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Improving the Homeownership Experience with a Variable Approach to Ownership

May 08, 2019

Introduction

In this whitepaper, we explore how tokenization can facilitate “fluidity” around the equity ownership of single family homes and multifamily units. Four scenarios are presented that tackle challenges created by the comparatively rigid way in way in which we typically finance residential property today.

The first scenario describes a way for homeowners to more easily tap their home equity for unexpected financial needs, or to prepay their mortgage if they have access to extra cash. The second scenario presents a specific business case for Master Planned Communities (MPCs) to retain their customers as families need to upsize, downsize or otherwise relocate. The third scenario shows how to mitigate existing challenges in the rent-to-own market.  The final scenario tackles the housing affordability gap where down payment requirements are an insurmountable challenge for many people seeking to become first-time property owners. Each of these scenarios is underpinned by tokenization, blockchain and smart contracts to deliver transparency, accuracy, cost efficiency and verifiability.

Tokenization, Blockchain and Smart Contracts

Before we dig in, let’s start with some basic definitions of tokenization, blockchain and smart contracts.

Tokenization refers to fractionalization of the ownership of a property, in a legal sense, into undivided ownership or financial interests represented by “tokens”, a type of digital currency recorded in a distributed ledger or blockchain. Blockchain is a data architecture comprised of a decentralized network of computers (or nodes) that hold timestamped packets of data that can contain many things, from metadata about a transaction or contract to document hashes¹.

Blockchains, because of their decentralized architecture, are virtually hackproof – in order to change a blockchain record, one would need to simultaneously find and access a majority of the nodes on the blockchain network all at the same instant – a feat not possible with today’s computing power. Blockchain technology has been around for many years and is the technology that enables trading of cyrptocurrencies such as Bitcoin but is being used in many other ways by government and industry to provide a more secure way to track, archive and verify transactions and data.

Smart contracts are self-executing contracts with the contract terms being directly written into lines of computer code. The code resides on a blockchain and enables automated, trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. Smart contracts render transactions traceable, transparent, and irreversible.

Scenario 1: Variable Home Equity

Consider a 3 bed/2 bath single family home in a New York City suburb with a purchase price of $575,000 and a $460,000 mortgage (80% LTV). Now let’s say the homeowner needs $10,000 for home improvements and wants to access the equity in the home as a source of credit. Today, the homeowner’s only options are to get a second mortgage (in the form of a home equity loan or line of credit) or refinance the first mortgage in a “cash out” transaction. Both options take time to close and involve payment of potentially significant fees by the homeowner. The result is that the homeowner does nothing and remains frustrated. If the homeowner’s need for liquidity is due to a health crisis or loss of income, they may have already fallen behind on mortgage payments, maxed out credit cards, or fallen behind on household bills, all of which can damage their credit score and reduce their ability to access the money they need at a time when they need it most.

The question is how to create a highly cost-efficient way for the homeowner to access their home equity without triggering an entirely new financing transaction. This is where tokenization and smart contracts come into play.

In this example, property tokens representing $1.00 of value would be minted at the initial closing of the first mortgage to document the respective financial interests of the homeowner and lender in the property. The homeowner is still the legal owner of the home and the lender still has a first lien in accordance with the promissory note and mortgage documents. The token balances at closing are shown in Table 1.

Table 1. Cash and Token Balances at Closing

At Closing
Property Value$575,000
Mortgage Balance$460,000
Home Equity
$115,000
80% LTV Threshold$460,000
“Excess” Equity
Tokens Owned by Bank460,000
Tokens Owned by Homeowner
Locked Wallet @ 20% of Value (unavailable)
115,000
“Excess” (available)
Total Tokens Minted575,000

As shown in Table 1, a portion of the homeowner’s tokens would be held in a locked wallet meaning they could not be withdrawn until the LTV drops below 80%. From that point onward, as monthly mortgage payments reduce principal, tokens would automatically flow from the lender’s wallet to the homeowner’s “excess” token wallet in accordance with a smart contract. If the home is re-appraised at a higher value, the token balances in the locked wallet and “excess’ token wallet would be adjusted accordingly. Re-appraisal does not affect the token balance in the lender wallet.

This paper is not intended to explore options for homeowners to access home equity above 80% LTV. Rather, the point is to illustrate a method that allows homeowners to access their home equity while avoiding credit checks, loan origination fees and other transaction costs, and long lead times associated with refinancing or second mortgages.

