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Introducing FARJHO (Flexible And Reversible Joint Home Ownership)

This blog post entry was originally posted at SwapRent.com Blog on 01/05/2010.

What is a FARJHO structure?

FARJHO is the flagship product of AeFT’s subsidiary InvestorsAlly.com. It is an offshoot from the R&D work on SwapRent embedded FARM product. The new name reflects the fact that FARJHO is meant to be a new way of home ownership structure, not just another mortgage product.

At the present time, there are many opportunities for investors to set up a fund to invest for the long term in foreclosed or distressed single family residences in many worst hit neighborhoods in California, Nevada, Arizona and Florida. FARJHO was created as a new way of shared equity based home ownership to allow institutional money to come in by letting renters and property investors co-own the properties in a LLC structure so that there would be a positive yield on their investments, similar to a real estate syndication process on commercial properties but with much scaled down expenses and complexity.

Due to its simplicity, this new commercialized service is ready for use by investors and homeowners without relying on the participation or any involvements by the government or major financial institutions. A common base structure for the US market is currently composed of a real estate syndication using an LLC legal entity. Each structure will be put together by a syndicator with up to a total of 10 members in the LLC. One of the co-owner members will be renting the property from the LLC and treat the property as his/her own principal residence.

For example, a home seeking person could identify a property in a particular geographical location. Instead of using a down payment say 5, 10 or 20% of the property value to apply for a conventional mortgage, which under most current circumstances he/she would not be qualified to, he/she could join the group of property investors to co-own the property in this all equity based syndicated LLC structure.

Although further financing using the property owned by the LLC is always possible as a variation of FARJHO if all members of the LLC so desire and approve, it is not a recommended structure. The intention FARJHO is to help renters become homeowners through minority stake ownership in the jointly owned LLC. A pure equity based structure without borrowing provides the long term social stability for home ownership and increase true housing affordability.

Since tax considerations are entirely passed through to each of the members, there is normally no point to use further leverage at the LLC level, unless the investors are of foreign jurisdictions. The use of moderate and reasonable borrowing to deduct the taxable income could be considered but should never be done to the degree that negative yield or negative cash flow occurs.

Tax advantages are man-made by nature. They reflect a government’s housing and property investment policies. Better tax treatments will follow prudent government policies when the economic benefits of innovative housing finance methodologies are more fully understood and accepted in the future.

For the time being, under the existing tax rules, property investors could manage the interest deduction individually since the rental income will pass through to each of the US based LLC members. For the homeowner/occupiers in the FARJHO structure, they could take advantage of the tax benefits of principal residence such as interest deduction and capital gains tax exemption for the portion of the equity that they own in the LLC. If they are interested in getting more of these conventional tax advantages, they could either increase their equity holding in the LLC or simply switch to complete ownership through conventional mortgage borrowing anytime they want, as long as they are able to afford it and be qualified for it.

FARJHO will serve as an additional consumer choice to increase housing affordability under the free market, not meant to replace any housing finance methods already in existence. It will only become a creative destruction if its economic value is proven and adopted by the consumers through further public education and awareness. For now it serves as a perfect alternative when homeowners either can not afford the conventional borrowing or are not interested in the conventional burden of debt.

Buy-out arrangements could be customized and structured in each individually syndicated LLC between members in the operating agreement of the LLC to serve different purposes of the members. When SwapRent^SM transactions become available at REIDeX.com in the near future, the flexibility and reversibility features as well as the benefits of FARJHO will only get to fully present themselves at that time.

When and how to apply a FARJHO?

The following information is on how to apply the new economic concept of the separation of shelter value and the investment value of a conventional ownership of a real estate property.

Example 1:

A home seeking person who currently rents identifies a property in a geographical area of his/her choice. He/She has the 10% of the property in cash from his/her own savings and would like to seek to jointly own the property with other investors as the ideal home owning structure.

The reasons could be because that he/she may not have enough monthly income to qualify for a conventional mortgage, prefers to use the discretionary monthly income for other household expenses, does not think the property value may increase in the near term, for his/her particular religious belief that rejects the lending/borrowing concepts or simply any other personal preferences.

He/She commits to pay a pre-agreed rent to the LLC that holds the title of the property for a specific period of time. The remaining 90% property ownership could be shared among up to nine other individual, corporate institutional or even governmental entities.

Example 2:

A group of investors have identified and bought a particular single family house at bargain price through a syndicated LLC structure either through a short sale process or from a bank’s REO portfolio.

The syndicator of the LLC tries to find a long term renter of this single family house in order to generate stable long term rental income. Many renters do not commit to the long term and do not usually care about the houses that they rent.

The syndicator/property manager makes an offer to a qualified renter who has the ability to pay for a small percentage of the property value and invites him/her to join the LLC as a minority stake holder/member himself/herself. Once the renter becomes the minority homeowner, he/she may intend to stay for the long term and would treasure the property and take good care of it as thought it were his/her own. In fact it is hie/her own, albeit partially. Although he/she does not have the economic income capability normally required to own the property entirely he/she gets to enjoy the high quality home in the neighborhood of his/her choice.

Through buy/sell agreements between LLC members, the homeowners could increase his/her equity ownership through buying existing member’s interests. Alternatively, he/she could use SwapRent^SM contracts to do so when they become available at REIDeX in the near future. In the worst case scenario, he/she could also become a LLC member in another property in the same neighborhood whenever he/she has the increased economic ability to do so and would like to have more investment exposures.

Comparing with conventional commercial property investments, FARJHO offer property investors less worries about vacancy and expenses. The investor’s SGI (Scheduled Gross Income) is his/her GOI (Gross Operating Income) and his/her NOI (Net Operating Income) since both annual vacancy loss and expenses are most likely zero in a FARJHO structure.

