Home Equity Sharing - Wolf in Sheep’s Clothing?

Making Sense of Dicey New Finance Options

A number of companies have recently emerged to help homeowners access home equity. Patch Homes recently landed a $5M Series A from Union Square Ventures, and joins a growing contingent of companies, like Point and Unison, who enable homeowners to ‘share’ home equity with investors, as opposed to the traditional option of borrowing against equity via a secured loan.

The companies are providing novel products to access equity liquidity, attacking the gargantuan multitrillion-dollar real estate market. Though only currently capturing a multibillion-dollar sliver, the home equity sharers are growing rapidly, with YoY origination at 20x for Patch, 10x for Point, and 3.7x for Unison.

USV Partner Fred Wilson blogged that the investment played to their firm’s current thesis of expanding consumer access to capital. Providing more options to consumers should be a good thing, argued from a purely capitalist perspective.

However, the inherent complexity and non-standardization of these new products make them prime for misunderstanding. As customers line up for the new options, it’s interesting to analyze which use cases make sense, and which ones likely don't. And for when they don't, it's interesting to consider whether the products are succeeding because of their complexity, or in spite of it.

Given my firsthand experience in the space, I decided to share my perspective on the genesis of these products, explain how they work, attempt to disentangle the financial realities from the marketing, and offer a prediction for this murky slice of fintech. 

1) The Siren Call To Trade Your Home Equity  

In 2016, I dove headfirst into the home equity share space, joining a startup to enable homeowners to “sell future home equity appreciation for cash today”. Homeowners, who usually have way too much exposure to home prices in their portfolio, could use the product to diversify and access capital. Investors could use the product to access single family real estate. Our platform sought to create a win-win partnership between homeowners and investors broadly.

Our timing seemed right because of a number of factors: 

• post-financial crisis, homeowners had recovered greater amounts of home equity and had a more balanced outlook on their homes so would be willing to part with equity;
• the rise in consumer comfort in the sharing economy (if you would lease your home to a stranger via Airbnb, why not sell some shares as well?);
• investors and regulators were warming up to financial innovation;
• the continued trend toward passive investment would connect well with large portfolios searching for diversified exposure to the asset class;

We weren't unique in seeing this opportunity: Point had just raised 8.4M from prominent VCs, Patch had just gone through the Techstars accelerator, and the industry incumbent RexHomes rebranded to Unison with a renewed marketing push. Business plan in hand, we tested our hypothesis engaging customers and investors.

Customer leads came from those shut out of the traditional mortgage ecosystem. Plenty of homeowners had home equity, but couldn’t get a loan - think former W2 workers turned freelancers, or immigrants, or whomever else banks notoriously neglect.

Investors needed to have the risk appetite to bet on a nascent financial product. To rationalize the investment, they logically needed to see a return profile that meaningfully beat existing products like simply owning a portfolio of rental homes. Additionally, given the equity share structure, investors demand compensation for:

• lack of governance (they have no control over your home as a minority interest)
• lack of liquidity (no market to trade these shares)
• long duration (10+ year products with no amortization)
• lack of cash flow (no interest payments!)
• increased regulatory and legal risk - what if homeowners plead ignorance when you force a home sale?
• modeling risk of not really knowing how a portfolio of these contracts would play out

In other words, the product would have to yield quite a bit more than a theoretical fractional piece of ownership to entice investors. Yet shifting too much value to investors away from homeowners would make the products inherently expensive.

I joined the project to create a broadly useful product for homeowners, yet learned that the equilibrium structures only made sense as a last resort capital option for a narrow set of homeowners. While possibly a viable use case, this was not the disruptive new product of large scope I had imagined. I became disillusioned with the value proposition and decided to move on.

2) The Devil is in the Details - Basic Mechanics Primer 

Hold on to your pocket protector, we’re about to get technical here. Feel free to skip ahead to section 4 if you aren't a fan of casual math.

Real estate investors receive returns from rental income and appreciation as prices rise. Therefore, an investor who buys a fraction of a piece of real estate should expect to receive a fraction of those same returns.  

Traditional Return = Rent + Appreciation

But what if the fractional equity no longer pays rent, which is a core feature of the equity share finance product? Then the investor needs to be compensated in other ways, and so the leading product in the market is to amplify the appreciation by a multiplier, commonly 3x-4x.

New Return = Appreciation * Equity Multiplier

In other words, 10% of equity is traded for 30%-40% of future home appreciation (or depreciation). E.g. your home is 1M, you receive 100k, and promise 30-40% of the upside on the home. The contract ends whenever you choose over its life (usually 10 years) at which point the home gets re-appraised (or can use a sale price) and the final payment is calculated. Having a mortgage doesn’t change this math, other than possibly excluding you from participating with too low of a starting equity amount.

