Why Advisors Should Recommend Home Equity Contracts
If the challenges of the investment advisory business weren’t significant enough – managing client expectations, retaining clients, growing assets under management, remaining relevant in a crowded space – then doing all of this in a low return environment will likely only complicate matters.
According to the IMF, the global economy is in a “synchronized slowdown” with growth in advanced economies projected to ease to just 1.7% in 2020.[i] More concerning is that discussion of lower capital market expectations is widespread across Wall Street. And this has called into question the reliability of a traditional 60/40 mix of stocks and bonds.
“Investors should be aware of the changing dynamic. The future of asset allocation may look radically different from the recent past and it is time to start planning for what comes after the end of 60/40.”–
Bank of America Merrill Lynch[ii]
“Expected returns for a 60/40 U.S. stock-bond portfolio fall 10 basis points to 5.4%, and the stock-bond frontier steepens.”
J.P. Morgan Asset Management[iii]
“…we can improve risk and return/risk substantially over 60/40…”
Wouter J. Keller and Jan Willem Keuning [iv]
“Traditional products will increasingly become components of outcome-orientated solutions, niches will become more mainstream and aspects of investment theory may be called into question.” ——–KPMG[v]
Following the Lead of Institutional Investors
If long-term equity market returns fall to single digits and fixed income yields remain depressed, what are individual investors, especially the ultra-high net worth, likely to do? How will they react if, indeed, the traditional 60/40 mix fails to produce the types of returns they have grown accustomed to over the last several decades?
Accredited investors, especially qualified purchasers, have the same opportunities as institutions. They can participate in the private capital markets. And according to KPMG, such high net worth investors will likely follow the lead of institutions, which have blurred the lines between traditional and alternative investments.
Institutional investors have adopted asset allocation strategies that go well beyond the mix originally theorized by Markowitz. They have for decades shifted their allocations to non-traditional asset classes in their pursuit of absolute and non-correlated returns.
Qualified purchasers have these same opportunities and advisors should expect them to increasingly look outside the public markets for strategies to help them achieve their outcome-oriented goals.
Structured investments present a particularly significant opportunity in this regard.[vi]
The Evolution of Home Equity Financing
An innovative structured investment opportunity has emerged in recent years to take advantage of a unique personal finance strategy. The strategy provides homeowners with a non-debt solution to monetize some of the equity in their homes. The investment is secured by one of the most stable asset classes in America; owner-occupied single-family residences. The instrument that connects the homeowner to the investor is a Home Equity Contract (HEC).
To put the scale of the Home Equity Contract opportunity in context it is well to understand the metrics of the residential real estate market in the United States. The aggregate market value of single-family homes in America is approximately $32 trillion.[vii] There is also a well-established mortgage market in the United States. According to the Board of Governors of the Federal Reserve, the total value of all mortgages in America is some $15.8 trillion.[viii] This suggests roughly $16 trillion in untapped home equity.
Home Equity Contracts are an innovative form of consumer financing created to satisfy the needs of equity-rich homeowners. Origination of Home Equity Contracts is rising rapidly because of fundamental changes in the residential mortgage market. The first of these changes is the shrinking market share of traditional commercial banks. Bank lending declined dramatically during the financial crisis and has not recovered. It remains below its pre-2008 peak.[ix] The void this created provided an opportunity for nonbank financial institutions to fill the gap. These direct lenders provide a more efficient allocation of risk to investors.[x] The third factor is that, since the financial crisis, homeowners have generally been unwilling to borrow against their home equity.[xi] An HEC gives them an opportunity to access the excess equity in their homes without having to incur any additional debt.
Home Equity Contracts are straightforward real estate option purchase agreements (option to buy contracts) between an investor and a homeowner. The contract gives the investor a security interest in the property in the form of a lien, a proportional stake in the existing home equity, and participation in any future home price appreciation.
Recording an HEC makes it a perfected lien. Like a traditional mortgage secured by the underlying property, the recorded HEC protects the investment. More importantly, it provides the investor with an equitable interest in the property. So if the homeowner does not perform on the contract, the investor has a legal right to sell the property.
