Bulletin #2
May 4, 2005
If you think that housing is not a problem in
They decide to do their homework ahead of time and get
pre-qualified for a mortgage. They would prefer to minimize their risk in
today’s housing market by getting a 6%, 30 year fixed
rate mortgage, rather than a variable interest mortgage, where their payments
could rise in the future. With their income, savings and credit rating,
(and neglecting closing costs) they are qualified for a $220,000 home – their
down payment, closing costs and a $200,000 mortgage. Their monthly
payments for all housing expenses including mortgage payment, tax, insurance
and utilities would be approximately $1,600, not a lot more than they are
paying for their apartment and within the HUD guidelines of not exceeding 30%
of their gross income.
Only one problem. There is only one 3 bedroom, 2 bath house
available on
Perhaps they can find a lower mortgage rate, so they
shop around. About the best rate that they can find today on a fixed rate
mortgage is 5% and that is not expected to last long. Stretching their
eligibility a bit, they can now qualify for a $225,000 mortgage or a home
priced at $247,000.
Still not good enough.
They are reluctant to consider an adjustable rate
mortgage in today’s market, but perhaps they should take the risk. The
best that they can do is a 4.5% ARM with an initial adjustment in 3 years and
adjustments every year after that. The mortgage program has a cap of
5.25%, so they have some protection against overreaching their expected income
when the adjustable rate increases as they fully expect it to do. They
now qualify for a $235,000 mortgage or a $257,000 home.
This is still not only not good
enough, but it is questionable if they even qualify since their savings
would only amount to an 8.5% down payment. And, they are taking the risk
that the mortgage payments will increase faster than their incomes.
Very disappointing! Perhaps they should wait another
year in order to save enough to increase their down payment. Not a very
attractive prospect because with an appreciation rate of at least 8%, which is
the last ten year annual average increase, or and perhaps as much as the%
current rate, the equivalent of that same house will cost between $297,000 and
$302,000. That is far beyond their ability to save enough to make up the
difference.
This family is falling further and further behind,
even though they are doing all the right things, maintaining a good credit
record and saving as much as they can.
What about affordable housing? Unfortunately,
their income places them in the HUD middle income category of approximately
$57,000 to $72,000. There are no affordable housing programs in
What alternative do they have?
As much as they love the islands, it is impossible to
ignore the opportunities close by. A quick check of the multiple listing service reveals 21 homes with 3BR, 2BA in
This family is not alone in this dilemma. In
1990, 30% of the population of
Can anything be done with creative financing?
The
One approach that has been used in many communities is
called Land Leasehold. In this approach, a third party retains ownership
of the land and leases it to the homeowners. In
Alternatively, employers will often own land that can
be put into a trust and used for employee housing. For example, the
public school district owns land that could be leased to employees at a very
low rate in order to attract and retain employees. Since Mary is a
teacher, this might be an option. It is not unusual for a school or
university to grant a 99 year lease to homeowners for a token fee. This
is the best deal that our young couple could expect to find. Under this
approach, their 6%, 30 year fixed rate mortgage of $200,000 with $22,000 down
payment and closing fees would allow them to purchase a $220,000 structure on
school land valued at perhaps $110,000 for a total equivalent value of
$330,000! In the current real estate market in
This is a very desirable solution with the only
problem that John and Mary will never own the land under their new home.
For some, that is not acceptable. It is also unclear what effect this
might have on resale value. Land leasehold is basically the same approach
that is used in the local Community Land Trust organizations for low and very
low income affordable housing where there continues to be a waiting list for home
availability, but there is no local experience with moderate and middle income
households.
What about Shared Equity? An approach that has
been used in commercial real estate for a long time has recently been applied
to residential real estate. Basically, a third party investor provides
part of the money needed to purchase the home in return for a share of the
appreciation. This third party might be a relative, a friend, an employer
or a completely independent individual. There are many unique approaches
to Shared Equity, but our future homeowners investigate two very different
strategies.
