By Joe Cianciolo, HomePace CEO
The pandemic has paved the way for the type of persistently volatile market conditions that perturbs even the most level-headed investors. Rising rates and geopolitical turmoil have combined to cause investors considerable consternation. In this environment, more investors are looking at home equity investments (also known as HEIs) to diversify exposure, enhance portfolio returns, and reduce duration risk. An HEI is a contract that allows a homeowner to sell some fraction of the appreciation of their home with the option to unwind the obligation at any point in time.
Investors have their work cut out for them as higher returns are required to justify the additional risk being taken on in the market characterized by increased volatility due to inflation. The Consumer Price Index (CPI) continued to rise to 8.2% in September after averaging 3.28% between 1914 and 2022. And while central banks worldwide are scrambling to catch up after an extended period of relaxed financial policy, their efforts might not make a difference soon enough to stop a recession. A 2013 study found that it typically takes between two and four years for central bank actions in advanced economies to impact inflation, according to Wall Street Journal reporting.
Traditionally, investors have increased their returns by adding leverage to a portfolio of safer investments, such as real estate, as an alternative to rotating into riskier assets. In recent years, the cost of adding leverage has been very low and widely available. In the current higher-rate environment, assets originated with this same strategy will be more prone to prepayment risk, making HEIs an attractive alternative.
For an investor buying an HEI, it serves as an asset-light way to get exposure to home price appreciation across markets in the U.S. While an HEI is still asset-backed with the house serving as collateral, it generally sits in position behind a traditional mortgage and in a more pari passu position to the equity of the homeowner. As a result, the expected return of an HEI is materially higher than that of traditional mortgages.
Investors in the Single-Family Rental (SFR) space, who traditionally borrow money to buy houses and rent them, will find that HEIs offer an attractive alternative in an environment where the cost of borrowing is high. An HEI is structured as an option contract that passes on some of the leverage taken on by a homeowner to the investor at no cost. When you combine the financing advantage with that of not needing a property manager, the cost of getting exposure to U.S. homes as an asset is much lower.
Furthermore, the duration risk associated with fast prepayment speeds of an HEI is much less than that of a traditional mortgage and therefore locks in a higher expected return for longer periods of time. A unique aspect of an HEI is the lack of periodic payment by the consumer. During the life of an HEI, dollars only change hands when it is issued and redeemed. For a homeowner, this characteristic allows the consumer to access built-up home equity without taking on any additional monthly obligation. For an investor, this asset would be expected to behave more like a discount bond, where changes in interest rates will generally be much less likely to affect prepayment speeds.
While residential real estate has been a popular haven for investors in times of uncertainty, there are widespread concerns about investor single-family housing purchases driving up overall homeownership costs. There have been accusations that home purchases by investors have caused home prices to increase to unaffordable levels, increase the number of renters, and materially change a community. This trend has disproportionately affected the least affluent communities. Given rising inflation, investors are looking for ways to achieve single-family real estate exposure without causing people to feel their neighborhoods are slowly losing their sense of community. HEIs allow investors to achieve similar returns without eating into the overall housing stock, while also allowing the individual homeowner to maintain ownership and continue to build equity.
HEIs give homeowners and homebuyers the same tools that large institutions use to break apart a physical asset into more usable pieces of wealth. With this tool, homeowners can pay down debt, start a business, invest in another home, or pay for things that are most important to them. That is, HEIs democratize savvy wealth strategies for the everyday person. Investors’ interest in HEIs will only continue to grow as HEIs transform the housing market for the better.