Receiving 10% in exchange for 30-40% percent of appreciation might not be as unfair as you might initially suppose! Remember, there is no rent being paid for the shares you are selling - so the multiplier provides the compensation.

A theoretical fair value for the equity multiplier is hard to pin down. Investors are making a first-order trade-off between forgoing rents today on the 10%, and synthetically financing exposure to the multiplied equity amount of 30-40%. The exposure has a positive expected value over the life of the contract, so investors will seek to maximize the multiplier.

There are a host of other complicating factors that make pure appreciation contracts more attractive over outright ownership such as enabling access to markets dominated by primary ownership, avoiding transaction costs, saving on maintenance/taxes, and eliminating the hassle of property management.

Property yields and expectations for appreciation are inversely correlated. Therefore, home equity sharers logically target regions with low yield / high appreciation expectations, enabling them to capture most of the financial benefits of ownership via the contracts.

Good Target Profile = Low Rent + High Appreciation 
Bad Target Profile = High Rent + Low Appreciation

With the product as described, investors would enjoy leveraged exposure to your home instead of receiving rent, but alas, this arrangement is too risky since customers can terminate at any point. Over the near term, prices are less predictable and a customer might unwind coming out a winner. Therefore, the contracts protect investors by reducing your starting home value (and increasing future appreciation calculations) by a ‘risk adjustment’ of up to 20%, ie if your home is worth 1M on the market, the equity share contract says it’s only worth 800k today.

The adjustment makes the contracts meaningfully in-the-money for investors from the get-go and makes early termination punitive for customers.

Final Payment Calculation = Original Principal + Appreciation * Equity Multiplier

Appreciation = End Home Value - Start Home Value * Risk Adjustment

To summarize, the contracts are structured with two primary input variables:

1. Equity Multiplier - the ratio of appreciation pledged compared to the amount received
2. Risk Adjustment - the amount your home price is reduced.

Secondary variables are end date and origination fees. 

3) The Cost of Capital is King

Once a contract is agreed, the eventual cost is driven by two outcome variables:

1. Home price appreciation (HPA)
2. Time held

The cost can be calculated as the IRR, understood like an APR equivalent. Think of this as the running interest rate on the upfront amount received, compounded annually. The below table shows an example cost analysis using a contract with middle of the line inputs:

• 3x home appreciation multiplier (e.g. swap 10% cash for 30% appreciation)
• 10% risk adjustment (your 1M home starts out at 900k)
• 3% upfront fee on proceeds (fixed)

Example interpretation: You own a home worth 1M and agree to receive 10% of home value in exchange for 30% of future appreciation. The contract adjusts the starting price down by a 10% risk adjustment to 900k. Your home price rises by 5% per year for 10 years, so it’s now worth 1.629M. To terminate the contract, you must pay back the original 10% (100k) plus 30% of 1.629M-900k, or 218k. Since you received 100k (less origination fees) and paid back a total of 318k 10 years later, the capital cost you 13% net of fees ((318/96)^.1-1)

Mileage varies with changes in the equity multiplier and risk adjustment, which depend on your credit profile and the home address. Looking at the table, there are higher IRRs in lower years reflecting the punitive nature of early termination, driven by the upfront risk adjustment and origination fees. The running cost is less onerous as time passes since the upfront adjustment is effectively amortized away.

In the very long run, the cost of capital would converge toward the actual appreciation rate - but the contracts are capped, usually at 10 years, or in Unison’s case at 30 years. Increasing the risk adjustment would bump all the IRRs higher (Point’s average is closer to 17%), as would increasing the multiplier (assuming >0% HPA scenario) The IRRs are usually capped in the 20% range to prevent egregious outcomes.

The first thing that jumps out in the table is that the likely range of costs is fairly expensive compared to traditional debt products. That shouldn’t be too surprising, considering that the home finance market is highly mature and standardized, and the fact that an equity product is theoretically more expensive than debt. To put numbers on this, first lien mortgages are in the 3%+ range and second lien/HELOCs are in the 5% range as of today. For credit-worthy borrowers, sharing home equity is an alternative to borrowing at second lien rates. And while traditional products are kept current or paid down via ongoing payments, the home equity product is not, so the cost is compounding over the years and the total amount paid will be higher in dollar terms (like taking out additional loans each month instead of making interest payments).

