At Landed, in addition to homebuying education and guidance, one of the key products we provide educators is our down payment program. Our program, funded by local community investors, is a form of ‘shared equity’ – instead of fixed monthly payments, the investment is paid back through some of the appreciation gains when the property is sold. In the case that the property loses value, this loss is also shared. This allows buyers to be less vulnerable to small changes in real estate markets.
Because this form of support has no monthly payments, it makes it a little easier for educators to afford their primary mortgage. The split of appreciation sharing between community investors and educators is always a hot topic, so we thought it made sense to write a longer piece on how we went about determining a ‘fair’ deal.
“Finding what’s fair” is one of our core values at Landed, and I thought it would be helpful to walk through our definition of fair, where that comes from, and where that might lead us in the future. To do a thorough job here, I’m going to investigate a few different approaches to figure out the “fair” number:
- advice of experts,
- comparison to other available real estate investments,
- analysis of the risk profile of the investment, and
- reasoned from moral/gut principles
Why is determining “fair” so hard?
Prices for things in a market economy are generally set by supply and demand. The more demand there is to see a sports team, the more expensive tickets will be. The more oil is being produced at any one time, the less expensive gas prices will be. The same goes for investment products. The more demand there is for a specific type of investment product, the better terms will be available to the person or company desiring the funds.
With investment products with very long histories, figuring out supply and demand is very easy. Take mortgages, for example. When more investors want to lend homebuyers money, mortgage rates go down. When investors are less interested in lending to home buyers (for example, they think they can make way more money in the stock market), mortgage rates go up. There are trillions of dollars invested in mortgages at any one time, so the market can do an extremely good job at setting a fair price.
But for new investment products with little to no history (like appreciation sharing), the challenge is a little more difficult. We don’t have trillions of dollars of investment to help us set the price. We have to start by guessing what we think the right number is, and then building the market around that guess. Then, when there is lots of investment interest, we can allow the market to take over.
So where did our first guess come from?
In our case, how did we settle on providing up to half of your down payment for up to 25% of the appreciation in the price of your home? It is important to keep in mind that this works in both directions; unlike a bank, if the price of your home goes down, we share in 25% of the loss.
We sometimes call this the 10% (half of a standard 20% down payment) for 25% (the amount of appreciation sharing) price.
Given Investment Experts
When we started Landed, we went straight to some of the largest sources of capital in the world – teacher pension funds. We asked them a simple question: what is the minimum amount of appreciation sharing you would need to invest the retirement money of educators to help educators buy homes?
The answer to that question was no less than 25%.
Given Existing Real Estate Products
When Landed approaches investors for community capital to invest alongside educators, investors immediately think of the Landed Down Payment Program in the context of buying rental property. They do not think of a Landed investment in the context of a mortgage. Why? Because mortgages guarantee the return of the invested money plus a fixed rate of interest. An investment in the Landed Down Payment Program does not guarantee the return of any of their investment, and the performance of the investment cannot be predicted in advance. In fact, their investment is speculative, based entirely on how the real estate market performs over time. It's similar to investing in rental property or speculating on land.
Given that comparison, investors want to know that the returns they will receive from an investment in the Down Payment Program will be similar to buying real estate. If not, why bother?
To answer that question, it is important to understand how rental property investments work. In cities, investors can expect to receive about a 3% annual rental profit on the purchase price of the property. So if they buy a million dollar property in cash, every year they will likely earn $30,000 of rental profit after all expenses. Just as importantly, not only do they get the rental profit, but they also get exposed to any appreciation or depreciation in the price of the home.
So if I buy a property in cash, I get a 3% rental return plus direct appreciation exposure. But what if I don’t want to buy the property in cash? What if I need a mortgage to buy this investment property? In that case, I will put in less money to buy the property, but also receive less rental profit. Why? Because some of that profit will go towards paying the interest I owe the bank. But even though I will receive less rental profits, I will still receive all of the appreciation profits if the property increase in value.
So less of a down payment means less rental income but the same amount of appreciation profit.
Notice that last line? In that case, all the rent investors earn go to paying interest expenses. But, on the positive side, the property only has to increase by 10% for their investment to increase by 25%! Feel familiar? That’s almost exactly what the Down Payment Program offers investors.
Given The Investment Characteristics
An investment in the Down Payment Program has some good things going for it compared to buying other real estate investments:
- An investor doesn’t have to worry about finding new renters at the end of leases.
- An investor doesn’t have to worry about taking care of the home.
- An investor doesn’t have to pay the costs associated with buying or selling real estate.
- An investor doesn’t have to be responsible for the mortgage directly.
Those characteristics might convince an investor that this investment is safer than a traditional real estate investment. And safer investments should come with a lower return. Otherwise why bother with riskier investments? So if a shared appreciation investment is ultimately less risky, shouldn’t we be able to get an ever better deal for homeowners? Something like 10% for 20%?
