The beauty of the Term Ownership system is it makes housing affordable for first time homeowners and can provide relief to distressed homeowners who are on the verge of foreclosure (while simultaneously turning a losing transaction into a profitable one for the bank). It is not rent-to-own. It is not a negative amortization product.
The buyer is an actual property owner - only, for a fixed period of time.
Then the investor/bank owns the home if, and only if, the buyer doesn't buy out the interest. The buyer typically pays 30% of the Fair Market Value (FMV), fully amortized over 5 years, for 5 years' ownership. The 5-year mortgage is, in effect, equivalent to a car loan. The bank/investor pays 70% plus closing costs.
The buyer has a secured mortgage on the 30% of FMV loan, so they get the tax breaks for interest and property taxes. The 30% being amortized over 5 years is completely paid off at the end of the five year term - so the buyer can walk away with no credit penalty.
If the buyer walks away, the bank/investor paid ~75% (figuring high to factor in closing costs) of today’s fair market value for a home that, 5 years from now, should have appreciated in value. If it hasn't appreciated, in all likelihood it will not have depreciated to the point where the bank/investor has lost money (but as with all investments, there is risk - average appreciation, excluding this strange period of the last few years, has been ~4.5 % per year though).
If the property appreciates, the rational course for the buyer is either to 1) buy out the bank/investor (via traditional refinancing or re-Term Owning), or 2) sell the property and pocket the appreciation.
How does the system work?
Slipping into real estate lawyer speak:
There is a seldom used form of deeding property called "conditional fee" ownership. When you buy real property, typically you buy a "fee" ownership - which means you own every right the government allows.
A "conditional fee" permits you to have every right except 1) what the government disallows and 2) the conditions imposed by the person conveying you the property.
The conditional owner, the homebuyer, is an actual owner - they have every right attendant to full ownership in the laws' eyes, unless a condition is breached. As long as the condition isn't breached they can sell, rent out, etc. just like a typical homeowner.
Traditionally, this form of property deeding is used to control someone's behavior. So for example, if Jane thinks John is an obnoxious drunk, but an adorable sober person, she could decide to deed him a house on the condition he never drinks another drop of alcohol. If John has even a single drop, by operation of law, the property is transferred to a third person/entity.
The patent, which was issued on March 18, 2008 by the U.S. Patent office takes this form of conveying property and turns it into a financial tool. Here the condition is - if you don't buy out the investor for x by date y, then the investor owns the property (this is a shared appreciation financing method where x is a certain % below the five year FMV). There is a sliding scale used if the person wants to sell off the full fee interest in the property early (although they could just sell their term interest to a third party).
Example First Time Homebuyer:
So let's look at a $100,000.00 house situation where the potential homebuyer has $1,000 total cash to put down and otherwise qualifies for a 7.25% interest rate. With Term Ownership, the financed balance is $29,000.00 - which comes to 12 payments a year of $577.66 P&I.
What happens if the homebuyer were to traditionally finance $99,000 instead of Term Owning? Well, the P&I payment would go up to $675.35 AND the buyer would be subjected to mortgage insurance because they don't have 20% equity (throwing on another ~$110.00 per month) AND the buyer would have to come up with about another $4,000.00 to cover the closing costs. (NOTE: Hazard Insurance and Property taxes are excluded throughout this message as they would be the same amount added to the P&I each month under both traditional financing and under Term Ownership).
Comparing the Term P&I of $577.66 (without needing mortgage insurance or closing costs) to the traditional financing cost of $785.35 (w/mortgage insurance) the ~$4,000.00 in closing costs, and the savings to the buyer are clear.
Investor Benefits:
What about the investor - do they receive any special perks? Yes. There is a tax benefit called "like kind exchange" where investment property can be transferred for like kind property. When the rules are followed, and this kind of exchange happens, capital gain taxes are deferred.
So, if the investor timely rolls the investment from one Term Ownership into a second, then they don't pay taxes and get to make use of the full value of the money for their benefit. In order to qualify for this perk, you must actually have an investment ownership interest - and the conditional owner is an owner - just without rights unless the condition is breached. A mortgage does not qualify for like kind treatment. A conditional ownership should fully qualify for like kind treatment (NOTE: as the system has not been implemented, it has not been tested, but appears to fit all of the requirements set forth in the tax code for like kind treatment).
