The long and the short of it
Innovation is accelerating in almost every field. Why should financial services miss out on all the fun? For example: why is it axiomatic that shorter repayment terms reduce loan repayment risk? This belief shapes investment strategies and the structure of debt financing globally. But what if conventional thinking is wrong? Or, at the very least, incomplete?
Working outside this framework requires innovation – not a million lines of code, just a determination to do things differently.?We are working on a fascinating project which will demonstrate two propositions. First, extending repayment terms for property development measurably reduces repayment risk. Second, treating the occupant, not the property, as the "underlying asset” radically simplifies financing structures.
Going south: This week, Prime Minister Christopher Luxon of New Zealand announced the creation of a new agency, called Invest New Zealand, that will encourage foreign direct investment, at scale, to boost economic growth. We find the announcement timely because we are collaborating with a coalition of innovators in Aotearoa New Zealand to finance affordable homes for Māori families who own land but lack funds to develop housing units. This project is all about foreign direct investment to fund perhaps the most ambitious socially motivated program in recent years in Aotearoa.
Our partners operate under the aegis of a newly formed charity, aptly named the 100 Year Plan Trust ("100YPT"). We say aptly named Maori plan for three generations at a time, these families have been around for more than a hundred years, and intend to stay for generations to come. What better way to test the notion of a community based ultra long-dated financing construct?
ESG with a capital S: The trust has reached out to tens of thousands of families (or "whānau"), many of whom own parcels of land in the country that brought Lord of the Rings to the silver screen. Paradoxically, much of that land lies fallow. Meanwhile, the owners pay hundreds of millions of dollars a month to occupy properties they will never own. If conventional financial structures were perfect this problem would fix itself.
Sadly, but unsurprisingly, banks think lending to these families is too risky. And when they do finance building projects they want to get their money back as soon as possible which creates (not reduces) risk to the bank. If we were holding the pen, we'd do things differently. An elegant rental pass-through structure would (1) pool the rent these families are forced to pay for decades and (2) auction that cashflow to institutions looking for ulta-long dated rent-like assets at scale. The idea is innovative, but not complicated. The following business model is intelligible to kids who can grasp high school maths and runs to 125 characters (including spaces).
The problem we are trying to solve is intransigence and inertia, which is precisely the issue the prime minister identified from the podium. Some deep pocket financial institutions (who employ many PhD mathematicians) can't get their heads around the maths. They append to that tweet a raft of questions, starting with the observation that our solution requires the creation of a "new bond asset class" and, while new ideas are welcome, new ideas that have been tested for decades are better than new ideas that are, erm, new. Hence, our pitch decks to investors start with an inaccuracy. We say the problem we are trying to solve is affordable housing. In truth, the problem we are trying to solve is finding a. way around the"Shock of the New."
It takes a village: Let's go back to first principles. Much of this land is owned collectively rather than by individual whānau. These families intend to put down roots for generations: raise kids, look after those who have retired, and hence are thinking 100 years ahead. Conceptually, financing the community collectively over very long periods is not complicated. Hence, I have highlighted the terms: "revolving group" and "forever." I struggle to understand how ring-fencing a closed block of assets, banning asset substitution, and requiring occupants to put down deposits out of non-existent savings adds value or mitigates risk. However, those are the "normal ways of doing things" so people who own beautiful tracts of land remain inadequately housed.
In the real world, people have jobs or other sources of income out of which they pay rent with measurable regularity if you look probabilistically at the portfolio rather than pretending that worst case scenarios, analysed at the case by case level, scale to a portfolio through simple multiplication. They do not. For a granular portfolio, the problem is stochastic and that's a scary word, so people who own beautiful tracts of land remain inadequately housed.
Banks throw millions at agentic artificial intelligence solutions based on abstruse mathematics that senior bank executives have no hope of comprehending. These systems are new. Implementing new systems and workflows is time consuming, expensive, and fraught with risk, but rushing in where angels fear to tread is okay as long as your institutional peers are rushing in with you. Meanwhile, these banks struggle to analyse the risks inherent in the core (and profitable) business of lending money to finance the purchase and development of homes. This activity is, literally and figuratively as safe as houses.