With 8% to 10% per year appreciation in
The deal is much more complex than implied here and
involves a number of creative tax solutions to work. The advice of a very
good accountant or tax attorney is advised before attempting this. For
example, the homeowners must pay a “fair market rent” to the third party
investor, but the investor may use this money to pay “business expenses” such
as a share of the real estate tax, insurance, various fees, and even utility
bills that the homeowners would otherwise have to pay. In addition, the
third party investor can charge depreciation against his gain and roll over the
investment into one after another with deferred capital gain tax on his
profit. The homeowners still enjoy a tax deduction for the mortgage
interest and their share of the real estate tax. If the homeowners elect
to sell rather than refinance, they can receive
up to $500,000 in capital gains with no tax. Compared to the same
investment on the mainland where appreciation is 4%, the homeowners receive
nearly $100,000 more by investing for only 7 years.
Therefore, join ownership with an investor can actually provide as much or more
appreciation as full ownership on the mainland.
Like all highly speculative deals, this has
considerable risk. For example, it is most sensitive to homeowners’
income and assumes that John and Mary receive promotions sufficient to raise
their income by 4.6% per year. A drop to just 4.3% pushes the refinance
date out to 8 years and each tenth percent drop after that pushes it out
another year. It also assumes that appreciation continues at an 8% rate
over that term and that a new mortgage can be obtained at the same 6%
rate. What happens if the homeowners cannot afford to refinance and do
not want to sell? These questions all need to be addressed as part of the
initial agreement. Moreover, as the difference between homeowners’
income and property values increase, it becomes increasingly difficult to make
this work. Ultimately, the investor has to assume a sufficiently high
percentage of the deal that the homeowner’s income increases will never
practically be sufficient to buy out the investor.
For example, only five years from now, that same
property would list for $404,000 at 8% appreciation. Assuming everything
else increases at a 3% rate of inflation, another young couple at the same
point in their lives would have a salary of $75,000 and might have saved
$25,000. They would qualify for a mortgage of $240,000. To afford
the same house, the third party investor would now have to bring $139,000 to
the deal. But, the homeowner’s salary is not sufficient to pay fair
market rent on the investor’s share. Even if the rent were reduced, they
would NEVER be able to buy out the investor, even if the homeowner’s income
increased by up to 6% per year!
What can be done to reduce the risk to both the
homeowners and the third party investor?
An alternative approach to shared equity attempts to
both minimize the risk and provide perpetual affordability. The approach
provides a modest annual income to the investor and protects his investment
against inflation while giving the homeowners the same increase in value that
they would receive on the mainland.
Under this, yet more complex plan, a “Starter Fund” is
needed, in this case, $16,000. The purpose of this fund is to assure that
the third party investor is paid a modest income in rent for the share of funds
provided. This might be paid by an employer or by a charitable
organization. Briefly, the investor provides the $55,000 as before and
the homeowners provide $22,000 for down payment and closing costs plus a
mortgage of $200,000 to purchase the $275,000 house. The investor asks
that the homeowners pay 7% rent or a little over $300 per month initially in
exchange for the use of the $55,000. Since the homeowner’s income is
fully encumbered with the mortgage payments and other housing expenses, this is
initially paid out of the Starter Fund. As the homeowners’ income
increases, this subsidy is reduced and the homeowners gradually assume
responsibility for that debt, within the 30% of gross income budgeted for
housing. In this case, it would take 10 years before the homeowners
assume all of this payment. However, after only 8 years and income
increases of only 3.5% per year, the homeowners can refinance and payoff the
investor. This is because the value of the property is capped at same
appreciation rate as the mainland, namely 4% and the third party investor’s
appreciation is capped at the rate of inflation, namely 3%. If the
creative tax solutions of the previous approach were used, the return for
everyone is somewhat improved.
No one gets rich under this approach, but the
homeowners earn exactly as much as they would on the mainland and the investor
receives a reasonable return plus a safeguard on his principal against
inflation. But, what of the starter fund? If and when the
homeowners sell the property, they are not only restricted to a cap on
appreciation at 4%, but they also have an obligation to pay back the starter fund
plus an increase sufficient to provide the same financing arrangement to the
next buyer. For example, if they were to sell at 8 years instead of
refinancing, they would have to pay back $22,000 out of the roughly $86,000
increase in appreciation that they will have earned. On the other hand,
if they remain in the house, it will cost only a total of $2,000 extra for the
8 years or $250 per year to stay on the island. Does that cost justify
living on the islands rather than on the mainland? Only the homeowners
can make that decision.
The message in this story is that there is still hope
for middle income working families in
As always, you can find all our reports including this
story at our website, <http://orcasresearch.org/>.
Signed,
Lee Sturdivant,
Paul Losleben and Steve Garrison,
Sandy Bishop,