Although now commanding strong growth across the US, Home Equity Contracts were originally offered in the California housing market. As such, much of this article is guided by the current state of applicable California law and US Bankruptcy law. But it does not constitute a legal opinion of any sort and may not be relied upon as such. Also, it should be noted that different laws and procedures exist for different states, especially with regards to judicial foreclosures and non-judicial foreclosures.
If you are interested in Home Equity Contracts and are seeking a more detailed analysis, we recommend that you obtain legal advice from your own legal counsel.
This document outlines six of the most likely downside scenarios an investor might encounter when participating in a Home Equity Contract: homeowner default on senior lien, foreclosure, homeowner bankruptcy, falling house prices, legal challenges to the terms of the home equity contract, and regulatory risk.
Home Equity Contracts, the new investment product for US residential real estate, are now opening new doors for American homeowners seeking liquidity without having to incur additional debt. By accessing a portion of the equity in their homes, homeowners now have greater financial flexibility to address many of their most pressing financial obligations.
As for investors, Home Equity Contracts offer the opportunity to gain access to owner-occupied residential real estate, one of the most stable but difficult-to-access asset classes in the US.
To briefly recap how a Home Equity Contract works, an investor purchases an option purchase agreement, through an independent third-party originator (such as the California-based Point Digital Finance), which allows the investor to participate in the change in value of the home during the option term, and profits if the home value appreciates. This option is evidenced by a performance lien on the home. The homeowner, meanwhile, receives the cash payment from the investor’s purchase, and settles the contract, including any house price appreciation – at any time during the life of the contract.
But what happens when a homeowner is unable to fulfill the obligations of the contract, or the house does not appreciate in value?
These are just two of the most likely downside scenarios that an investor ought to investigate prior to participating in a Home Equity Contract. And while the evidence to date suggests that such scenarios are highly unlikely to materialize, it is nonetheless important to account for those rare instances when things don’t go as planned.
In this piece, we explore not only what happens in such scenarios, but also how we address them and where possible, seek to minimize their impact. But before we address specific scenarios, we should first highlight perhaps the most important feature from a risk management perspective of our Alternative Strategies Fund….
Reducing downside risk through portfolio diversification
The Kingsbridge Alternative Strategies Fund offers investors exposure to a diversified portfolio of structure Home Equity Contracts. As is the case with diversified portfolios, therefore, should one contract end up failing to perform, it is highly unlikely to have any material impact on the aggregate performance of the fund. This is due to 3 main factors:
- A high volume of contracts – As of February, the Fund contained nearly 350 individual Home Equity Contracts. What’s more, we anticipate this number to rise considerably during this year and beyond. The impact of any single Contract on the aggregate performance of the fund, therefore, will be minimal.
- Geographical diversification – as the following map shows, the Home Equity Contracts currently active in our portfolio are located across many states.
Where Kingsbridge’s Home Equity Contract homeowners are located (January 2020)
Again, this geographical diversity will only broaden going forward. Given the often vastly differing microeconomies between regions and states, any event that adversely impacts a home/homeowner in one state is highly unlikely to do so in another, meaning that again, only a small portion of the fund will be affected.
- Homeowner diversification – the financial situation of each of the active homeowners participating in the fund’s Home Equity Contracts is going to be markedly different from one another. One homeowner defaulting, say, due to bankruptcy, will not affect the likelihood of another homeowner defaulting.
And with the Contracts being designed for homeowners with a considerable amount of equity already in their home, it means that while it is possible that a few homeowners may experience financial hardship, a small number of individual cases won’t have a significant impact on the outcome of Kingsbridge’s diversified portfolio of Contracts.
That said, let’s now take a look at how we address some of those downside scenarios for individual Contracts.
Scenario #1: The homeowner defaults
For an investor, one of the most important questions to ask from a risk perspective is whether the homeowner will default on the payment owed that is senior to the investor’s equity. And there may be rare and unfortunate instances where just such a scenario transpires.
But it should be emphasized from the outset that the likelihood of homeowner default in Home Equity Contracts is exceptionally low. According to their in-house calculations, most originators put the chances of a qualified homeowner defaulting on his/her obligations at less than 2%.
The main reason for such a low default rate is that Home Equity Contracts are only eligible to those homeowners who already have sufficient equity in their homes. In practice this will usually mean 30% as an absolute minimum, and in many cases up to 50%. Having such a strict qualifier in place, therefore, greatly minimizes the likelihood of homeowner default.
