Fractional Residential Real Estate Ownership: Home Equity Without a Mortgage.
Jackson is a high earning 23 year old renter who is feeling the effects of the inflation. Since 1978, the cost of college tuition increased by 1,120% and housing costs have increased by 380%. Saving for a down payment and closing costs feels impossible. Cyndi is successfully self-employed but lacks two years of tax returns. Sarah has a 750 FICO and okay income, her husband has a high income job, but his FICO is 550. Melissa and John are credit-worthy, but they don’t want to get a mortgage because they expect to move around before settling.
Fractional shares leap over mortgage barriers: Age, credit, immobility, W2 income, and down payment savings. Housing independence is a binary proposition. Become a mortgagor and build wealth by owning your home’s principal and appreciation, or become a renter and own nothing, and lose savings to “first-month, last-month and security deposit”.
Paradigm Shift
Renters occupied around 36% of the 122.8 million U.S. households in 2019. Fractionalized homes have the potential to replace rentals altogether. Instead of young adults leaving their parent’s home and getting a rental, they get a fractional. A stealth proptech startup wants to normalize this pathway. They’ll purchase a home on your behalf, and you’ll purchase pieces of ownership bundled into your monthly rent, in a similar forced savings mechanism that a mortgage offers. At any time you can sell your interest, obtain a mortgage and buy the home outright, or even leave some or all your investment in the home and receive cash flow and appreciation from future occupants.
When tenants front first month, last month and security, they are forking over a sum that’s nearly 2% of the home’s current value. Many renters are close to crossing the barrier into a 97% LTV, 3% down mortgage. Rental deposits and inflation can subject a near-mortgage-ready person to a life of perpetual renting. Fractional ownership transforms rental deposits into co-ownership. Similarly, closing costs don’t make sense if you’re not going to stay put. Not to be confused with the down payment, and often overlooked, they require a huge chunk of cash that quickly gets consumed by mortgage origination fees, reimbursing pre-paid taxes, title and mortgage insurance, etc. Mortgages naturally select for the less geographically ambitious, as it can take a few years of principal and appreciation accumulation before you’ve offset closing costs and even begin to realize the return on investment. Fractional shares ownership is compatible with flexibility and can thus help make equity and finance a part of culture among younger generations, where a mortgage is either out of mind or perceived to be out of reach. Mortgage is synonymous with marriage and a permanent address as far as their parlance is concerned. And yet, Freddie Mac found that among the credit-visible portion of Gen Z, 55% were mortgage-ready based on debt, credit and income. They make up just 2% of homeowners.
A study on household formation found that 90% of millennials moved out of their parents homes by age 27. The median age at the time of moving out was about 19 years. According to Experian, the median age of a first-time home buyer is 34. Occupying fractionalized property can make the mortgage available earlier and to more people.
Fractional home ownership isn’t necessarily an alternative to a mortgage, but it is an alternative to renting and helps people accumulate home equity without taking on mortgage debt.
In this inflationary environment, 2 Trillion in student loan debt, lifestyle competition on Instagram and TikTok, and subsequent lifestyle creep chipping away at discretionary income, forced savings by means of accumulating shares of home ownership combats this phenomenon and accelerates personal savings rates:
Rent-to-own Alternative
Almost all Americans dream of buying their own home. When couples smile for the camera while holding the keys to their new house, there’s an enormous feeling of having reached a major milestone: “We officially bought a house!” The detail that its the bank that owns the home does little to take away from the experience. For this reason rent-to-own startups like Divvy and Landis have had a lot of traction, as they purchase the home on behalf of the occupant. The dream house makes up at least half of the American dream. Nothing gets the dopamine flowing quite like searching for your home, let alone being empowered with an all-cash offer. Fractional ownership takes this a step further and transforms the ‘rent with the option to buy-out’ value proposition, into more of a ‘rent while buying-in, plus the option to buy-out’.