The second thing that jumps out is how expensive APRs are in absolute terms in normal environments. Appreciation has historically averaged in the mid-single digits ranges, and higher in the bay area where Unison, Point, and Patch are targeting. Referencing the terms of our example contract table, a 5% HPA scenario held for 5 years would cost a homeowner a whopping 17% per annum. Even low appreciation at the inflation rate of a modest 2% still results in double-digit IRRs for sharing your equity during the first 5 years.  

4) To Share Home Equity or Not? That is the Relevant Question.

When does it make sense to consider sharing home equity? Given these cost ranges, in likely far fewer scenarios that you might have initially thought.

The first category of customers, call them “axed borrowers,” are the house rich, cash poor segment who need money for whatever reason, and are being rejected by traditional lenders. Sharing home equity offers a compelling option to avoid needing to sell your home, or turning towards high yielding personal loans or credit cards. The motivator could be an emergency, to fund your own business or any number of alternatives where there is a catalyzing need. This cohort can be sourced through partnerships with traditional originators, forwarding customers who are denied HELOCs to the equity sharer funnel.

The second category of customers, call them “opportunistic”, are those who are coupling the decision to borrow home equity with the use case for the funds. Here the use is motivating the need and not vice versa. These customers can be sourced through a variety of marketing channels, including the surprisingly effective direct mail pamphlets.

This is where the analysis gets a bit interesting. The savvy consumer would ensure that returns on using the funds exceed the cost of funds by a reasonable margin. Leveraging the product to pay off debt might make sense, so long as that debt is high interest, like credit cards, and there’s no light at the end of the tunnel to pay down the balances for years (recall equity share costs are very high for the first few years). 

However, the temptation to use the proceeds to pay off other secured loans, like a mortgage, is likely value destructive given the expected range of APRs. You would need your home price to depreciate over a long horizon for that to have made sense, but nonetheless this is commonly offered as a use case, like in this blog post by a16z. And thinking the proceeds are so cheap (free?) that they should be used to fuel an IRA or other public investments is likely a fool's errand for the unsophisticated investor - there is no arbitrage opportunity as one sponsored reviewer initially assumed.

The home equity share sites take a soft marketing tone - emphasizing the process, the partnership approach, the benefit of no interest payments, and the myriad use cases for utilizing the funds. The sites don’t go out of their way to provide a matrix of scenario APRs - the examples/calculators are lacking in being able to adjust basic parameters. Neither do they help customers cut through misconceptions over the nuances of the product, but rather play into them by emphasizing the lack of debt, interest, and partnership. This approach is at best naive, and at worst psychologically exploitative: 

• Debt-Free is misleading. The contracts are a bonafide liability with an end date, and are a lien on your home. You will have to eventually unwind the share either via a refinance, some other windfall, or the sale of your home (or they can force the sale). While it’s true that the agreement won’t show up on your credit report, the economics are akin. This wording plays into an overall cultural aversion to debt - yet the capital will ironically be more expensive than its debt equivalent. A more accurate mental model to invoke is a collateralized loan like a mortgage with an equity kicker, not an asset sale where there is no residual contract.  
• Interest-Free is misleading. While there are no monthly interest payments, the cost is accruing and realized on the backend. The contracts are structured in such a way that in most environments, including flat and even depreciating (thanks to the upfront risk adjustments), the end payment is in meaningful excess to the principal received. There is still a cost of capital here, albeit less visible and variable depending on the market. Framing the interest rate as 0% in comparison grids vs other loan products harps on cognitive biases for consumers to prefer poor expectation gambles over known fixed costs (like a loan) to their detriment, and excessively discount the future cost. 
• Partnership is misleading. While the counterparty does better when your home price rises, and vice versa, the contract is still a bilateral agreement between you and an investor and is zero-sum. Unlike taking chips off the table to a parri passu partner, this investment is senior in the capital structure, does not have any of the costs associated with ownership, and is skewed against the homeowner with the upfront valuation adjustment, early termination fees, and appreciation multiplier. Underwriting is designed to give investors alpha, and the argument to use as a hedge is highly questionable given long-run trends. Consumers who focus too much on the idea that it could be cheaper than a loan might be confounding possibilities with probabilities. 

