Equity Sharing: Be Sure to Write the Small Print

The real estate bust could turn into a boon for anyone who has been shut out of the housing market simply because of finances.

Thanks to low interest rates and stagnant or declining prices, houses are more affordable than they’ve been in a while. Now 52% of the nation’s households can qualify for a loan on the median-priced home, contrasted with only 43% in 1989.

The change is even more pronounced in areas where real estate prices are high. In Los Angeles, for example, 28% of households can now qualify to buy the median home, versus only 10% in 1989, the California Assn. of Realtors says.

There’s only one catch: you still need a down payment. On the median-priced U.S. home, a 20% down payment amounts to more than $20,000 in cash--an insurmountable hurdle for many families. In California, where housing prices are more costly, the entry requirement is even higher--often between $35,000 and $70,000.

But there’s more than one way to come up with a down payment. One such alternative is called equity sharing.

Equity sharing brings together two investors to buy one house. Generally, one investor has the cash for a down payment, the other has enough income to make monthly payments. They strike a deal and buy a house together.

At its best, equity sharing allows one partner to break into the housing market quickly and easily while the other earns a reasonable return on investment. At worst, it can produce losses and conflict among investors, who are often family members.

However, when these deals go sour, it’s usually because the partners haven’t structured the arrangement properly, experts say. Frequently, because of poor planning or the lack of a written contract, one partner will get the bulk of the benefits, while the other bears most of the risk. And that generates ill feelings all around.

To illustrate, let’s look at a common equity-sharing deal.

Newlyweds John and Jane Smith want to buy a home. They’re earning $35,000 annually--plenty to qualify for a loan on a $100,000 home. But they don’t have the money for the down payment.

John’s parents have lots of savings, so they decide to buy a home together. The senior Smiths provide a $20,000 down payment and the junior Smiths agree to make the monthly payments on an $80,000 mortgage.

Assuming that John and Jane get a fixed-rate mortgage at 8% interest, the total monthly payment--including 1% property tax and a $300 annual insurance premium--amounts to $695.35.

John and Jane get to live in the home and they get the benefit of deducting mortgage interest on their taxes. Depending on where they live and what other itemized deductions they have, the tax break can allow them to recover between 10% and 40% of their housing cost.

Let’s say the house appreciates 5% per year and they sell in three years. The total profit of $8,816 ($15,762 minus a 6% realtor’s commission) is split 50-50.

Assuming the monthly after-tax carrying costs are comparable to what the newlyweds would have paid in rent, John and Jane’s $4,408 profit is a windfall. The parents’ profit amounts to roughly a 7.3% annual return on their investment. Everyone is satisfied.

But what happens if the house doesn’t appreciate? Since this arrangement only anticipated sharing profits, John and Jane come out whole. But the senior Smiths lost $6,000 on the realtor’s commission--not to mention the opportunity costs involved in locking up $20,000 for three years. Mom and Dad are no longer speaking to Junior and his money-grubbing wife.

To avoid such problems, there are a variety of possibilities to consider before striking a deal. Items to consider aren’t limited to rates of real estate appreciation--or depreciation--either. The parties should also look at what happens if John and Jane divorce and Jane gets the house. Do John’s parents have to leave their $20,000 locked up, or can they terminate the deal?

What if the junior Smiths need to sell before the term of the deal is up? What if they want to stay in the house after the senior Smiths want to cash out? And, finally, if the property declines in value or simply doesn’t appreciate, do the junior Smiths have a financial obligation to the senior Smiths?

A good equity-sharing contract should spell out the rights and responsibilities of both parties in all these situations. It should help ensure that partners terminate the deal feeling pleased rather than peeved.