Equity Finance Mortgages

I sit on the advisory board of a company, Rismark, who have been investing innovative residental real estate finance models (So I need to declare my interest there). This work came out of the Prime Minister’s Home Ownership Taskforce (2003) of which I was a member.

This week, equity finance mortgages hit the market. They were launched by Adelaide Bank who are partnering on marketing the Rismark product. You can read more about them here. The basic idea is that your bank takes a 20 percent stake in your house and bear that if, when you sell your house, it has depreciated in value. If it has increased in value, they share in the price to the tune of 20 percent (their stake) plus another 20 percent of the upside only. So if you bought a house for $500K, your outlay would be $400K. So if you sell it for $600K a few years later you get back $460K. What this means is that you have saved interest on $100K of borrowings you might have had to make. What is more is that you have shared the risk with another rather than bearing it all yourself.

EFMs are probably not for everyone but may be worth considering as an extra option when you are buying a house. Click here for a news report and another one.

13 thoughts on “Equity Finance Mortgages”

  1. Thanks for the kind note, Joshua. It has certainly been an incredibly long and hard road. Around four or five years, over $10 million, and immense personal sacrifices on the part of many people has been invested in blasting down the doors to the EFM market development. If you did a media search around the original Prime Minister’s Home Ownership Task Force you would find a never-ending list of naysayers, including most Australian lenders. One of the central challenges the Rismark team has faced when trying to develop a liquid secondary market in synthetic residential real estate equity claims (aka EFMs) has been the need to concurrently create two quite different consumer and investor markets: that is, firstly, the market for zero-interest EFMs, which can (a) cut the upfront and ongoing costs of purchasing a new home by 20%, (b) enable consumers to purchase properties that are 25% larger than those that they can currently afford, or (c) reduce their current repayments by more than 25%; and secondly, the wholesale institutional investor market for securitised pools of EFMs. Each of these objectives, which I outlined at some length in my original report to the PM, opened up a Pandora’s box of additional challenges: would consumers be comfortable sharing the risks and returns inherent in home ownership with investors; if so, what was the depth of consumer demand likely to be; how should one calibrate the EFM’s cost of capital; how would these instruments be taxed; are they debt or equity; how does an EFM change a consumer’s behaviour; would these products give rise to adverse selection and moral hazard problems; will consumers use EFMs to ‘game’ against the lender by timing their entry and exit into the product to the detriment of that lender; how should the investment vehicles be structured; what would the cash flows look like; what rate of return would they deliver; what about the potentially very low yield in the first 5 years; can you gear these vehicles; how do you compensate consumers for capital expenditures; would adverse selection impact on a pool of EFM’s performance; how does the current property cycle impact on one’s ability to raise capital for such investments; are EFMs financial products or mortgages; who should regulate them, the UCCC or ASIC; will the banks be comfortable distributing them; what about the potential reputational risks; how do you accurately measure the performance (ie, both risk and return) of residential property given the existing indices are so crude; accounting for the size of the mortgage market, with over $220 bn worth of home loans issued every year, how do you raise enough capital to support the expected demand and make the product meaningful for distributors; what is your business model; where are the fees/economics; what part of the value chain can you capture given the incredibly competitive nature of the mortgage market; what political support do you require; how do you deal with issues of partisanship; how can you disentangle capex from the historical index returns; how do you raise private equity for a business model that has never existed, and which has been very publicly questioned by seriously smart individuals; and how do you protect your ideas and retain a first mover advantage; the list of questions went on, and on, and on…It is certainly the toughest experience that I have ever endured in my life.

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  2. What had me curious about it was the maximum amount you can borrow being capped at $400k.

    I was thinking a EFM would be great for an investment property, as it would make the rent received closer to the loan repayment amount

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  3. Joshua,

    I wonder if there will be problems with up-take of EFMs while the majority of sellers (according to one the links you provided) are non-big-name mortgage companies.

    I say this because I know of a case of someone who would be a prime candidate for an EFM already refusing to talk with mortgage providers other than (what is to this person the tried-and-tested) big banks. I’ve encouraged this person to at least talk with a mortgage broker like Peach before signing on to what may be higher rates with Great Big Bank … but in making a complicated decision this person finds comfort in sticking with the Bank. We could go on about the irrationality of this behaviour, however, given that this person’s level of financial literacy is probably in the middle of the curve, there must be other solutions.