A great number of people exist in a space where they are overqualified for rent-to-own and under-qualified for a mortgage. They would be better suited as a co-investor than a renter. Should you want to move, you can sell your interest, or sell some and leave some of your investment behind. If you have 1–2% to put upfront, after a few years of making monthly payments you’ll find yourself owning between 3 and 5% of the home. Thus, you could earn 3–5% of the rental income and appreciation from the next occupant. Disadvantaged rent-to-own tenants whose home doesn’t appraise for the predetermined buy-back price are only left with the option to continue renting or have their escrow monies returned to them after a steep fee is deducted.
Framework
Fractionalized real estate ownership is increasingly common across commercial and investment property. Pacaso sells 1/8 fractional shares of vacation property, enabling the co-owners to spend time at the property in proportion to their ownership interest. In other words, a vacation home for a fraction of the price. In a primary residence application, the occupant could co-invest by purchasing 1/8, or any fraction, upfront, or along the duration of their occupancy. They pay fair market rent to occupy the remainder. The more ownership they accumulate along the way, the more rent they essentially pay themselves, which is a form of rent reduction. Arrived homes is another platform where anyone with $100 can co-invest by purchasing fractional shares in a traditional rental property, and receive cash flow and appreciation. Extending these value propositions to the occupant only stands to benefit the condition of the property and reduce property management expenses. When tenants become co-investors, it better aligns the interests of all the parties. Buy-back prices are pre-determined prices set at the contract date, that price in a home price appreciation forecast. When the contract is exercised in markets that perform exceptionally well and the property appraises beyond the contract price, the occupant inherits that equity. This is analogous to an in-the-money call option. Underscored by the last couple years of growth, down payment saving wheels just spin if you’re merely keeping up with home price appreciation. Buyers can lock a contract price in ahead of time, and move into their dream home today versus one, two or three years down the road when they’re credit or finances has become mortgage-ready.
NFTs, LLCs and USDs
A discussion with anyone about fractionalized ownership will inevitably segue into NFTs. Fractionalzing may mean a home has been purchased with an LLC, recorded as such in the tax records, and fractional interest in that LLC can be purchased and recorded on a ledger. An NFT involves additional due diligence, as it raises questions around what exactly one is investing in. An asset may inform the value of a token, in that sense it is “asset-backed”, but if one were to purchases all the tokens issued against a property, they are essentially worthless until the title is transferred. Transferring titles and recording deeds will require ink on paper for the foreseeable future, as it would otherwise entail all the local County Clerk’s offices migrate their tax records and public records onto a blockchain. It may be the case that endeavor is so impractical it requires new laws that would allow blockchains to create synthetic records. A blockchain ledger, coupled with smart contracts, is undoubtedly a more reliable and efficient means of distribution and record keeping. It would deliver a death blow to the title insurance racket.
“At the touch of a button”
The time it takes to transfer title or fund a loan actually coincides rather nicely with the due diligence process: previewing a property, negotiations, first deposit, inspections, corrective proposals, second deposits, final walk-through, etc. Legally conferring property ownership “at the touch of a button” could play out nicely in a fractional, co-investing arrangement where the slower process of a title transfer isn’t applicable until a mortgage buy-out is performed. There is real utility in the blockchain ledger’s ability transfer anything instantaneously. Tokens could conceivably be issued to sellers after a lender issues the clear-to-close, so as not to have to wait around for a check or roll the wire-fraud dice. Of course, they can be exchanged to USD for a fraction of what it costs to wire money or get a bank check. Sellers who do deed packets in lieu of attending settlement often have to wait days after closing for the escrow company to FedEx the bank check of their sale proceeds. NFTs can easily be converted to USDs and could fill a gap here. I digress.
The proptech and fintech boom that has taken place over the last decade has taken models that have been around forever, like wholesaling (Offerpad, Opendoor), or rent-to-own (Divvy Homes, Landis), and injected capital markets dollars into them to make these models much more consumer-friendly, which is to say they’ve become mainstream. There is a real opportunity to leverage the contemporary relationship between tech and investors do some good and make a difference in the lives of people who may not fit neatly into the mortgage category, but are otherwise qualified and capable of producing better, more reliable returns for investors, in exchange for equity. Fractional shares is another symbiotic relationship in the proptech/fintech ecosystem.
