Managing Home Equity to Build Wealth By Ray Meadows CPA, CFA, MBA
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1 Managing Home Equity to Build Wealth By Ray Meadows CPA, CFA, MBA About the Author Ray Meadows is the president of Berkeley Investment Advisors, a real estate brokerage and investment advisory firm. He has worked in real estate and finance for over 15 years at Wells Fargo Bank and Citigroup, among others. Ray is also a professor of finance at Hult International Business School where he teaches Investment Management. If you are like most Americans, you are looking for ways to improve your financial cushion for retirement. While home equity is often a very substantial part of net worth, this does not provide cash for paying the bills. Worse, recent events show that equity can quickly be lost if local real estate markets turn down. This paper will analyze a new option for addressing these problems and compare it to existing strategies for funding retirement. Building up home equity is a traditional way of saving for retirement; but kept in the form of equity it cannot make up for the reduction in employment income that comes with retirement. Homeowners must therefore make some decisions about how to manage their overall asset portfolio to fund retirement needs. In particular, they might need to either reduce cash expenses or turn home equity into spendable cash. Assuming you want to maintain your current level of spending, there are three possible ways to access home equity: 1. Sell the home, invest the equity elsewhere and use the income to pay rent in addition to other spending. 2. Borrow more against the home by refinancing or taking out a home equity loan. 3. Sell a share of the home equity to an investor/partner (using for example a REX Agreement). Selling the home may be the ultimate solution depending upon where and how you want to live. It might be necessary to take this route if you don t plan ahead by managing your liquid assets to ensure they will last the rest of your life. Unless your savings are very large relative to your needs, you will need to minimize withdrawals from retirement accounts for as long as possible to get the most out of tax deferral and return compounding. Drawing on taxable accounts for a few extra years can add a great deal to your long term financial security - so outright sale may be necessary if you don t have enough liquid assets at retirement. Page 1 Copyright 2012
2 Selling an Equity Share Can Extract Cash from your Home Without Selling the House or Taking on Debt. If you are like most Americans, who wish to remain in their homes in retirement, you can increase your financial security by pulling out equity to reinvest elsewhere and use those funds to postpone and/or reduce withdrawals from retirement accounts. Borrowing may be an option if you do so while you still have high enough income to qualify for the loan. Even then, it s most likely the bank will require that a substantial amount of equity remain in the house to protect their loan from losses. When you reinvest this money to provide income, you will need to earn returns higher than the cost of the money you borrowed so as to cover the loan payments and come out ahead over the long run. And, of course, this option increases your leverage and risk from a decline in house prices. If another economic downturn occurs, you could experience losses in both your home equity and your investments, and still be obligated to repay all of the debt secured by your home. The third option is a more recent innovation that allows you to stay in your home but essentially take on a partner who pays you cash for a share of the equity. Obviously you will still want to reinvest this money to maximize your spendable income but the potential benefit is much greater versus borrowing because there are no loan payments to make. Instead the partner collects their share only when you decide to sell the house and that could be up to 30 years in the future. This option will allow a longer deferral of retirement account withdrawals than borrowing and it might turn out to be better than selling to rent because you maintain a locked in cost of housing. In the next section we ll cover some other important points about managing assets for retirement. With these points in mind we ll then dive into the details of a particular equity sharing agreement called a REX Agreement, introduced by a San Francisco-based company called FirstREX. Then we ll compare this with competing solutions, such as borrowing, and discuss the things you should consider when deciding if an equity sharing product makes sense for you. Managing Assets for Retirement: Home Equity Your home is just one part of your portfolio of assets that will support you in retirement, but it is a big part, which makes smart management crucial to the overall success of your investing strategy. Despite the conventional wisdom, recent history shows that house prices, just like all asset prices, sometimes go down. The average house in the U.S. declined 37% from its recent peak. Copyright 2012 Page 2
3 The Lesson of the Housing Bubble: Too Much Wealth Tied up in a Home Risks your Retirement Security. Because homes are bought using leverage, with a small percentage down, such declines wiped out 100% of many homeowners equity far more than the losses experienced in the stock market during the same period. Just as putting too much money into risky technology stocks led many to disaster in the early part of last decade, keeping too much money tied up in home equity can also lead to financial disaster. The lesson we should learn is that we must manage our housing asset along with our total portfolio to minimize risks and maximize retirement security. If you studied Investment Management in school, then you learned about using diversification as a way to reduce risk in a portfolio. In common sense terms, grandma would say: don t put all your eggs in one basket. In a stock portfolio we need to hold at least 20 stocks say 5% in each stock. That way, if one loses 50% of its value, we re still OK; on an overall basis it means a loss of just 2.5% of our portfolio. But most people can hold only one house and they simply have too much wealth tied up in this one asset. To lower risk, we want to reduce the home equity portion of our portfolio to a point where losing it all won t endanger our retirement. Looking at things from an investment management perspective, the smart thing to do is spread out your