But just how many US homeowners have already amassed such levels of equity, you might be wondering? A significant amount, as it turns out. And it’s growing.
The research shows that homeowners are becoming more equity-rich on the whole – and less underwater. According to ATTOM Data Solutions’ fourth-quarter 2019 U.S. Home Equity & Underwater Report, 14.5 million US residential properties – or 26.7% of the 54.5 million mortgaged homes in the US – are considered “equity-rich”, meaning that the combined estimated amount of loans secured by those properties (or “loan to value” (LTV)) is 50% or less of their estimated market value.
Just 3.5 million (or 6.4%) mortgaged homes are now considered “seriously underwater,” with a combined estimated balance of loans secured by the property at least 25% more than the property’s estimated market value. US homeowners are therefore four times as likely to be equity-rich than seriously underwater.
As Todd Teta, ATTOM’S Chief Product Officer, makes clear: “Homeownership continued boosting household balance sheets across the US in the fourth quarter of 2019, as people paying off mortgages were much more likely to be in equity-rich territory than seriously underwater. That marked yet another sign of how much the country has benefited from an eight-year housing-market boom.”
Before a Contract is agreed, moreover, the originator will use in-house methods to perform a stringent, data-driven due diligence process to ascertain the appropriate risk level for all potential homeowner candidates. Some use traditional Fannie Mae/Freddie Mac guidelines, in addition to debt-to-income ratios, FICO scores (a widely used credit score created by the Fair Isaac Corporation) and the amount of reserves they have at their disposal.
Point, for instance, implements a data-driven approach that involves carefully scrutinizing how the product is structured, how it is underwritten and which homeowners are suitable for the product. As the firm’s investor operations lead Jordan Fox explains:
“We carefully consider financial data, home value, and available equity. We also have a deep understanding of local title and recording practices. We want to be sure that our funds will improve the lives of our homeowners, that homeowners will be able to exit the contract when the time comes, and that our investors are buying a perfected instrument.“
Ultimately, it is likely to come down to a binary decision: either the homeowner is approved for a Home Equity Contract, or he/she is considered too risky and his/her approval is denied.
For those homeowners deemed as sufficiently low-risk, they will be eligible to participate in a Home Equity Contract. The Contract itself is structured as a residential real estate Option Purchase Agreement between the homeowner and the originator (who is backed by investor capital), with the originator’s rights being secured by a performance Deed of Trust on US Residential Real Estate.
The option structure will normally stipulate that the homeowner sells the originator the right to acquire a percentage interest in the appreciation of the property’s value, in exchange for an initial payment to acquire the option.
And the Deed of Trust stipulates that the homeowner is required to abide by certain requirements, as found in a typical mortgage Deed of Trust. The biggest difference with this Deed of Trust, however, is that it secures the homeowner’s performance, rather than its payment. According to California law, it can secure the performance of an “act,” which in this case, is the homeowner’s obligation to pay the originator a percentage of the property’s appreciation in value.
Homeowners are also required to maintain the property, pay property taxes and maintain property insurance, as well as refrain from taking actions that will unfairly devalue the originator’s investment in the property, such as by conveying the property below fair market value or via a non-arm’s length transaction.
If the homeowner breaches any these performance obligations, the originator can declare a default. But does a default necessarily lead to foreclosure? Far from it.
Avoiding a foreclosure
As Point makes clear, “We never want to foreclose on a customer, and it’s not in our interest financially, so we perform a lot of due diligence upfront to ensure the partnership is a successful one.”
And even if foreclosure presents itself as a feasible option, the originator will invariably first explore other solutions that involve working with the homeowner to fulfill his/her obligations. Such solutions include:
- The homeowner could sell the property and share the equity with the originator. Due to the amount of equity a homeowner retains, he/she will invariably receive more cash from a voluntary sale, and as such, the originator will almost always prefer working cooperatively to avoid foreclosure.
- The homeowner could repurchase the option.
- A payment arrangement could be arranged with the originator that may not be stipulated in the original Option Agreement, but that would be secured by the Deed of Trust. For example, the originator might decide to advance funds to help a homeowner who is delinquent on a senior lien (such as the mortgage lender), in order to avoid an imminent foreclosure.
If the above options are not feasible, however, as the secured party, the originator can enforce the homeowner’s obligations under the Option Agreement and initiate foreclosure proceedings.
