Sep 14, 2023
What Is Equity Sharing?
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You might have to be creative to have a lower mortgage rates than public market options. Consider equity sharing as a tool to lower your monthly mortgage payments.
What is Equity Sharing?
Equity sharing, also known as shared equity financing, is a unique financial arrangement between two parties: an Owner and an investor. The Owner could be a prospective homebuyer or an existing homeowner.
In an equity sharing agreement, the investor makes a cash commitment to the Owner at the outset. This investment can be used for a variety of purposes, such as mortgage payments, home improvements, or even unrelated expenses like medical bills, school tuition, starting a new business, or paying off credit card debt.
Typically, the Owner is responsible for all ongoing costs associated with the property, including mortgage payments, property taxes, insurance, and maintenance. However, there are instances where the investor may agree to cover some or all of these costs.
The equity sharing agreement concludes with the investor receiving a payment based on the property’s value. The Owner can make this payment through savings, refinancing, or selling the property. Equity sharing agreements usually have a predetermined duration so that the investor knows when to expect their return.
Equity sharing transactions can be documented using various contracts, but equity sharing agreements and equity sharing option contracts are most common.
How are the Equity Sharing Investor’s Proceeds Calculated?
To better understand the economics of shared equity financing arrangements, let’s define some terms. The “Investor Contribution” refers to the amount that the investor provides to the Owner, either as a mortgage payment contribution or as a cash payment. The “Equity Share Percentage” is the percentage used to determine the amount that the Owner needs to pay the investor at the end of the equity share. This percentage is determined at the start of the transaction and is clearly stated in the agreement.
If the property’s value increases during the term of the agreement, the investor receives their initial contribution plus a percentage of the appreciation based on the Equity Share Percentage.
For example, if the Investor Contribution was $50,000 and the Equity Share percentage is 30%, then regardless of whether home value goes up or down, the investor will always get 30% of the equity value. In a downside case, however, it’s possible for an investor to lose their entire investment. If there’s an increase in value, then they receive an additional percentage of net appreciation (say 15%). Here’s how it works:
If value goes up by $100,000:
Base $50,000 + Equity Share 30% * 100,000 + Appreciation Share 15% *100,000 = $95,000
If value remains flat:
If value goes down by $100,000:
Base $50,000 + Equity Share 30% * (-$100,000) + No Appreciation Share = $20,000
These examples are simplified and assume that any change in property value is due to market forces alone. In reality, factors such as improvements and maintenance by the Owner can impact market value and are taken into account when calculating investor proceeds.
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