Bank Benefits if they choose to be the Investor:
The key benefit for a bank in choosing to be the investor is that it will instantly have Community Reinvestment Act credit. The CRA is designed in large part to make homeownership affordable. A three part test exists to determine whether large financial institutions such as Wells Fargo, Bank of America, Chase, etc. are meeting the CRA requirements. The three areas tested are “lending”, “service” and “investment”. A bank can meet both the lending test and the investment test by being the 5-year lender AND being the investor. One of the key factors in the investment test is whether the investment is innovative and makes housing more affordable. This is a highly innovative program and should score well on the test. While the requirements are different for smaller institutions, this program will still help them with meeting their CRA requirement.
Builder Benefits
Right now there is a lot of inventory that is not being sold because of several factors. These factors include rising material and land prices, credit crunch on the population as a whole, and the foreclosure crisis depressing prices in the resale market. A tool is necessary to reinvigorate the housing market.
Traditionally, builders have marked up properties 15-25% or more. So, in the past, a $200,000 home cost perhaps $150,000 to build. Right now, even offering steep discounts, many spec homes are sitting vacant and traffic to model homes has dropped dramatically.
A homebuilder could offer this program, in one of two ways - either as an in-house investment or by using an out of house Investment Company to purchase the remainder interests.
Builder "In-House" Usage
A home offered for sale by a builder at $200,000, would receive a $60,000 payment from the term buyer. Assuming the cost to build the home was $150,000, the unpaid "investment" component paid by the builder is $90,000 plus closing costs (figuring high, let's assume it is $100,000). Assuming that the 5-year investment buyout is $200,000 (i.e. there is no appreciation over the course of five years), the internal rate of return in this scenario is 14.87%. If the property comes back (instead of being bought out by the term owner), then the builder can realize costs savings by utilizing its existing sales forces to resell the property.
Builder "Out-of-House" Usage
There is currently no Investment Company in existence buying these interests as the method has not yet been implemented. However, I am currently investigating the feasibility of an IPO to form a corporation to act as the investment/conditional fee purchaser. If those in the housing industry are interested in using this system as one more tool for selling homes, a letter of support could be instrumental in making such a company possible. In that case, as far a home seller is concerned, the sale will simply be a sale - the price will be determined, the 5 year loan would be funded by a financial institution and the conditional interest will be funded by the Investment Company.
Example Foreclosure Prevention:
What about foreclosures?
Let's say someone bought a $220,000 house and put down 10% (financing $198,000). They financed with an ARM that has jumped up to 9% from an original 7%. The original P&I payment was $1,317.30 ( $110.00 mortgage insurance for a total of $1,427.30). After two years of payments, the balance on the note is $193,831.97. The new payment is $1,593.15 $110.00 ($1,703.15).
Since purchasing, the owner's property has dropped in value to $200,000.00.
The new payment is too much for the owner, they don't have the equity to sell the property, or refinance it traditionally, and they are a foreclosure waiting to happen. Or they can refinance into Term Ownership.
30% of $200,000 is $60,000. Subtracting out the existing equity in the property - $6,170.00, provides the amount financed for 5 years. In this case, the amount financed is $53,830.00. Again, at 7.25%, the new P&I payment is $1072.26 - a $630.89 monthly savings over their new payment on their ARM. It is a life saver, and a home saver.
For the bank, instead of facing an average cost of $60,000 to foreclose, it turns an unprofitable situation into a profitable one AND gains CRA credit AND public goodwill.
Admittedly, if the bank is not holding its own paper, and there is mortgage insurance, than the risks are reduced in a foreclosure situation for the bank. However, these foreclosures are still eating into bank profits, and it is better to earn a profit then to end up writing down billions.
For the mortgage insurers, incentives can be given to refinance these distressed homeowners into this system in order to protect their own interests.
Foreclosure example 2 - Borrower upside down
Assume that the borrower has a home that is only worth $184,0000, but owes $200,000, with an interest rate that has just increased to 9%. The Payment will be ~$1,610 plus $110 in Mortgage insurance for a payment of approximately $1,720. Refinancing into Term Ownership, the Owner would have to finance 30% of FMV ($55,200) the negative equity ($16,000) in this case the amount borrowed and amortized over 5 years is $71,200. Even if the Interest were to stay at 9% due to increased risk, the monthly payment would be approximately $1,480. If the rate is at 7.25%, the new P&I payment would be at about $1,420. While not as beneficial in payment reduction as a person with some equity in the property, it is about $240-$300 less than the current pay structure. Once again, the pay structure is affordable
Royalty Payment
The use of the system will require a royalty payment of 1/10th of 1% of the appraised Fair Market Value, paid at closing as a closing cost.