Housing Finance Reimagined

Housing is not only the world’s largest single asset class at nearly $200 trillion, it serves as a key ingredient in the recipe of economic and societal stability. It blends one of Maslow’s basic needs (shelter) with a wealth creation aspect. It plays a role in labor transition, while proving to be a tool of consumer spending, as values rise, and liquidity is accessed. As housing is generally a financed asset, residential mortgage rates become an element of monetary policy to stimulate or retract the pace of the economy. Overall, the scope of housing and its stepsister, housing finance, are keenly critical to most economies, but can we improve outcomes?

Given the price of homes, to acquire this dream, outside financing is typically required, and an observed challenge is that only one flavor of financing is provided, namely debt. Debt is binary – either you pay it, and everything is fine, or you don’t and bear the consequences. With other asset classes, there are various forms of financing, namely equity, which shares the price risk of the asset financed. While debt allows for investment leverage, i.e., when asset values rise, the owner/equity holder enjoys boosted returns. Debt however shows no favorites, and as markets decline, debt still needs to be paid in full, essentially the flip side of leverage, where lower levels of equity can evaporate. We have seen over the last twenty years, housing tends to be a somewhat volatile asset, so doesn’t it make sense to have a form of financing that echoes the asset price volatility?

Housing finance in many ways has been usurped by government mandate, policy and practice. Since the 1930’s, driven by a national mandate of homeownership, the powers championed borrowing to acquire a home, introducing amortizing loans at increasing advance rates against the property. One can query whether this move was to enable homeownership or as certain pundits have suggested, create an approach to quell the rising power of the labor movement by indenturing workers to housing payments and undermine the motivations to strike. Financial engineering or social engineering?

If there’s a history, there’s no mystery

The history of housing finance is merely the history of mortgage (debt) finance. We evolved home lending products, we have securitized them to shift risk, and we embed the notion of borrowing, particularly in the USA, as we are only one of four countries to “enjoy” mortgage interest deductibility. And while policy makers state that a MID removal would create a blow to housing prices and homeownership rates, do note that the USA ranks only 45th in the world in homeownership, behind the likes of Canada, China, India, Cuba, Greece, Brazil, Italy and Japan, where no MID exists, and many countries, like Canada, average home prices are higher. This proclivity to debt has become innate, and in down markets, the ramifications are severe. Consider the current COVID landscape, where mortgage delinquencies exceed 7.5% nearing the level experienced during the 2008-2010 mortgage crisis. Should this be cause for concern? Without doubt.

Steps forward …

So, let’s reimagine housing finance. And through the lens of the Fourth Industrial Revolution.

To reiterate, most asset classes use a variety of direct, contingent and derivative methods of financing, to benefit the user of capital but also the supplier of capital. But housing, we largely have debt. Consider for a moment the use of equity in the housing finance framework. Thus, from the buyer/use of funds’ perspective, the use of additional equity reduces the level of debt incurred, and with it lower payments, which improves affordability, and incremental cash flow due to the lower payment. One can say that bringing equity in will reduce the buyer’s gain upon sale but consider three things: (i) home prices are volatile so while prices may go up, they could also be lower at the time of sale; (ii) if prices do go down, the buyer shares the decrease with the equity participant, unlike debt; and (iii) the monthly savings on a lower payment is tangible now, which could be saved or spent, whereas appreciation is not guaranteed.

From an equity investor’s perspective, an equity sharing investment program enables such investor to participate in the world’s largest asset class, single family residential real estate, currently limitedly available. Imagine assembling a portfolio of residential real estate fractional positions, which track national, regional and local economies. An effective multi-trillion-dollar market, untapped. And assuming the buyer is an owner-occupant, the investor has a “vested partner”, who maintains the property and services whatever mortgage debt is placed on it. So, in effect, the investor benefits from leverage, which he/she doesn’t personally service, nor is liable. From a research standpoint, many firms provide ongoing data and analyses on price movement, currently to measure loan-to-value levels, but such data can be repurposed for tracking returns in an equity portfolio.

Rise to digitize

Then the concern is posited: Real estate transactions are heavily documentary and process-laden to transfer ownership. While we can assume that monetization events for equity investors to be only at the ultimate sale, which generally occurs every 7-10 years, let’s alter the paradigm and introduce new technology, part of the Fourth Industrial Revolution. In effect, designing a framework, consistent with 4IR, that provides streamlined interconnectivity, data transparency, and decentralized decisioning and transactability, changing the investment protocol.

So, imagine a buyer wants to purchase a home for $500,000, and has $50,000 for his/her down payment. As his down payment is less than 20%, his mortgage lender would typically require mortgage insurance, an incremental cost to his monthly payment. As an alternative, this buyer comes to ESM (aka Equity Sharing Market) and finds an investor to put up at least $50,000 if not more, for a 45% equity stake in the property. The transaction is digitally documented via a smart contract, reflecting ownership percentages, rights and preferences, then rests upon the distributed ledger being hosted by ESM.

Two years elapse, during which the investor receives monthly updates of property value and compliance reports, such as for mortgage payments. At two years, it’s time for the investor to exit the investment, though the homeowner wants to continue his/her stay. The investor has the ability, via ESM, to trade away his contract to another buyer in the market, allowing the supply and demand to set price. There would be no need to transact on a laborious basis, with escrow, title and recording issues, as all the specific transactional elements are contained in the smart contract. Essentially, the contract is analogous to a bearer bond, and traded in a captive, digital and decentralized market.

With this approach, significant levels of fresh capital can enter housing, and in a manner that investors can participate in home price movement not only in the USA but globally. An equity approach would significantly reduce the overleverage nature of housing, creating more investment than indenture. For both profit pursuit as well as ESG initiatives, many seeking to improve housing opportunities in challenged geographies, the ability to decentralize and digitize housing assets can have an incredible impact on an essential need.

So, let’s reimagine.

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