Now suppose the home was purchased five years ago with a 30-year mortgage at a 4.3% fixed rate. The principal balance of the mortgage will have been paid down to $418,041 reducing the LTV to 73%. An updated appraisal has concluded the value of the home has appreciated slightly to $600,000. Now the LTV is 70%. The updated token balances are shown in Table 2.

Table 2. Updated Token Balances

At Closing5 Years LaterIncrease/Decrease
Property Value$575,000$600,000$25,000
Mortgage Balance$460,000$418,041$(41,959)
Home Equity$115,000$181,959$66,959
80% LTV Threshold$460,000$480,000$20,000
“Excess” Equity$61,959$61,959
Tokens Owned by Bank460,000418,04141,959
Tokens Owned by Homewoner
Locked Wallet @ 20% of Value (unavailable)115,000120,0005,000
“Excess” (available)61,959
61,959
Total Tokens Minted 575,000 600,00025,000

In this scenario, periodic appraisals are envisioned at regular intervals to “true up” the appraised value of the home to current market value, thus allowing the homeowner to access the full value of their equity (less the locked portion) while protecting the lender in the event the property value falls. The cost of the periodic appraisals can be pre-paid and amortized as part of the monthly PITI payment. Appraisals could also be required if certain one-off events occurred over a certain dollar threshold such as an addition or remodeling.

Another advantage of this structure of mutual benefit to the homeowner and lender is the ability to “miss” a monthly mortgage payment (but not escrow payments for taxes or insurance). In this situation, the homeowner can remain current on their mortgage by transferring tokens from their “excess” wallet to the lender’s wallet. This would cause the loan balance to increase by the amount of the skipped payment thus lengthening the maturity of the loan, subject to a maximum limit established by the lender (if any). This scenario saves the bank from placing the loan into default and preserves the credit score of the homeowner.

If the homeowner needs $10,000 to cover emergency expenses, the lender could provide that cash and a smart contract would automatically deduct 10,000 tokens from the homeowner’s wallet for deposit into the lender’s wallet.

The reverse is also true if the homeowner makes a payment that is greater than their stipulated monthly payment. In that case, an additional number of tokens would be transferred from the lender’s wallet to the homeowner’s “excess” wallet beyond the scheduled amount associated with the regular payment, resulting in more rapid pay down of principal.

The reverse is also true if the homeowner makes a payment that is greater than their stipulated monthly payment. In that case, an additional number of tokens would be transferred from the lender’s wallet to the homeowner’s “excess” wallet beyond the scheduled amount associated with the regular payment, resulting in more rapid pay down of principal.

Note that the tokens in this example do not need to trade on an exchange as they are merely a way for the homeowner and the lender to document and track their respective financial interests at any point in time. The transfer of tokens is strictly between the homeowner and the lender. In essence, this program transforms a traditional mortgage into a combination line of credit and reverse mortgage at the same time, backed by blockchain, and eliminating the need to undertake new financings when family circumstances change.

All of the above would be governed by a smart contract, driven by data generated by the lender based on the amount of money paid to or received from the homeowner while enforcing lender covenants regarding LTV and loan maturity. The smart contract ensures the calculations and token transfers are automated, verified and transparent, as illustrated in Figure 1

Figure 1. Variable Home Equity Structure

Benefits of the variable home equity structure include:

  • Variable home equity is a way to provide homeowners with flexibility to increase or decrease the amount of equity in their residence based on their financial situation in real time.
  • The smart contract ensures automation, accuracy and verifiability for tracking the respective financial interests of the homeowner and lender, represented by their token balances at all points in time. Each month a mortgage payment is received by the lender, the smart contract automatically adjusts the token balances in the lender’s and homeowner’s wallets, with all transactions etched into a blockchain.
  • The smart contract automatically enforces lender covenants regarding LTV, maximum loan maturity and other conditions, as required by the lender.
  • Token transfers are a fast, cost effective, secure and auditable method of documenting the financial position of the homeowner and lender at all times.
  • Periodic re-appraisals mitigate the risk that the lender’s LTV strays above their desired maximum threshold. Appraisal costs can amortized over the re-appraisal period and prepaid as part of the homeowner’s stipulated monthly payment.
  • If the homeowner encounters financial difficulty, a negative credit reporting event and foreclosure can be forestalled giving the homeowner time to rectify their financial situation and a longer timeframe for the lender to react to changed circumstances.
  • If the homeowner’s purchasing power increases or they experience a windfall, the variable home equity structure provides a seamless mechanism to accelerate principal repayment and increase the equity they own in their home.