Scenario #2 – When foreclosure is unavoidable
In California, the foreclosure process would typically be non-judicial. A judicial foreclosure is theoretically possible, but is typically costlier and more time-consuming.
Among the most likely default scenarios will be when the homeowner fails to pay senior loan obligations. In most instances, the originator will be a junior lienholder, with the homeowner’s primary mortgage lender in a senior position.
Should the senior lienholder decide to foreclose on the home, and this foreclosure process has already commenced, the originator can take one of three options:
- It can protect its equity position by bringing the first current and commencing its own foreclosure action, thus enabling the originator to “own” the foreclosure process.
- The originator can buy out the senior lienholder, which would thus enable it to foreclose from a first position. It would then control the foreclosure and would be the first to be paid from the proceeds of the sale of the house.
- It could allow the senior lien to foreclose, and would then be paid through any excess proceeds from the auction sale, via either interpleader action or court distribution.
The Deed of Trust will normally contain a Power of Sale provision as standard that entitles the originator, in its sole discretion, to exercise its power of sale under the Security Instrument, and to foreclose upon the Property to the extent permissible under applicable law. It thus allows the originator to foreclose nonjudicially, even if it is in a junior lien position, where state law permits.
A Typical Foreclosure Timeline:
- Event of Default occurs: Originator will try to pursue a cure with any senior lienholders, to try to avoid foreclosure
- Right To Cure: Homeowner receives Right to Cure notice from originator, again to avoid foreclosure
- Notice of Default: Recorded after the 120th day of default, triggering the start of a 3-month publication period.
- Notice of Sale: Prepared after the 3-month waiting period. The Notice is sent by the foreclosure trustee to the required parties.
- Trustee Sale: A public auction takes place, where the auctioneer executes the originator’s bidding instructions. Once the bid is finalised and the funds are transferred, the property is sold. The foreclosing trustee then notifies the originator and prepares the Trustee’s Deed Upon Sale.
- Surplus Funds Determination: If the property sells to an outside bidder, the foreclosure trustee wires funds to the originator. If there are surplus funds, the foreclosure trustee may file an interpleader to determine allocation of funds to junior lienholders and the former owner.
Scenario #3 – The Homeowner declares bankruptcy
A default is also recorded when the homeowner declares voluntary or involuntary bankruptcy, or any other event of insolvency. The structure of the Option Agreement, however, will normally afford the originator two levels of protection.
- The option gives the originator a recorded and not yet fully implemented right to the property, which should be recognized by most bankruptcy courts.
- If the court does not recognize the originator’s inchoate right to the property, or if the option structure is challenged, the Deed of Trust should allow the originator to initiate a foreclosure on the property in order to receive what is owed under the Option Agreement.
And because the Deed of Trust will typically provide the originator with the status of “secured creditor”, the originator’s claim is secured by the perfected lien on the home to the extent of the value of the collateral securing the claim. This boosts the likelihood of succeeding in bankruptcy court vis-à-vis unsecured creditors, and thus the originator should be entitled to 100% payment.
Secured creditors are normally paid from the proceeds of their collateral (or may foreclose upon the collateral) before any other creditors are paid, whereas unsecured creditors are only paid after secured creditors, administrative creditors and priority unsecured claims (including certain tax claims and professional fees) are paid.
Importantly, the originator will not suffer from a discounted sale value due to a distressed sale of the property. Thanks to protections that will normally be contained within the Deed of Trust, the originator’s share of the sale proceeds will instead be based upon its liquidated damages, which are in turn based upon the property’s non-distressed sale price.
Scenario #4: Falling house prices
As a reminder, the Home Equity Contract itself is structured as a residential real estate option, stipulating that the homeowner sells the originator the right to acquire a percentage interest in the appreciation of the property’s value, in exchange for an initial payment for the option.
What’s more, the contract will normally allow the investor to enjoy this house price appreciation from a discounted purchase price, rather than at the appraised market value when the contract is initiated. This benefits the investor in two main ways:
- The investor receives accelerated upside participation, such that the option is ‘in-the-money’ on day 1 of the contract.
- The investor receives protected downside participation, such that the downward risk adjustment can accommodate a modest price decline, say up to 20% discounted from the appraised value, within which the investor continues to profit.