Keep it simple: Creating elaborate funding structures won't change the unemployment rate or forestall a recession. These structures (often called residential mortgage backed securities) are designed to shift risk up and down the waterfall and (ahem) reduce tax. Likewise, asking the applicant to risk their entire life savings before the bank loses a penny is an elegant way to force those who are least able to bear the risk to bear pretty much all the risk. So people who own beautiful tracts of land remain inadequately housed
That's why it is critical to ask: what risk are we talking about and how do we quantify risk in the first place? Let's look at it from the landowner's perspective:
Which would you rather:
I believe the individual whānau would have a higher incentive to keep up their payments if they knew they were building generational wealth. The desire to satisfy basic needs at the bottom of Maslow's pyramid (housing) and take a peek at the top of the pyramid (self-actualisation) makes this communal endeavour less, not more, risky than collecting rent from conventional tenants. If true, the risk of financing the second strategy will be lower than the first. The problem is compounded in Aotearoa New Zealand as there are peculiar restrictions on the alienation of Māori freehold land, so the bank can't simply evict the occupant for non-payment. However, these are measurable risks that clever bankers can take into account when they price the financing if they want to, or not if the whole thing sounds too risky.
Slow down, son. If you think like a financial institution it all gets very confusing. What do you mean by financing a community? And what's this long-term nonsense? Surely, forcing the landowner to repay the financing quickly will reduce risk. Moreover, where's the "tangible asset" I can grab if all goes pear-shaped? Didn't some clever chap observe that in the long run we're all dead?
In our view, these morsels of conventional wisdom create, not reduce, risk. For those familiar with my posts you will not be surprised to see me crank through the maths. Strap in.
Let's do the math. Imagine you put a billion dollars into a pot to fund homes for 4,000 families at a quarter of a million dollars per unit. These families currently pay something of the order of $2,000 per month ($24,000 per annum) representing just under a 10% running yield, rising with inflation for decades. Skim off some of the proceeds to pay the developer and you might have 8% per annum left – more than enough to reward the finance providers, employees, and taxpayers. If there's anything left, the shareholders might even receive dividends.
Since it takes 30 years to buy a home that's an aggregate of $2.4 billion coming from disadvantaged families who only need a billion to turn empty land into affordable homes. Although we are working with a charity, the community we want to serve is not asking for a handout.
Next, let's look at funding costs. Mortgage banks would be lucky to clear a hundred basis points per annum of net interest margin if they could borrow at a government bond yield (currently 500 basis points in New Zealand) and lend at today's thirty-year mortgage rate (currently 600 basis points). If you strip out long dated inflation using the New Zealand Reserve Bank's 2% target, your government bond rate, plus a decent margin, drops to about 400 basis points. Eyeballing it, an asset throwing off 8% running can easily amortise a debt at 4%. This high finance malarky is hardly quantum physics.
Introducing OT1S – a mathematical illustration of. our proposed approach: Amortised over 30 years, the finance provider needs $58 million per annum (measured in constant spending power) to recover a 4% real internal rate of return. This drops to $44 million per annum if amortised over 60 years. Starting with $80 per annum, the portfolio generates 60% more surplus cash flow if the repayment period doubles.
Reinvest half the surplus into a portfolio held Off to 1 Side (nicknamed OT1S) and you can pay employees, tax, and dividends with the other half. You don't need a classical (and rigid) securitisation vehicle when you have a mission-driven Trust serving the community sitting on the board. Since a billion dollar annual program exceeds any new housing initiatives planned by the current government, we call this "part for-profit part charitable" governance structure ESG with a capital G. And, since the housing units will be eco-friendly, we haven't forgotten the capital E. Job done.
Here's where the magic happens: After 30 years, OT1S will become a $1.2 billion portfolio of 5,000 homes if the original financing was amortised in full over 30 years. However, with the 60 year annuity repayment, OT1S will become a $2 billion portfolio of over 8,000 homes at the same 30 year mark.
Let's take stock. A closed book securitisation would be underpinned by 4,000 families. With our approach, after thirty years, the bondholders would have first dibs on the rent from 12,000 families, if they can get their heads around the risk.
With continuous compounding for two or three human generations, OT1S will generate enough cash to service the entirety of the original 30 year annuity within 24 years. Lengthen the annuity to 60 years and (all else being equal) OT1S could service the original financing within 16 years. To anyone armed with high school maths, this sounds like risk reduction.
Thus, the term of the financing for the portfolio can comfortably exceed the term of the underlying leases. In theory, the annuity could be perpetual. Yes, there's some maths involved here, but not much. If you strip out the maths, the risk analysis rests on the supposition that "the Māori community has been around forever and probably will be around for generations to come." That's 95 characters, including spaces.
This is what success looks like: The longer-term financing:
I welcome suggestions and analysis from people who take the opposite view. Help me understand why bond investors should feel better about financing long dated assets over a shorter period. How does introducing this funding mismatch reduce risk? More to the point, what social good is served by sticking to the status quo?
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Ike Udechuku | Cofounder | Pathway
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