The Structure of A Home Equity Contract
The investment merits of Home Equity Contracts are derived from three fundamental elements:
- Discount; and,
- Home Price Appreciation
The structure of an HEC is established during the underwriting process and is specific to each contract. This structure creates from the outset a cushion of downside protection (via a discount) and accelerated upside return participation (pegged to the underlying home’s future price appreciation). It also establishes a dollar amount and expected maximum return (internal rate of return, or IRR) for the contract.
All of these are calculated using numerous factors. The specific weight of each factor is determined using both traditional (mortgage) and proprietary underwriting standards.
In addition to conventional underwriting criteria like the homeowner’s FICO score and comparable home prices, several other factors determine the structure of each Home Equity Contract. This tailored structuring is designed to create for the investor higher participation on the upside and lower participation on the downside.
From inception a Home Equity Contract establishes something of an in-the-money call option. The contract has real quantifiable value from the moment it is established. That value is based on the upfront discount structured during the underwriting process. This discount is a “risk adjustment” from the appraised value of the home.
For example, if a home is appraised for $900,000 and a 19% risk adjustment is applied to that appraisal, then the adjusted home value would be $729,000.
This cushions the investor from an unexpected adverse price move. In the first few years of the contract this discount is a source of return, even if there is no price appreciation in the underlying property.
Importantly, when the homeowner settles the contract the proceeds the investor receives are recognized as capital gains – not interest income.
Home Price Appreciation
Another element of the HEC’s structure is the investor participation rate. This is the fixed percentage of equity participation the investor has in the underlying property’s price appreciation.
For as long as the contract remains in place, the investor will be entitled to this proportion of the home’s value. As the property’s value increases, so does the value of the investor’s proportional stake. As time goes on, home price appreciation becomes a key factor in determining the investor’s rate of return on the contract. That rate of return is a function of the time value of money.
The structure of the Home Equity Contract is what creates a high probability of success. Each HEC’s structure is developed in the underwriting process. Here the specific information necessary to price an HEC is revealed. That pricing builds in an expected IRR for the investor.
Then each contract begins life at a discount to the underlying home’s appraised value. From that point forward, the investor has a stake in the price appreciation of each home based on a predetermined participation rate.
While structure, discount, and home price appreciation create the intrinsic value in a Home Equity Contract, the economics of the American real estate market support their investment appeal.
Why Invest in Home Equity Contracts
Investors seeking enhanced returns and inflation protection in a non-correlated asset class should consider Home Equity Contracts.
Home Equity Contracts are not real estate investments. The underlying investment is an innovative personal finance strategy. Home Equity Contracts provide homeowners with an alternate way to free up the untapped liquidity in their home.
Before the advent of the HEC, homeowners could access their home equity in just one of three ways. They either had to sell the house outright. They could refinance their first mortgage and take cash out. Or they could borrow against a second, Home Equity Line of Credit, or HELOC.
All of these methods could result in additional debt, a strain on cash flow, an increased risk of
default, a lower credit score, or an inability to obtain further credit.
HECs let homeowners use their equity without selling or additional borrowing. There is no debt service, since the HEC is not a loan, so there are no interest payments. Home Equity Contracts can be structured with 10-year or 30-year terms, but they can be terminated by the homeowner at any time during the agreement.
At the time a homeowner settles a terminated contract, there is no prepayment penalty and the value of the HEC is determined using the original contract variables (See “Contract Inputs” in the table on Page 3).
Where mortgage financing provides consumers with liability-based liquidity, the Home Equity Contract is “equity-based” financing. It frees up liquidity in an asset that, in the aggregate, has enjoyed a long history of price appreciation.
Today, home prices are more than 15% higher than the pre-financial crisis peak reached in July 2006.[xii] According to S&P CoreLogic Case-Shiller, home prices in the United States have risen at an average “real” annual rate of approximately 1.2% above inflation since 1975. The backdrop for Home Equity Contracts appears very favorable, even if prices encounter moderate declines.
The reason for this is that each HEC is priced at a discount to the underlying home’s appraised value. Those discounts average 19%.