asset allocation across the various opportunities: home equity, U.S. stocks, U.S. bonds, foreign stocks, foreign bonds, gold, etc. When one thing does poorly, another will do well - so that overall we can achieve better returns and lower risks. Reallocating wealth out of home equity and into other asset classes is a very important strategy regardless of what means you use to pull the cash out of the home. Using a REX Agreement You Can Re-allocate Home Equity into Liquid Assets to Reduce Risk, Increase Income and Fund Retirement Needs. Turning Home Equity into Cash using a Rex Agreement A REX Agreement is a contract which can provide you with a significant lump sum cash payment today in exchange for sharing the future appreciation or depreciation of your home s value with an investor (FirstREX). It is not a loan and thus there are no monthly payments or interest charges. The REX Agreement simply converts a portion of your home equity into cash. The agreement is recorded along with a security instrument but this does not interfere with mortgaging the property up to an agreed limit ranging from 70-75% of property value. The agreement lasts 30 years or until you sell your home. You can terminate early, but you will pay a penalty to terminate in the first five years. Copyright 2012 Page 3
4 You choose the percentage of future appreciation/depreciation to share (between 20% and 50%). You receive an immediate cash payment. In a typical deal, the payment amount might equal about 20% of the house value (I call this the cash ratio) times the chosen share percentage, although this can vary based on the qualifying characteristics of the property and the homeowner. Therefore, if you choose the maximum share of 50%, you might receive cash equal to about 10% of the value of your home up front. When you sell your home, the amount due to FirstREX (if any) is calculated and paid out of the sale proceeds. This is a true equity product, so under the assumptions above, if the house depreciates 20% over the life of the agreement, FirstREX gets nothing at the end and you keep all the cash they paid up front. At inception of the contract, the homeowner and FirstREX must agree on the value of the property. This is typically accomplished using an independent third party appraiser. If the agreement is terminated prior to an actual sale by repurchasing the contract, the ending value would also be determined by an appraisal. If repurchased in the first five years, the property value cannot be less than the initial value. If the homeowner repurchases the contract in years 6 to 10 FirstREX would only share in half the depreciation that it otherwise would for periods longer than 10 years. If the agreement is ended during the first five years, by selling or by repurchasing, there is a termination fee equal to 20% of the cash received at inception of the agreement. There are some limitations on eligibility. You must have good credit and sufficient equity in the home. The home must be typical for the area, well maintained, and not have greater than average risk from natural or environmental hazards. There are occupancy and property type requirements as well. Termination of a REX Agreement The agreement typically terminates when you sell your home, or after 30 years. You also have the flexibility to terminate without selling your home if you believe your home will soon appreciate rapidly or if your life or financial needs change. At termination there is a settlement payment which depends on the change in the house value since inception of the agreement. Assuming that more than 10 years have elapsed, and the home has not declined in value by more than 20%, the payment to FirstREX at termination is calculated as follows: Copyright 2012 Page 4
5 Settlement = Up-Front Payment + Change in House Value FirstREX % share x Note that if the house depreciates, the change in value will be negative and therefore the final settlement payment to FirstREX will be less than the amount received up front. If the house declines by more than the cash ratio (which was assumed to be 20% in the discussion above), then there is no payment to FirstREX at termination. The above applies after 10 years have elapsed. In years 1 to 5, the homeowner would pay the penalty amount as noted previously. In addition, when the homeowner ends the REX Agreement by repurchasing it, instead of selling the home, during years 1 to 5 the Change in House Value cannot be less than zero, and in years 6 to 10, the Change in House Value is multiplied by 50% in the above formula. During the Term of a REX Agreement The agreement requires that the homeowner keep up their mortgage loan and insurance payments and maintain the property in good condition. If you remodel the home, keep records of the work done, and apply for a remodeling adjustment, you can get credit for the increased value attributable to the remodeling work. Other Solutions to Tap Equity for Retirement Needs When interest rates are low, mortgages are generally the lowest cost way to access home equity, but in the current environment there are limitations on who qualifies and the amount it s possible to borrow. In a scenario with low price appreciation, mortgages may not be the cheapest way to go. In either case, as we shall see, an equity sharing arrangement may still make sense. Depending on the Circumstances, A Mortgage May be a Cheaper Source of Funds. But in Many Situations it Can be Optimal to Also Utilize an Equity Sharing Agreement. In the current interest rate environment, if you have the income to qualify, and you are willing to service additional debt, borrowing against your home may make sense. Mortgages with rates fixed for 30 years are priced at about 4% as of April Taking a mortgage loan for up to 75% of the house value (LTV) will not preclude you from also entering into a REX Agreement. Reverse mortgages are available for people over 62 even if they don t have income because these mortgages require no payments. For most situations you would use the Federal Housing Administration s Home Equity Conversion Mortgage Copyright 2012 Page 5
