With home values now rising faster than the national rate of inflation in a number of major markets, a financing concept from the late 1970s is making a quiet comeback: equity participation, also known as equity sharing.
Equity participation typically involves two parties. The first is a home buyer who lacks the cash or credit to qualify for a standard mortgage. The second is an institutional investor who will provide the dollars necessary to put the buyers into the home they want.
The investor receives an equity stake in the house itself. The equity may be 50 percent, but the bottom-line legal fact remains the same: When the house is sold, the investor has to be paid his or her agreed-upon share of the net proceeds.
In the meantime, the home buyer living in the house also pays the investor rent for occupying the investor's portion of the property. If the investor has a 50 percent stake in a house that could command $500 a month in the local rental market, the home buyers pay half of that -- $250 a month -- to qualify under Internal Revenue Code section 280(A) federal tax rules for equity-sharing arrangements.
Nearly moribund during the tough real estate years of the early 1980s -- when home values stayed flat or went backwards in most parts of the United States -- the equity-participation market has been turned back on by the current rebound in home prices. Symbolic of movement in the field is a Philadelphia-based real estate investment firm, Prescott Forbes Group.
Prescott Forbes has a regional network of 45 associates around the country, all of whom use the firm's documents, techniques and legal counsel to put together equity participations for purchasers of single-family homes. The firm's Steven Adams says Prescott Forbes will close upwards of 500 equity-sharing transactions on homes and condos this year, and a considerably larger volume next year if the national economy stays on its present track.
The locations of the transactions run the gamut from markets with strong jumps in housing value -- such as metropolitan Boston, northern New Jersey, Connecticut, suburban New York and selected cities in Texas -- to areas racking up average or slightly better returns, including Atlanta and portions of California and the Midwest.
Although the search for "solid appreciation" has led the firm to concentrate in markets growing now, Adams added that "we're now looking to do business in markets that are in the 'turnaround' phase of the economic cycle" and may do better during the next five years than some of 1985's high-fliers.
An average 7-percent-a-year appreciation on a well-priced home in a growth market should be possible in dozens of areas this year and next, according to Adams. Cities such as Boston, Austin, Texas and large portions of the Northeast have seen average appreciation rates in the double digits in 1984-85, according to the National Association of Realtors.
If the same 7 percent rate continued on average for five years, a $90,000 house in a nice neighborhood in 1985 should be saleable for $130,000 to $140,000 by 1990.
Because most equity participations require low cash down payments up front from investors, the return on the dollar from even more modest levels of property-value appreciation can be impressive -- often above 30 percent a year.
A standard program offered by Prescott Forbes involves co-signing on a conventional mortgage in exchange for a minority share of the home equity. An example:
Although a young, first-time buyer has the minimum down payment for a mortgage -- say, 10 percent -- the bank absolutely refuses to make the loan unless a third party with solid credit guarantees, or cosigns, the mortgage documents.
Prescott Forbes' investors do this via an equity-sharing percentage, rather than a straight fee. In a case cited by the firm, the investor received a 15 percent stake in a $90,000 house in exchange for the risk of potentially having to assume full payments on the mortgage. The investor made no cash outlay whatsoever, and received $24 a month after tax from the occupant.
In three years, the investor had a $4,772 net profit -- his share of the sale proceeds. According to Prescott Forbes' calculations, the average annual yield to the investor was more than 1,500 percent.