Why is it that so many good ideas come to us as we’re drinking? Thankfully for me it’s because I’ve got great friends with great ideas. They have bad ones too. But anyway, I was talking to one of my friends at a bar and we got to talking about loans and borrowing money to purchase homes. We all know that companies have two methods to pay for their business operations. They can borrow money in the form of a loan or issue ownership in their company to investors.
But if you want to buy a house you only have one option, get a mortgage. Why aren’t there any companies out there that will “invest” in your house the way you might invest in Apple stock? Think of it the way a company raises money when they do an initial public offering. Investors purchase the shares that you (as the company) are offering. If those shares appreciate, they make money on that appreciation. If the company wants to buy back shares they can. If they have to pay a dividend, they will.
Can we port this model to houses? You bet. Pretend I’m buying a home that costs $100,000 (the old people here will remember back when that was a normal thing). And let’s pretend that Citi pioneers this new investment style that I’m going to call JET (joint equity transaction) financing. I go to Citi and we strike up a deal. What does it look like?
- My Investment: 5%
- Citi’s Investment: 95%
So I own 5% of the house and Citi owns 95%. Now let’s assume no other transaction takes place until it comes time to sell the home. The home is now worth $110,000 one year later. At the sale I get 5% back ($5,500) and Citi gets $104,500. We each made 10% on our money. And if houses appreciated 10% a year we’d have JET financing with no questions asked. But it doesn’t, so we don’t. So we have to incent Citi to actually go through this deal. So I’m going to buy the rest of the house from Citi. How? I’ll make regular payments to them just like a mortgage. The terms of those payments don’t matter but just pretend I buy back 3% of the house each year so we can move on.
What does Citi get for their trouble? When I go sell the house (now worth $140k), I’ll get my equity back based on the original price. Say at this point I now own 50% of the home. I’ll get $50k plus 5% of the appreciation (based on my down payment) which is [.05 * $40k = ] $2,000 for a total of $5,200. Citi will get the other 50% of the home plus 95% of the $40k in appreciation which totals $88,000. But I’ve also paid them for 45% of the original value over time so their net gain is [88 + 45 = ] $133,000.
I could pitch that investment to just about anyone because they get repaid and a cut of the proceeds equal to the initial outlay instead of the current state of ownership. What are the advantages of JET financing over a regular mortgage for Citi then? If you repay them completely then they simply get a nice return the follows the housing market. It’s essentially risk-less for them because if the value of the home goes down that comes out of your pocket (just like a regular mortgage).
So what’s in it for you? Flexible options. Perhaps you don’t have to make any payments if you don’t want to. Just if the value of your home goes down you have to put money in escrow to make up for the loss. If you want to build up equity you can. You also won’t have to pay interest. So every payment goes towards equity. The downside is you’re on the hook for drops in property value (just like you are now) and you only get the % of home appreciate equal to the % of your down payment.
Without running through some mathematical scenarios (no time and that’s not what this blog is about) the arrangement sounds kind of fair. Of course if this market became mature you’d see all the banks selling off their stakes just like they did with mortgages to institutional investors. And I know you’ve been thinking about the collapse of home values lately but that’s detrimental whether you’re in a mortgage or a JET.
Hash out any other pros and cons or issues in the comments if you wish, but file this under “awesome ideas”. But then again, I was drinking.