Revolutionary help for homeowners
Homeownership doesn't have to be 'all-or-nothing.'
Home prices in the US are in free fall. As long as that's the case, millions of homeowners will face the risk of foreclosure – and the wider economy will suffer. Therefore, stabilizing the housing market effectively and equitably is essential. But it's going to take more than lowering mortgage rates, passing stimulus packages, buying toxic mortgage-backed securities, and freezing foreclosures.
What's needed is a groundbreaking approach that prevents foreclosures and increases the affordability of the existing housing stock, thus increasing housing demand. Both of these issues can be addressed with a simple, yet radical, innovation: fractional homeownership.
Currently, home purchases are financed entirely with the owner's personal capital (down payment) and debt (mortgage). Though no law forbids it, there is no opportunity for homeowners to get external equity financing, in which a passive investor shares in the financial gains and losses of the home's value.
People either rent or own their residence – and moving from the former to the latter is a major leap. To make that jump in recent years, consumers often turned to exotic mortgages, which exposed them (and lenders) to great risk. Fractional homeownership solves that problem. It bridges the gulf between renting and owning, providing an array of financing structures to achieve the American dream.
Fractional home ownership allows home financing to include a minority passive equity partner. With such a partner, homeowners can "right size" their financial obligation by owning less than 100 percent of their home while maintaining the material (and tax) benefits of ownership. With a standardized fractional home ownership security, institutional investors could and would be that partner.
Consider this scenario: Susie wants to live in a $300,000 home. To do so, she must bear $300,000 of exposure to the housing market, and associated mortgage expense. Susie's "consumption" of housing equals her "investment" in housing. After crunching the numbers, she concludes that the home is unaffordable. But homeownership shouldn't be limited only to those who can afford a 100 percent ownership (investment) stake. There is no reason why it must be "all or nothing."
A home equity fractional interest (HEFI) security separates the consumption and investment decisions. That means Susie could own, say, 80 percent of that $300,000 home (with $240,000 financed by a down payment and mortgage) and an outside passive equity investor would own the other 20 percent. In this new scenario, Susie would "consume" $300,000 worth of housing, but would have only $240,000 of investment exposure.
This innovation would have major short-term benefits for foreclosure mitigation, and long-term benefits for stabilizing home prices. And it is possible now.
Across America, millions of families want to stay in their homes but can't keep up with the mortgage payments – often risking foreclosure. But it doesn't have to be that way. If the owner can afford the bulk of the monthly payment, the mortgage could be restructured into a reduced loan corresponding to a majority ownership stake of the home's current market value – with the difference covered by a HEFI security. Because the owner would now have equity in the home (previously, the mortgage probably exceeded the home's market value) and a sustainable mortgage expense, risk of foreclosure is greatly diminished. Significantly, because the homeowner "pays" for the mortgage reduction with the issuance of a HEFI, there is no moral hazard. This restructuring is not a bailout, doesn't risk taxpayer money, and is not unfair to responsible homeowners or renters.
The HEFI security represents a passive investor interest in a home – analogous to a share of stock, which represents a passive investment in a company. Institutional investors, such as those who manage pension and endowment funds are interested in HEFIs to achieve diversification beyond stocks and bonds.
The single family owner-occupied (SFOO) equity asset class is as large as the entire US stock market. To be properly diversified, institutional investors might want to hold about as much in the SFOO equity asset class as they do in stocks. Right now, though, there is no practical way for them to invest in SFOO equity; HEFIs and a HEFI trading market – which my firm is creating – would create an attractive and practical way for them to invest in this asset class.
In summary, fractional home-ownership would bring sorely needed assistance to currently troubled homeowners and to aspiring homeowners striving to achieve the American dream. It would also bring significant benefits to the economy by: (1) reducing foreclosures, (2) reducing the oversupply of housing by injecting a major new source of money into the housing market, and (3) providing a market for price discovery in housing, thus reducing price uncertainty. Together, these benefits mean greater affordability, transparency, liquidity, stability, and demand for the nation's housing market.
• John O'Brien is codirector of the Center for Innovative Financial Technology and faculty director of the Master's in Financial Engineering Program at the University of California Berkeley's Haas School of Business. He's also managing partner at Home Equity Securities LLC.