Scenario 2: Master Planned Communities

Developers of master planned communities (MPCs) are striving to acquire “customers for life”. As families’ needs change and they want to upside or downsize, MPCs would like homeowners to remain within their communities. Tokenization provides a convenient pathway to create a powerful financial incentive to make that happen, even if a family needs to move out of the area.

In this scenario, which builds on Scenario 1, homes within a MPC would be tokenized with a branded property token specific to that MPC with a value pegged to a specific monetary value, e.g., one token represents $1.00 of market value. For example, a home which sells for $600,000 would have 600,000 associated property tokens. The tokens would be placed in digital wallets owned by the homeowner and their lender in the same manner as described in Scenario 1.

If the homeowner subsequently wants to move to a larger home because their family size has increased, they could trade up to another home in the MPC by applying the equity they have in their current home, represented by the tokens in their digital wallet, to the new home. If the MPC developer/operator facilitates this transaction, real estate sales commissions can be avoided which can represent a sizeable portion of the homeowner’s equity. For example, if the current home is valued at $600,000, a 6% real estate commission (sell and buy side) is a $36,000 expense to the seller. If the homeowner has $150,000 of equity, this commission reduces their available equity by a whopping 24%. Essentially, the MPC developer/operator is leveraging their incumbency as the MPC operator to see all potential sellers within the MPC, all potential buyers interested in moving into the MPC, and all current residents wishing to move within the MPC.

Data shows that Americans change homes more than 10 times over their lifetimes. Even halving that amount to 5 times within the same MPC (or MPC network) could result in well over $250,000 in savings to the homeowner on fees and commissions over their lifetime.

If a family needs to move out of the area, the MPC can have reciprocal arrangements with other MPCs to retain those customers so they move within a defined MPC network. The avoidance of real estate commissions is a powerful financial driver and reinforces MPC brand loyalty.

Benefits of the MPC structure include:

  • All the benefits of Scenario 1, plus:
  • Provides a meaningful financial incentive for families to remain within the MPC;
  • MPC-branded tokens reinforce the MPC brand and can be extended to additional uses within the community (e.g., club membership, home services, etc.) to make the customer relationship even more sticky;
  • Forming consortia with other like-minded MPCs is a way to keep families within a defined MPC network; and
  • The structure positions the MPC to upsell additional services, including
    • Mortgage origination
    • New construction work for both new home construction and improvements to existing homes, particularly if it can be paid with equity tokens

Practical implementation issues include:

  • The same as Scenario 1, plus:
  • The MPC would have to assess its ability to provide a satisfactory matching service based on its deal flow.

Scenario 3: Rent-to-Own

There are many companies, both big and small, that offer a rent-to-own product in all 50 states which involves investing in, for example, single family homes in low income areas and then renting them with the ultimate intent to sell the home to the renter. To accomplish this, the landlord “holds” a percentage of the money from each rental payment in an escrow until the renter has accumulated sufficient funds for a down payment. If the renter can obtain a mortgage at that time, they can then complete the purchase. The positive aspects of this arrangement include:

  • It creates a forced saving plan for lower income renters; and
  • A pattern of on-time rent payments can be used to demonstrate renters’ creditworthiness and build their credit score.

However, there are numerous downsides:

  • It requires the renter to trust the landlord to safeguard and account for the money paid toward the down payment;
  • Many rent-to-own homes are sold at prices far above their true market value;
  • Even after renting for several years, many lower income renters are still not able to qualify for a mortgage; and
  • A default in even a single rent payment can cause the loss of all money paid toward the down payment.

As a result, a significant portion of rent-to-own transactions fail to deliver for renters with the landlord keeping all money paid by the renter.

Smart contracts and blockchain could mitigate many of the downsides of these transactions by creating a system where all payments are tracked in a data architecture that cannot be controlled by the landlord. This would allow implementation of rent-to-own strategies that take advantage of the positive attributes of these programs while minimizing or even eliminating the negative elements.