Despite the hair on understanding the financial consequences of the trade, the products are proliferating, and with good reason. The equity sharers aren’t nefarious, but strong marketers coloring within the lines of regulation. I see their growth attributed to positive innovation in a void left by banks, in the form of:

• Superior customer-friendly process. The sites are friendly and engaging. The underwriting process is technology-enabled and less invasive than what’s asked by mortgage underwriters. Homeowners can receive fast quotes, with friendly sales reps proactively reaching out to navigate the process. User reviews, not surprisingly, emphasize the experience as “straightforward, quick, painless, etc” contrasted to the notorious rigmarole employed by incumbent lenders. And while the product may be somewhat murky, the process compensates and is easily appreciated
• Providing options to those whom banks do not underwrite. Banks have rigid guidelines in underwriting home finance loans, and for customers who don’t conform - those with low or no credit or income - they are SOL in accessing their equity outside of selling the roof over their heads - until now. Creating a product that pairs lending with equity exposure has enticed private capital to flow to this segment. Providing a new option to a segment that previously had no options is the critical white space. 

5) Blissful Ignorance Interfering with a Strong Balance Sheet

Classic economics would suggest that customers, as perfectly rational econs, would borrow at the lowest possible rates. Given the imputed costs of equity share products at the available terms, customers should only engage if they were being denied by banks for traditional products. Real world experience suggests that customers lack the mental models to understand the implications of new financial products and risk engaging in value destructive behavior. These products, in particular, are difficult to grok: while the math calculations above are straightforward, they are generally out of reach for those engaging with making a decision to share equity.  

The sites themselves market widely, to both those with and without traditional options. Patch brazenly asserts the product is a “better alternative to home equity loan”. Quick googling shows the internet is also rife with poor calculations and affiliate driven advice - see flawed advice here, here and here, completely lacking a discussion of expected costs. Without a heartfelt appreciation of expected costs, consumers might gleefully pay down loans with equity, and enjoy spending the new windfall from not paying monthly interest. The real cost will be determined later, but will likely be in the mid-teens APR and compounding until you unwind years down the road. If you would balk at fueling consumption by growing a 15% APR credit card, this wouldn't be too different, except much harder to see!

I wonder to what extent would consumers’ behavior change with a thorough understanding of the financial consequences? I’m always fascinated by the consumers who sign up regardless because of their idiosyncratically kinked utility curve when it comes to money - doing things that are known to be sub-optimal due to laziness, psychology, or just plain irrationality. What you don’t see or understand can’t hurt you - for now. 

Regulators would be wise to set standards to ensure consumers are informed beyond simply the rules of the game, such as disclosing the full cost in various scenarios without needing to mock-up tables in excel and research historical real estate price data. Customers should consult their own advisors and, to state the obvious, not rely on their counterparty for guidance. Fintechs should put their best foot forward in providing full cost estimates to ease comparison to other products. And while there are qualitative differences between an equity-share and debt, this product is ultimately financial and should be compared in the usual parlance of APR as part of the assessment process.

6) The Unbundling, Evolution, and How We Will All One Day Swap Home Shares

I applaud the innovation in the space, and ultimately agree that more options for consumers is a good thing, even as there are bumps in the road around standardization, transparency, and structuring customer-friendly terms in the nascent products. The alternative world of too much regulatory conservatism would stifle the flow of capital, and foster the institutional problems like those experienced by customers alienated by their banks.

We will continue to see lenders - nay - capital providers of the future service customers in more flexible ways, as capital continues to flow more freely with the emergence of niche fintechs. I would expect to see an unbundling of the various value propositions offered in the equity share products into disparate offerings:

• If the appeal is in a tech-driven underwriting process, why not use traditional products served in a customer-friendly way? check out Figure
• If the appeal is simply access to credit, why not engage with a more flexible home finance lender? check out Button Finance
• If the appeal is entirely in the lack of interest payments, why not borrow via a zero coupon loan or other alternative structures that aren't linked to your home price?
• If the appeal is in reducing portfolio risk against home price depreciation, why not purchase a pure swap or insurance product originated closer to fair value?

Any of these demand drivers likely represent future opportunities in fintech. A streamlined process for customers to engage is table stakes in 2019. I believe the current bundling we’re seeing in the home equity share product is a consequence of trying to make the new products for an underserved segment sufficiently attractive to the early investors who have higher costs of capital.  

As the market matures, the contracts will likely tilt the economics more to the consumer as more participants begin buying equity share portfolios reducing the cost of capital. As this happens, the “opportunistic” use cases start to expand creating wider appeal. The products will increasingly look closer to representing the economics of, well, actually selling a fractional share (queue asset token pitches). From where we are today with current market terms we have a ways to go, but there is plenty of entrepreneurial energy, and VC capital, pushing the space forward and we will be keen to watch the evolution. 

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If you are building something in this sector, or have thoughts on this topic, I’d love to hear from you. Drop me a note at [email protected]

independent opinions and errors are mine