    Is there a particular reason for why the big banks are not signing on for EFMs?

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  4. Tanya, I don’t think there is any particular reason other than conservatism. It is quite common for larger companies in an industry to be slow adopters of more radical new products.

    People who stick with big companies, therefore, also tend to be those who are more conservative. And that is probably what your friend is attracted to.

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  5. Hi Joshua,

    Nice article. Being on the cusp of homeownership for the last year or so, I have been interested in the large number of suggestions aimed at extending housing affordability, including EFMs. However, my naive understanding of the economics of this product suggests that if EFMs become a widely used financial tool will end up driving housing prices up by increasing demand, in the same way that the first homeowners grants has. Tinkering around the edges of financial supply, while ignoring housing supply seems to be short-termism in my mind, and EFMs seem to do this. I would be interested to read your views, though.

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  6. It looks to me from their website like you have to repay your original 20% loan amount plus 40% of the upside (or, if you borrow 10% of the value of the house you pay back the 10% plus 20% of the upside, if you borrow 15% you pay back 15% plus 30% of the upside…) (see here: http://www.efm.info/qa/efm-costs-if-a-home's-value-rises.aspx). So in the example above, you’d get back only $420K when you sell, not $460K.

    It’s a nifty idea but doesn’t the problem arise when you want to move homes? In your example above, you initially outlayed $400K to get a $500K home, which is nice. But if you sold your (now) $600K home to move into another $600K home, you have to repay the loan and you now need to find another $180K to afford an equivalent home to the one you had before (because you’re left with $420K). So in a sense, you’ve just gone backwards, haven’t you? If you now take out a $180K EFM, that’s 30% of the house value, which would suggest that the bank would take 60% of the capital appreciation when you sell, plus you’d have to repay the $180K. Unless I’m missing something, that seems to be getting hazardous.

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  7. David, no that isn’t the case. The appreciation is $100K. Therefore, of that you get $60K and the provider gets $40K. So you have outlayed $400K initially but now have $460K once you sell.

    There is no going back. You could get an EFM on the new home.

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  8. Matthew, in the short-run if these are popular they will (a) substitute away from existing mortgages and (b) may increase buyer’s ability to pay. So this might increase house prices. They act this way in the way lower interest rates do. So affordability can only have done up overall (higher house price but lower cost of financing).

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  9. Yep, sorry, I was looking at the appreciation as being $200K. You are indeed left with $460K.

    But if you switch homes, you’re still left with a problem, although not as acute as I stated. If you sell your (now) $600K home to move into another $600K home, you have to repay the loan and you now need to find another $140K to afford an equivalent home to the one you had before. If you now take out a $140K EFM, that’s 23% of the house value, which would suggest that the bank would take 46% of the capital appreciation when you sell, plus you’d have to repay the $140K.

    My point is that with an EFM, your equity as a proportion of the house value reduces a bit every time you move house. So unless your income is increasing faster than house prices or you can set aside part of the saved interest payments from the EFM, you might find home ownership (in the sense of eventually owning your home outright) getting more difficult, not less.

    I’m not saying they’re a bad thing, just that equity financing has its own costs and benefits.

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  10. If getting an equity finace mortgage is so easy then why when my property is worth 1 million dollars, I have 80%equity in it, I earn 90,000 per annum and I want a 20% efm in order to reduce my current mortgage payments was I refused??? Furthermore I was given no explanation, was told all my financial requirements met the criterion, I had a perfect credit rating. Would it be that the propert market has slowed down and Rismark are afraid of having to keep to their word??

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  11. Michelle, almost certainly because of the 3,000 plus postcodes nationally we can only currently lend in about 800 because of the restrictions our investors place on the geographic universe (over time we hope to significantly expand this). The credit crisis has also made life more challenging by reducing the availability of funds (ironically for us because we don’t securitise and this should be the perfect time for EFMs). Email me your details directly at info@rismark.com.au and I will see what we can do. Thanks

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