For instance, with smart contracting:

  • The renter no longer needs to rely on the landlord to safeguard the accounting of their payments toward the down payment;
  • The renter can choose from a wide variety of homes, not just over-priced listings;
  • Lenders can clearly define the qualification requirements for a mortgage at the inception of the rent-to- own cycle, even embedding certain conditions into the smart contract, to provide assurance to the renter they will qualify when the conditions are met; and
  • If the renter defaults in their payment or otherwise moves out before purchasing the property, the payments they previously made toward the down payment can be tracked for refund or applied to the next rent-to-own home.

Additionally, security deposit insurance can be utilized to eliminate the cost burden of having to post first and last month’s rent in order to get into the home more easily.

Scenario 4: Variable Ownership

Convention holds that, to occupy your home, you either rent it or own it. You can own zero percent or 100 percent. Most people would prefer to own their home, particularly their primary residence, to benefit from any appreciation in the value of the property and to capture tax benefits associated with the mortgage interest deduction. But housing affordability has declined across the US placing homeownership out of reach for a growing segment of the population for no other reason than an inability to come up with the down payment, even if prospective buyers can otherwise qualify for a mortgage. In these situations, renting is the only alternative. And because rental payments are usually paid in after-tax dollars and the renter has no rights to property appreciation, many feel that renting is not their preferred option.

This scenario outlines a middle ground, a more flexible approach, where homeownership does not have to be an either/or proposition. This variable ownership model is particularly suitable for people whose incomes are expected to change over time. For example, millennials can expect to gain purchasing power as they progress in their careers. A variable ownership structure would allow them to efficiently acquire more equity in their current home without having to move and buy another home. when they are able to purchase. Older persons with substantial home equity may want the flexibility of tapping that equity without having to enter into a reverse mortgage. And anyone else who experiences a windfall such as an inheritance or an adverse event such as a health crisis may want the flexibility to modulate their home equity without having to sell, refinance or acquire a home equity loan or line of credit.

A variable ownership model is a flexible arrangement that makes sense in this new reality if a cost-efficient mechanism can be devised that balances the needs of investors and home occupants alike.

Table 3 summarizes the purchase assumptions for the suburban home described in Scenario 1.

Table 3. Home Ownership Assumptions

Sales Price$575,000
Buyer Closing Costs3.5%
Total Funds Required$595,123
LTV80%
Amount Financed$460,000
Mortgage Term (years)30
Interest Rate (fixed)4.30%
Monthly P&I$2,276
Monthly Property Taxes$730
Monthly Insurance$80
Monthly PITI (Pre-Tax)$3,086
Owner’s Marginal Tax Bracket25%
Monthly PITI (After Tax)²$2,347
Down Payment, including closing costs$135,125

The same home would rent for approximately $3300 per month based on data from Zillow. The landlord’s perspective on the same home is shown in Table 4.

Figure 2. After-Tax Occupancy Cost and Down Payment vs. Ownership %

Table 4. The Landlord’s Perspective

Monthly Rental$3,300
Gross Annual Income$39,600
Annuyal Taxes$8,760
Annual Maintenance (assumed)$2,000
Net Annual Income$28,840
Cap Rate 5.02%

Interestingly, using the above assumptions, the pre-tax PITI figure of $3,086 is farily close to the monthly rental price of $3,300 and deductibility of mortgage interest would drive down the after-tax PITI cost further to $2,362 – a substantial difference favoring ownership over rental. Figure 2 illustrates the relationship of after-tax occupancy cost to down payment across the spectrum of variable ownership scenarios in this example.

To make the Variable Ownership structure work, a “Topco” or trust would be established to own the property as shown in Figure 3. The trust would be the single owner of the property for purposes of title, mortgage, and insurance and tax escrow. Ownership of the property would be fractionalized in the form of tokens that are unique to that property. The tokens do not need to trade on an exchange as they are merely a way for the occupier and the landlord to document their respective financial interests at any point in time. In other words, the transfer of tokens is strictly between those two parties. The governing document of the trust would recognize the tokens as the unit of ownership of the property and prescribe the respective rights of tokenholders in the property, including:

  • Documentation of a monthly payment based on the ownership split at closing (“Stipulated Payment”) and adjustments thereto based on changes in taxes, insurance and common charges (e.g. HoA fees, co-op assessments, etc.);
  • Documentation of the payment due the landlord for each percent of their ownership in the property; and
  • Calculation of how much of the occupier’s monthly payment goes to PITI and how much goes to the landlord as a rental payment for each percent of their ownership in the property.