6 (HECM) program. Currently the maximum LTV available is about 66% and upfront fees of over 4% will reduce proceeds further. If your current mortgage is significantly below 66% LTV, this program may be useful if you re not willing to outright sell the property. With a reverse mortgage, the interest accrues and is added to the balance over time so that the LTV will increase through time to the extent that interest charges exceed the appreciation of the property. Note also that the interest rates on reverse mortgages are about 2.3% higher than on regular mortgages (rates are about 6.3% as of April 2012). So it is very likely that on a reverse mortgage the LTV will rise through time. Because there is a maximum loan size under the HECM program, the program is not available to any homeowner that currently owes more than $500,000 on their home, regardless of the value of the home. Determining if the Rex Agreement is Right for You As with all financial decisions we need to consider taxes. The approach we will take is to look at after-tax costs in various scenarios and analyze such costs relative to the benefits of the upfront cash payment. Taxation Effects The REX Agreement is like a forward sale contract (without a stated maturity) and is therefore an unexecuted contract until final settlement. For tax purposes it should be treated as an option on real property. Therefore, the up-front payment received is not taxed and there are no tax implications until contract termination. The homeowner covers all expenses and mortgage payments and gets the corresponding tax deductions. If the contract ends with the sale of the property, the up-front payment should be treated as if it were part of the sales proceeds and the final settlement payment to FirstREX will effectively reduce the sales proceeds received. Therefore, assuming the total gain is within the excludable amount on the principal residence, the homeowner would not have any tax bill upon selling the home. If the contract is terminated without a sale there is no definitive treatment under the current tax code. Any net payment from FirstREX (i.e. after the five year penalty period) would surely be taxable as ordinary income. A payment to FirstREX would probably be treated as closing of the option contract and therefore a capital loss. This should be deductible but only to the Copyright 2012 Page 6
7 extent of $3,000 in excess of offsetting capital gains. 1. In the scenarios that follow we will assume that if you buy back the contract early at a gain, you will pay taxes at combined federal and state tax rates of 32%. Otherwise the gain or loss will not be taxable or deductible. Scenario Cost Analysis Because of the early termination penalty of 20% payable upon termination in the first 5 years, it will usually not make sense to use a REX Agreement for a horizon of less than 5 years. In the longer run, a return to higher appreciation rates on housing could make the REX Agreement more costly. Thus we will focus on an intermediate horizon of 5 years plus one day as our base case horizon for calculating costs and benefits. The table below shows the net after-tax return or cost (as a negative number) on the upfront payment under a variety of scenarios: Appreciation or Annualized Benefit or (Cost) Refer to Depreciation House Sold Buy Back Contract Note: -5% 5.6% 1.8% 1 0% 0% 0% 2 5% (4.6%) (4.6%) 3 10% (8.4%) (8.4%) 4 Notes: 1. If the house depreciates over the time horizon, the homeowner makes money on the REX Agreement a negative cost for the funds. 2. With no appreciation or depreciation, the up-front money is free for the whole five years and can simply be repaid. 3. With 5% cumulative appreciation over 5 years (less than 1% per year), the net annual after-tax cost is 4.6% - roughly equivalent to a high yield bond or reverse mortgage. 4. With 10% cumulative appreciation (less than 2% per year), the net annual after-tax cost rises to 8.4% - not as high as a credit card rate but getting close. It will be tough to beat this rate in your stock portfolio. When Should You Do This If your housing forecast for the next five year is flat or down, you should use the REX Agreement even if you don t need the money 1 The tax treatment discussed here is my opinion only. These transactions are not specifically addressed by the tax laws and thus IRS interpretations may differ from that presented here. Always consult with a Tax Professional before entering the agreement. Copyright 2012 Page 7
8 take it and invest in bonds to increase your income and provide liquidity while reducing your housing risk. Use a REX Agreement to Access Emergency Funds or to Provide Additional Retirement Income Security. If you have a need for cash and you cannot borrow the funds, or you do not want to borrow because of the costs, the REX Agreement could be a sensible choice depending on your overall circumstances. If you are not old enough to draw out of your retirement accounts without penalty, this is a good solution. In some situations the gains from delaying Social Security or delaying retirement account withdrawals are enough to justify using cash from a REX Agreement to bridge the gap. Finally there is the risk of outliving your retirement savings. Many people consider their home equity as their insurance against living too long. They figure they can always sell to fund living expenses beyond 85 or 90 when their regular savings run out. With a REX Agreement it may be possible to cover this risk and still keep the home and at least half the increase in equity. This is because there is a very cost effective way of dealing this risk by buying a deferred annuity also known as longevity insurance. Because these contracts have an insurance feature (you only collect if you live), the returns on the premium paid today can be much higher than bonds or the implicit costs of the REX Agreement. These require a chunk of money up front. If you could otherwise not afford it, then using a REX Agreement to fund purchase of a deferred annuity may be the best choice. Of course, it will depend upon the length of deferral and pricing of the actual contract you purchase. Conclusion For homeowners with equity in their home who don t want or can t qualify for more debt, an equity sharing contract can provide an attractive alternative source of cash to fund life needs while reducing home price risk, without adding debt. Innovative solutions such as the REX Agreement can help homeowners stay in their homes, fund retirement, reduce debt, make needed home improvements or pay for other major purchases such as longevity insurance. There are various situations in which such a product may be right for you. Knowing all the facts, making comparisons to other products, and analyzing your specific circumstances are the keys to making a good financial decision. Copyright 2012 Page 8
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