Should prices continue to fall below this risk-adjusted cushion, only then will the investor realize any loss of the investment principal. But how likely is that to happen? Not very, if historical prices are any guide:
On a rolling 10-year basis, other than the Great Depression, there has not been a single period since 1900 when house prices have experienced a significant, consistent decline. More recently, leading property analytics company CoreLogic found that home prices nationwide increased by 4% in January 2020 compared with January 2019, and also rose by 0.1% from December 2019.
And the outlook going forward? CoreLogic forecasts that home prices will increase by 5.4% on a year-over-year basis from January 2020 to January 2021.
“January marked the third consecutive month that annual home price growth accelerated in our national index, as low mortgage rates and rising income supported home sales,” observes Dr. Frank Nothaft, CoreLogic’s Chief Economist. “In February, mortgage rates fell to the lowest level in more than three years, which likely will spur additional home shopping activity and price appreciation.”
But even if a major housing collapse is around the corner, much of the research from the 2008 downturn indicates that during a recession or poor housing market, equity rich homeowners stay put, as evidenced by the reduced number of home sales during those periods.
97% of homeowners stayed in their home during the 2008 downturn, rather than walking away, even when their home was significantly underwater. Historically, existing home sales decline when home prices decline. The homeowner typically stays put when prices drop.
Scenario #5 – A legal challenge to the terms of the Home Equity Contract
Given that Home Equity Contracts are a new investment product, it should be acknowledged that many of its features have not yet been tested in court or specified by legal statutes, including some of the default remedies that are intended to be administered through non-traditional paths.
Nonetheless, based on the limited legal rulings gathered to date, Home Equity Contracts have seemingly strong legal grounding within the courts. States generally recognize such option structures. And while a court may recharacterize an option transaction into a sale or loan, it will normally only do so when the transaction is a disguised financing.
Several cases have considered such transactions, with each concluding that an option with no absolute obligation to repay the sum advanced is not a loan.
As far as Home Equity Contracts are concerned, this distinction is perhaps most clearly demonstrated in the 2017 California case of Aaron Foster vs. EquityKey Real Estate Investments. The case involved several challenges and claims that were made that disputed the option structure of EquityKey’s Home Equity Contract.
The Plaintiff, Aaron Foster, sued EquityKey with seven claims relating to a Home Equity Contract agreed in June 2010 between EquityKey and Aaron’s father Michael Foster, who passed away in 2016, and from whom his son had inherited his interest in the home. The claims included TILA (the Truth in Lending Act), fraud, financial elder abuse, and unfair business practices.
The Contract stipulated that EquityKey would pay Mr. Foster a $196,000 “option payment” in exchange for Mr. Foster granting EquityKey the right to participate in 100% of the appreciation of his property for up to fifty years from the date of the agreement, from its initial value of $1,200,000. It was secured by a Performance Deed of Trust to which Foster Sr. agreed, and which stated that the arrangement represented an option payment and “not a loan.” The Deed also stated that Foster Sr. “understands, acknowledges and agrees that it is binding upon his estate, heirs, successors, and beneficiaries.”
Foster’s son Aaron alleged the following:
- That his father entered into this contract based on “false and deliberately misleading” representations by EquityKey that the contract was not a loan and because of Mr. Foster’s “age and mental status.”
- That “due to Michael Foster’s age and the complexity of the contract, as well as EquityKey’s deliberate effort to hide the nature of the transaction, … it was not possible for Michael Foster to understand and/or discover the true nature of the agreement with EquityKey….”
- That EquityKey’s intentionally deceptive efforts prevented Mr. Foster from understanding the true nature of the transaction, and thus no valid contract was formed.
- That only after his father’s death, when the son was going through his late father’s records, did he discover the EquityKey arrangement.
But Defendant EquityKey filed a motion to dismiss the case, arguing that all claims were time-barred (i.e. the prohibition to the legal claim due to the lapse of a specified amount of time), and that the complaint failed to state a claim upon which relief may be granted because the contract is an option, and is not a loan, as a matter of law.
Ultimately, the court sided with EquityKey and granted the motion to dismiss for the following reasons:
- The agreement states that it is “not a Loan or Security,” and is instead “an option in real property.”
- The contract also warned that EquityKey’s option “may result in…Mr. Foster…including your heirs, estate, beneficiaries and legal representatives…receiving less from your Property in a sale or other Property Transfer than if you did not enter into this Agreement. We recommend you thoroughly discuss this transaction with your heirs and beneficiaries, as well as your legal, tax and financial advisors to make certain you, and those who may be affected by this transaction, understand and are comfortable being bound by this Agreement.”