Perhaps, but an investment in the Down Payment Program also has a very bad thing going for it, namely, an investor does not get to decide when they want to exit the investment. That decision is ultimately up to the people we serve (educators and school employees). Not a lot of other investment products work that way. Think about it. How upset would you be if you were an investor in Apple, but Apple, and only Apple, decided when you sold your stock? What if they only let you sell your stock 10 years later, or 30 years later?
Tying up your money for a long-time without the direct ability to sell is sometimes called an illiquid investment (a liquid investment is something you could easily convert to cash if you wanted to). When investors put money in something that is illiquid, like the Down Payment Program, they expect to earn a premium. Otherwise why bother? It’s just like deciding between buying a refundable airplane ticket and a non-refundable one. If there is no discount for the non-refundable one, you would be foolish to buy it.
Reasoned from Gut Principles
Landed is a unique financial services company because it makes no profit from the Down Payment Program it manages on behalf of community investors. Any appreciation profits educators share with us go straight out to investors. Landed takes no cut. Our job is only to organize down payment funds and be a fair arbiter of the rules. We take this role extremely seriously; we hope all of our employees can ultimately be both recipients of down payment funds and community investors.
But having talked to thousands of customers and investors, people come to the question of fairness in one of two ways. They either believe that:
- community investors put in 10% of the value of the home, they should get 10% of the appreciation/depreciation, OR
- community investors put in 50% of the down payment, they should get 50% of the appreciation/depreciation.
The answer, like many things, is somewhere in the middle. Investors shouldn’t get 50% of the shared appreciation, because they are ultimately taking on much less risk than a true 50% owner. Their name is not on the mortgage, and they don’t pay any of the closing costs associated with buying or selling the property.
At the same time, community investors should get more than 10% of the shared appreciation because otherwise they would have absolutely zero financial incentive to participate. Remember, they share in any potential loss too – like you, they could lose their entire investment! In the case of only 10% appreciation sharing, they would always be better off buying rental property. With rental property, they would get the 10% appreciation exposure PLUS rental profits.
It’s interesting that after all the analysis above that the answer ended up almost exactly in the middle. But whether the right answer is 20% or 35% will ultimately be decided by the market. It may even change over time and between cities.
What if the Landed Down Payment Program provides more or less than 10% of the purchase price?
This is one of the easiest questions to answer, although it is perhaps unintuitive. Think of a 10% investment in your home as actually ten investments of 1% each. Each of those ten investments would be associated with 2.5% appreciation/depreciation sharing, so that when all ten investments are added up you get 25% sharing. All else being equal, an investor in the Down Payment Program would be indifferent between having all ten of those investments in one home, or having those ten 1% investments spread across many different homes.
So with that information, we can answer what would happen if the Down Payment Program only contributed 5% against the home price: in that case, there are five 1% investments in the home, all with 2.5% appreciation/depreciation sharing. The total amount of sharing would be 5 * 2.5% = 12.5%. Similarly, if the Down Payment Program contributed 15% of the purchase price, that would be fifteen 1% investments, all with 2.5% appreciation/depreciation sharing. The total amount of sharing would be 15 * 2.5% = 37.5%.
An interesting thought experiment is to think about what would happen if the Landed Down Payment Program provided 40% of the purchase price to buy a home (although this is never something we do!). In that case, there would be forty 1% investments, all with 2.5% appreciation/depreciation sharing. The total sharing would be 40 * 2.5% = 100%!! While the initial reaction is to say that 100% sharing is ridiculous, think about what is happening here. In this situation, the homeowner is essentially getting a guarantee that they will be able to sell the home for exactly what they purchased it for (because the investor would be taking all the home price risk) and in exchange, they are getting a 40% discount on the monthly cost of a home. That discount would make their monthly payment significantly less than they would otherwise pay in rent (but they would have to pay for any maintenance and repair). They would pay less than their fellow renters, and have better rights because they are an owner and not a tenant! To the investor in this scenario, they are essentially doing the same thing as buying rental property; they are taking 100% of the home price risk with a 40% down payment! They would be earning zero rent, but they wouldn't have to pay for maintenance, repair, vacancies or other transaction costs. As discussed above, they also wouldn't be in control of when the home was sold. Those trade-offs need to be about equal, otherwise, why would the investment managers of your pension bother to make an investment in the Down Payment Program?
Working to create new financial tools for homebuyers is hard. No financial tool can solve the problem that, in cities, most single-income educators are not paid enough money to live in the communities they serve. But for dual-income families who want to remain permanent members of their communities, getting a down payment boost from family can often be the difference between getting on a path to financial security and being trapped in a cycle of escalating rents.
Financial tools should also not be an excuse to ignore the pressing problem in cities… that building more urban housing (through infrastructure, transit and housing investments) is too expensive and too politically challenging.