If the occupier’s payment in any month is less than the Stipulated Payment, then their property token balance would be automatically adjusted by transferring tokens from their wallet to the landlord wallet thus forestalling a negative credit reporting event and, ultimately, an expensive and painful foreclosure process.

If the occupant wants to put more money toward the monthly payment, the excess over the Stipulated Payment would go toward buying more equity in accordance with a predetermined structure, e.g., re-appraisal, fixed buyout price schedule, etc.

All of the above would be governed by a smart contract so that the calculations and token transfers are automated, verified and transparent.

Figure 3. Variable Ownership Structure

Benefits of the Variable Ownership structure include:

  • The variable ownership structure provides flexibility to the occupier to get into the home they want but cannot otherwise afford to purchase outright while preserving their ability to buy more ownership at any time under an agreed formula;
  • For investors/landlords, the variable ownership structure differentiates their properties and, because of the increased flexibility they are offering occupants, should be in comparatively higher demand if not also command a rent premium;
  • Security deposit insurance could be used as an enhancement to eliminate the burden of locking up first and last month’s rent in a “non-productive” escrow account;
  • The structure would not limit the occupier or lender to sell their ownership interest, either to one another or a third party, at any time; and
  • The variable ownership structure could also be applied to a For Sale By Owner (FSBO) situation.

Practical implementation issues include:

  • The cost of the Trust would have to be taken into account, but due to the high degree of automation afforded by the smart contract, it is not believed this will be a significant expense. Further, If tokens are accidentally lost or wallets are hacked, token balances could be re-constructed and restored to their proper level because the blockchain would provide a complete and accurate record of all transactions.
  • Investors and developers may have to adjust their business plan to accommodate a mixed ownership model. However, the increased flexibility provided to occupiers should offer a potentially higher return both in terms of marketable rents as well as purchase price.

A Final Note on Appraisals

Because periodic appraisals are a central feature of making variable ownership products viable, CPROP believes a better appraisal process can be implemented which has a higher level of standardization, automation and accuracy as compared to incumbent methods.

To this end, CPROP has introduced a new data platform, PropAbility℠, to create a data collection method that standardizes the process. No matter where you live or who is doing the appraisal, the same comprehensive data sets can be collected and weighted based on pre-defined algorithms to generate a more accurate and repeatable appraisal with a highly standardized process. Blockchain would be used to increase data security and establish immutable timestamps thus creating an independent reference point for appraisals, facilitating tracking of notable changes with respect to each property, and to track and score appraisers on their individual assessments as compared to follow-on market transactions.

The appraisal could be wrapped in a user interface, accessible via phone or tablet, that captures, organizes and delivers essential information to an algorithm working in the background that generates the final appraisal making CPROP’s approach unique, accurate, repeatable and scalable.

Conclusion

The scenarios described above share one thing in common – increasing the fluidity with which homeowners can manage their ownership position to more closely conform with life’s events, both positive as well as negative. A paradigm shift is sorely needed in the mortgage market to move away from rigid products that make this difficult and to eliminate the costly and time-consuming process of refinancing or taking out second mortgages to gain desired flexibility while making homeownership more accessible to a larger portion of the population. These products benefit first-time homebuyers and low- and middle-income families, in particular, by lowering the difficulty to acquire some level of homeownership while allowing existing homeowners access to the equity they already own in their largest financial asset without the need for additional financings, credit checks, contracts and approvals.

Blockchain can serve as a powerful backbone to existing financial products and structures to ensure transparency and auditability. Smart contracts ensure accuracy and efficiency. Tokens makes the accounting obvious to all stakeholders in a highly cost-efficient and durable manner.

Residential real estate products and services are evolving quickly as consumers demand more flexibility, less expense and more customized services. That is precisely the market demand the scenarios described in this paper are designed to address.

¹A document hash is a 64-character string of numbers and letters generated by a publicly available algorithm that is unique to a specific document or transaction. A hash is often referred to as the document’s digital fingerprint and is used to verify that nothing in the document has changed since the hash’s blockchain timestamp.

²Assumes 90% of P&I is interest (deductible) but property taxes were considered to be non-deductible due to limitations on deductibility of state and local taxes imposed by the Tax Cuts and Jobs Act passed in 2018.

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