With the exception of the Great Depression and the Financial Crisis of 2008, real estate prices in the United States have rarely experienced a period of double-digit price declines. Still, even at the height of the 2008 to 2012 subprime mortgage crisis two important facts were revealed about American homeowners.
(Source: Robert Shiller U.S. Home Price Index Data; Hometap Analysis)
The first is that homeowners with a high level of home equity don’t default on their mortgages.[xiii] The second is that the vast majority of homeowners who were underwater on their mortgages did not sell their homes when prices declined.[xiv]
Managing Risk In Home Equity Contracts
The main risks in HECs are the property and its owner. The primary risk related to the property is that it might not increase in value over the life of the contract. Understanding the national residential real estate market aids in managing this potential risk.
Between 1975 and of 2019 residential home prices appreciated at a compound annual growth rate of more than 4.5%.[xv] This is the national average, so some markets will have performed better than others. Forecasts of future growth rates for markets around the country will likewise show variability.
Experienced investors understand this and are selective about the markets in which they select Home Equity Contracts. Ideal candidates are located in established, strong residential housing markets.
Investors perform extensive housing market research and data analytics at a local market level, including by zip code and neighborhood to make sure that the contracts they own have a high probability of being profitable. Past home price appreciation and depreciation are also studied as are long-term statistical variations in home prices for the area.
Further risk mitigation comes from an understanding of the fundamental nature of the residential real estate market. Homeowners in America currently have more equity in their houses than they have ever had.[xvi] Understanding this allows the investor pricing and underwriting flexibility tied to a homeowner’s level of equity. This is one of the risks more closely associated with the homeowner, rather than the home.
Risks associated with a homeowner are typically revealed in a standard credit check. Investors in HECs seek to understand the FICO scores, employment history, payment history, and debt utilization of the people using a Home Equity Contract. Here too these reviews are regular and ongoing to make sure that the credit worthiness of homeowners doesn’t deteriorate over time. In addition, investors seek to understand how the homeowner is performing on things like mortgage payments, property taxes, or homeowner association assessments.
This ongoing risk management can be separated into three distinct buckets over the life of the contract. There is a high degree of scrutiny during the underwriting process. Continued due diligence is performed during the servicing of the contracts. And additional risk mitigation techniques are employed while managing the portfolio of Home Equity Contracts.
The Home Equity Contract Marketplace
As noted earlier, the U.S. housing market is huge and there is likely more than $16 trillion of equity available for homeowners to access. The HEC market is young and growing rapidly. While institutions have committed billions of dollars to Home Equity Contracts, there is still ample room to grow!
Origination of the contracts is dominated by a handful of venture capital backed FinTech companies. There are no commercial or investment banks currently providing Home Equity Contract financing. The business is being driven by disruptive innovators using big data analytics and software-driven platforms to identify attractive properties and homeowners. These same originators then service their own contracts and perform ongoing risk assessments for the duration of each agreement.
The market is certainly not yet to scale. Home Equity Contracts are currently available in just 20 states. Nevertheless, this is expected to change dramatically. By the end of 2020, Home Equity Contracts could be available in 70% of the U.S. housing market as originators continue to scale their platforms.
Each originator in the market is partnered with capital providers that purchase and manage pools of contracts. The majority of these capital providers are direct investors buying for their own account. They include large hedge funds and real estate investment trusts. There is only one fund open to the public that invests in Home Equity Contracts.
The Kingsbridge Alternative Strategies Fund
Since 2016, the Kingsbridge Alternative Strategies Fund is one of the original investors in Home Equity Contracts and is the primary vehicle for individual investors to gain access to this asset class.
We understand the risk-reward dynamics of HEC investing at a granular level. We have very close relationships with many contract originators who implement our specific selection criteria in the creation and selection of HECs for our investment. We are intimately involved with them from the beginning of the underwriting process through the end of contract.
This experience strengthens our ability to mitigate underwriting risk. As contracts age to expiration, Kingsbridge works with contract originators and servicers to manage and mitigate risk. We monitor the portfolio on a contract-level basis to confirm that home and homeowner quality are in line with the contract requirements during the entire duration of the agreement.
