refinance are realized.
Should homeowners need cash more immediately, a Home Equity Contract may well make more sense – there is no monthly payment to make as the Contract is not a loan, and the homeowner can sell the home at any time. Both the homeowner and the investor will also be able to participate in the upside from any appreciation in the house price.
As we have explained in this piece, although the coronavirus may well lead to a sharp economic contraction in the US this year, there are several reasons to remain upbeat over the prospects for Home Equity Contracts this year, in addition to the country’s overall housing market.
The evidence to date clearly demonstrates the persistence of strong interest in Home Equity Contracts, with expectations of further demand growth later this year. And with currently active Contracts located in areas of the country less likely to be seriously affected by the virus economically, the outlook remains positive at this stage.
Economic and housing market strength prior to the outbreak also suggests that both are likely to return once the virus is contained and a recovery sets in. With the Fed intervening to keep rates low, with the government and banks playing their parts to prevent foreclosure activity, and with homeowners more likely to remain sheltered in their homes than sell them during these fraught times, moreover, we can be confident that the housing market won’t experience a repeat of the turbulence of the Great Financial Crisis.
Important Disclaimer: Kingsbridge Wealth Management, Inc. does not guarantee the data contained in this report are complete, accurate or free of errors or omissions. The information has been obtained from sources we believe to be reliable, including third party custodians, portfolio accounting software providers and performance reporting software providers. The evaluation of the securities and other investments in this report is based on information taken from the customary sources of financial information and may be updated without notice.
Past performance must not be considered an indicator or guarantee of future performance.
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