The following article explains how the strength of the US Residential Housing market and increasing homeowner equity provides a vast opportunity for Home Equity Investment Contracts (HECs)

 

Over the course of your life, it’s likely that you will place considerable importance on your overall net worth – that is, the value of assets you own net of all outstanding debt. After all, this particular metric is arguably the wealth indicator most accurately aligned with one’s economic well-being at any given point in time.

A high net worth will invariably allow a household to enjoy a comfortable standard of living, whilst during periods of hardship such as that experienced by many over the last year or so, a solid net worth will equip the household with a vital financial cushion. But what is especially interesting about household net worth trends in the US is the principal constituent assets that households own – with homeownership right at the top of the pile.

According to the Federal Reserve’s , a triennial survey designed to assist both the government and the public at large understand the financial condition of American families and the effects of changes in the economy, the “Primary Residence” represents the US household’s largest balance sheet item, accounting for around 26% of all assets held. This is followed by other Financial Assets (20%), Business Interests (20%) and Retirement Accounts (15%).

Source: National Association of Home Builders (referencing SFC 2019 data)

Homeownership not only provides a comfortable venue to live, eat and sleep, it also offers up a crucial opportunity to build wealth. Indeed, the SCF shows that the median US homeowner has 40 times the household wealth as that of a renter – $254,900 versus just $6,270. It also confirms that the rate of homeownership in the country increased between 2016 and 2019, from 63.7% to 64.9%, thus reversing the declining trend that prevailed between 2004 and 2016.

As for how homeownership proportions change with household income, a clear inverse relationship has prevailed over many decades. Those households in the lower income cohorts have a greater share of their wealth represented by homeownership, and this share declines as incomes grow. The 2019 SCF found that housing wealth represents almost 75% of the total assets of the lowest-income households on average, which falls to 50-65% for middle income households and 34% for the highest brackets.

Clearly, homeownership represents a major chunk of household net worth at all income levels. This has significant implications for Home Equity Contracts (HEC) – the innovative real estate equity instruments that enable households to tap into the value of their homes to access liquidity without having to take on additional debt. Without HECs, a huge chunk of household net worth could remain locked up in the value of the home, making it a decidedly illiquid source of wealth. But for those homeowners with sufficient home equity, HECs can unlock this value, providing crucial access to wealth that would otherwise be inaccessible.

The importance of gaining this access cannot be underestimated, especially given that throughout one’s life, home equity accounts for a substantial portion of overall net worth.

 

Source: U.S. Census Bureau, Survey of Income and Program Participation, Survey Year 2018

As the above chart shows, other than the Under 35 age group, home equity accounts for at least 60% of net worth, and tends to increase in share with age. That’s a massive amount of value that ought to be made available.

And given the strength of the US residential real estate market – as reflected by consistently appreciating house prices over a near 10-year period – levels of home equity have risen substantially during this time, and continue to do so. Recent analysis by CoreLogic found that US homeowners with mortgages (roughly 62% of all properties) experienced an overall equity increase of almost $1.5 trillion in the fourth quarter of 2020 from a year earlier, equivalent to 16.2% growth year-on-year. This trend is further supported by the SCF, which states: “For families that own a home, the median net housing value (the value of a home minus home-secured debt) rose to about $120,000 from about $106,000 in 2016.”

With the HEC investor receiving an equity-like participation in the home, moreover, positive returns are generated for the investor as the value of the home rises. Again, the phenomenal strength of the US real estate market over the last few years has helped investors achieve attractive returns – something of a rarity during the recent period of unprecedented market turbulence and uncertainty.

That said, one of the biggest concerns from an investor’s perspective is that the US residential real estate market could be overheating, and that a pronounced dip in prices could well be around the corner. HECs address this concern in a handful of important ways:

  • Contracts are typically modelled and structured on the basis of a modest annual appreciation in house prices of 2% – clearly a conservative figure when compared with the actual house price gains that have transpired in recent years.
  • HECs have a risk-adjusted structural downside of around 19% discount to the fair value of the home, on average (as of February 2021). This provides a significant buffer for investors should house prices start to fall.
  • The investor receives accelerated upside participation by generating positive returns above this discounted house price (rather than from above the home’s current market value).

Another potential issue stems from the typical duration of the contract, which ranges from 10 years to 30 years, and thus raises the possibility of a downside event occurring on the part of the homeowner prior to satisfying the HEC’s repayment requirements. However, given that the weighted-average-life for a HEC is like that of traditional mortgage pools, HECs are forecasted to exit well before their terms of 10 or 30 years.