- A similar warning, advising Mr. Foster not to sign unless he had read the entire agreement and encouraging him to seek legal counsel and financial advice before signing, was included in capital letters above the signature line.
Aaron also claimed that the Discovery Rule should apply and as such, the statute of limitations should not have commenced until Aaron’s discovery of the true nature of the transaction in 2016, after his father’s death and with the assistance of counsel. But the court ruled that this also failed for several reasons:
- The facts relevant to the discovery of the claims were included on the face of the contract signed by the father. As such, he had all of the information necessary to discover his claims through his own due diligence back in 2010 when he was competent. Even if he did not understand the terms of the contract, therefore, he could have applied diligence to gain an understanding.
- Even if EquityKey’s statements were deceptive as alleged, it does not excuse Aaron’s delay, as the transaction documents expressly discussed and disclosed the terms of the agreement.
- Despite the allegations of EquityKey’s deceptive statements, the agreement itself encourages the exercise of diligence, advising potential signatories to seek the counsel of an attorney or financial advisor before signing.
- The father’s failure to discuss the transaction with his son also does not excuse his delay. Aaron’s claims are the same as his father’s, and thus the limitations should not freshly commence after the father’s death. Prior to his passing, Mr. Foster had also told his son that he “had made a deal for essentially ‘free money’ and believed that he could not be forced from the home at any time or for any reason,” which demonstrates that Aaron was on notice of the transaction – and its potentially suspect nature – while his father was still alive.
Finally, the Plaintiff argued that equitable tolling – a legal principle which states that the statute of limitations will not bar a claim if the plaintiff, despite reasonable care and diligent efforts, did not discover the fraud until after the limitations period had expired – should apply.
But seeing as the information the Plaintiff needed to discover his claims was available on the face of the transaction documents, and that Foster Sr.’s lack of understanding could have been addressed through legal counsel earlier, the argument that equitable tolling should apply fails, regardless of any misleading statements made by EquityKey.
Scenario #6 – Regulatory Risk
As is the case with any new investment product, regulators are keen to scrutinize just how such products should be regulated within each state. Especially in today’s post-2008 climate, where regulators are generally more pro-active when it comes to applying regulations on new types of business within their states.
This is no different for Home Equity Contracts, which have only started to gather traction nationally over the last few years. Originators have been regularly in contact with regulators in those states in which they aim to advance the Home Equity Contract as a viable investment product, in order to ensure they remain in full compliance of the rules. Many of those discussions are focused on ensuring that homeowners are adequately informed about the nature of the Contract, and that the product is not deemed to be usurious.
Federal regulatory organizations with whom originators are in contact, and in many cases have already presented to, include the Federal Reserve, Federal Housing Finance Agency, the National Credit Union Administration and the Consumer Financial Protection Bureau. The latter of those has already asserted that homeowners with 50% equity are not considered an ‘at risk’ class of financial consumer, and that they can make informed decisions about the financing options available to them.
Originators have also had lengthy discussions with Consumer Advocacy organizations including the Center for Responsible Lending, the National Consumer Law Center, the Consumer Federation of America and the AARP.
To date, there has very little about Home Equity Contracts that have been deemed as ‘extraordinary’ from a regulatory perspective. This is mainly because, rather than being a debt product, the Home Equity Contract is an equity-based principle transaction whereby homeowners are selling a portion of their equity to investors. As such, individual state regulators will not normally classify the Contracts as a “lending product,” which would be a riskier proposition.
We have outlined six of the most likely downside scenarios an investor might encounter when participating in a Home Equity Contract. But as we have explained, the sheer multitude and diversity of Kingsbridge’s fund holdings means that, invariably, should such any one of those scenarios affect an individual Contract, it will end up being a non-issue in terms of its overall impact on investor returns.
Thanks to the structure of the Contract, moreover, specifically the downside protection afforded to the investor from the initiation of the agreement onwards, house price depreciation up to a certain point will still enable the investor to profit. And perhaps most important of all, the fact that only equity rich homeowners can participate in Home Equity Contracts in the first place means investors can be reassured that the likelihood of them not performing on their obligations remains negligible.
With risk-adjusted downside protection, accelerated upside participation, and house prices forecast to rise during the coming year at the very least, therefore, Home Equity Contracts currently represent a highly attractive proposition for investors seeking to gain access to US residential real estate.
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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