Portfolio level risk controls start with controlling position size. No single contract, represents so large a proportion of the total fund that its default could jeopardize aggregate returns. To determine the fair market value of the underlying contracts we regularly perform probability-weighted expected return with Monte Carlo simulations to identify the mean and expected value of the total portfolio.
Unlike many structured investments, our fund does not use any leverage to enhance performance. Investments in Home Equity Contracts deliver equity-like returns with lower-than-bond-like risk. Home Equity Contracts possess the three characteristics of a great investment:
- a strong demand for investor capital;
- the capital solves an easy to understand problem; and,
- the capital is adequately compensated for the risk.
Kingsbridge invests in Main Street, not Wall Street. This capital remains on Main Street. It is invested in the excess home equity of people’s primary residences.
Our investments align our interests with those of the homeowner. If the homeowner wins, we win. If home price declines below the risk adjustment, we both participate on the downside.
Investments in Home Equity Contracts are not correlated to traditional asset classes. So if the global economy is slowing, and the public capital markets produce lackluster returns, then investments in HECs may offer investors a significant return premium over and above a 60/40 mix of stocks and bonds.
Institutions rely on structured investments to augment portfolio returns. High net worth investors, such as qualified purchasers have the same access to these types of investments.
Home Equity Contracts are an emerging structured investment in an innovative personal finance strategy that offers investors the security of liens on residential real estate. These real estate option purchase agreements provide investors with the equivalent of a preferred equity participation in residential real estate.
Akin to in-the-money call options HECs provide built-in profit at inception and accelerated real property price appreciation after that. HECs are equity investments, so when contracts terminate and homeowners exit, the funds investors receive are recognized as capital gains – not interest income.
The investors providing capital to the HEC market are main large institutional investors like hedge funds and real estate investment trusts.
The Kingsbridge Alternative Strategies Fund is one of original investors in HECs and the only fund open to qualified individual investors. The fund is unleveraged and can provide investors an equity-like return with lower risk.
Investment advisors should familiarize themselves with HECs to better understand the potential risks and benefits so that they can recommend them to investors who are seeking enhanced returns and inflation protection in a non-correlated asset class.
[i] International Monetary Fund, “2019 World Economic Outlook: Global Manufacturing Downturn, Rising Trade Barriers“, October 15, 2019.
[ii] Larry Light, Chief Investment Officer Magazine, “The 60-40 Stock-Bond Asset Mix Is Dead, BofA Warns“, October 18, 2019.
[iii] George Gatch, John Bilton, Karen Ward, Tim Lintern, Victoria Helvert, J.P. Morgan Asset Management, Long-Term Capital Market Assumptions, September 30, 2019.
[iv] Wouter J. Keller, Jan Willem Keuning, Protective Asset Allocation (PAA): A Simple Momentum-Based Alternative for Term Deposits, April 5, 2016.
[v] Tom Brown, Ian Smith, Lucy Luscombe, KPMG, Investing in the future How megatrends are reshaping the future of the investment management industry, 2014.
[vii] Source: Zillow Research (as of December 28, 2017).
[viii] Source: FederalReserve.gov. As of December 2019.
[ix] Thomas L. Hogan, Rice University’s Baker Institute for Public Policy, “What Caused the Post-crisis Decline in Bank Lending?”, January 10, 2019.
[x] Joshua Morris-Levenson, Robert Sarama, Christoph Ungerer, “Does Tighter Bank Regulation Affect Mortgage Originations?”, January 20, 2017.
[xi] Source: American Banker, “Burned in 2008, Americans are refusing to tap their home equity”, October 28 2019.
[xii] Source: S&P CoreLogic Case-Shiller Home Price Index.
[xiii] Source: Calvin Zhang, Federal Reserve Bank of Philadelphia, “A Shortage of Short Sales: Explaining the Underutilization of a Foreclosure Alternative”, February 2019.
[xv] Source: Federal Reserve Bank of St. Louis, November 26, 2019.
[xvi] Alcynna Lloyd, HousingWire, “Borrower home equity rises to all-time high in first half of 2019”, September 25, 2019.