Example 3:

A homeowner currently has a deeply underwater house. He/She contemplates a strategic default on his/her own house but does not like the idea of becoming an apartment renter. A buy-and-bail strategy sounds more appealing to him/her. He/She could use an all equity based FARJHO structure to become the minority owner/renter of an alternative property in his/her neighborhood before he/she begins discussions with his/her current mortgage lending bank to give up his/her existing homes in either a short sale or a flat out walkaway foreclosure.

The strategic defaulters usually could not secure another mortgage to buy another comparable home before or after he/she walks away from his/her existing home. To qualify for a new mortgage on a second home, he/she has to either have 30% net equity in his/her existing home or a very large fully documented monthly income to qualify for the mortgage payments of two homes. This is often not the case with most upside down homeowners.

An all equity based FARJHO co-ownership structure makes it convenient for a smoother transition to a long term comparable or even nicer and often more spacious home through a partial equity ownership without having to lose the homeowner status by becoming a conventional apartment or house renter. It may turn a somewhat  embarrassing, face-losing event into a move up in prestige as a partial owner of a much bigger house!

How small business owners could use SwapRent transactions to create jobs at grassroots level – why it may help reduce homeowner’s intentional strategic defaults

This blog post entry was originally posted at SwapRent.com Blog on 12/06/2009

Regarding President Obamas White House job summit held on December 3rd of 2009, irrespective of the debate outcomes on what kind of green, pink or blue jobs to create, the 64 thousand dollar question is still how to come up with additional money to fund new jobs creation and create new economic stimulus. It is the greenback, not the green jobs, that is going to get us out of the current economic problems.

Beating the dead horse on pushing for more conventional bank lending through private sector or tapping more taxpayer’s money may only push us into a vicious cycle of further unscrupulous lending, over-leveraging and increased political risk sooner or later. Perhaps it is time to think outside the box for an innovative solution out of the current conundrum. Capitalism has always survived its own excesses and abuses through repeated innovations. This time around, it should be no different.

With that being said, I would like to revisit the subject again on how property owners could use SwapRent transactions to create jobs and generate new economic activities at local community grassroots level as an alternative that will not incur any further debts for our federal or local governments or inadvertently make Wall Street fat cats even fatter.

Since this new alternative housing finance system is not based on a lending concept but rather a tradable co-ownership equity financing concept to help our nation de-leverage, it does not have to rely on a low interest rate environment to be effective to create jobs and to stimulate our nation’s economic growth. Therefore, once a SwapRent market has been established, the Fed or central banks in other countries could raise rates at any time as they see fit in order to prevent growing further asset bubbles, to fight potential inflation or to save the value of the US dollar without having to worry about its potential impact on hurting the chances of an economic recovery.

The relevance to job creations is the part in the proposed SwapRent book chapter that talks about how entrepreneurs could create new monthly income by willingly giving up partial future appreciation of their homes which may or may not be realized by the horizon date (e.g. 2, 3, 5, 8 or 10 years) given the current economic situation. The entrepreneurs could then use these pooled new monthly cash flows to hire people or make new investments at the grassroots level. However, this concept would be much better explained and executed in the broader context of how the government could use SwapRent transactions to accomplish these economic stimulus goals as more fully explained in that chapter.

All the government needs to do is to encourage and facilitate the current risk holders of those legacy mortgage assets to be very generous in the design of the initial monthly subsidy income scheme so that local property owners and other normal small business owners feel it is too good a deal to pass. Based on pure free market principles, the more people there are in the “targeted neighborhoods” to sign on to this new program the more likely the local property markets and the local economic prosperity will indeed recover and the more likely free market based investors will step on each other’s shoulder to rush to inject fresh new fund into the local communities directly through this new free market mechanism. As a result the more the SwapRent contracts will appreciate in value due to the property market recovery that will reward the initial monthly subsidy providers. As described before, this new economic concept of a farming approach to wealth creation is indeed a self-fulfilling prophecy in the true spirit of capitalism. The more you sow, the more you’ll reap.

Wealth creation by enhancing property value in this manner is by no way creating asset bubbles again. Low interest rates will. Bubbles are created when buying interests were created from using borrowed money where owners have an on-going obligation to service debts. The SwapRent approach by nature is based on a tradable economic version of the shared equity financing concept. Equity financing means that owners do not have any interest burden of debts. Therefore asset wealth value created this way is not like leveraging created asset bubbles made up of hot air that are usually doomed to burst, the analogy could be more like igneous rocks cooled from molten lava. This is simply the inherent more stable nature of equity financing vs. debt financing.

Homeowners who see the signs of an imminent swift recovery will think twice about their earlier plans to walk away. The only way for homeowners to feel that they should not purposely make a strategic default and walk away seems to be to somehow make them feel that they might be missing out on a swift recovery if they do walk away.

If the government itself is the stake holder, it would be an excellent opportunity to use the TARP fund for the purpose of providing the initial monthly subsidy through the SwapRent transactions. The initial offerers of these monthly subsidies to homeowners through these SwapRent contracts, whoever they may be, could later sell these appreciated SwapRent contracts to other free market investors to get their money back. This economic concept is not unlike what the Government had successfully done to use TARP money to rescue big banks by asking for a warrant of the equity of the bank they provided money to last year. SwapRent contracts executed at REIDeX make possible and facilitate practicing these similar economic concepts on homeowners and property owning small business owners by providing a precise quantitative pricing methodology, standardized operational procedures and a secondary trading marketplace.

Pension funds and insurance companies could be the ideal long-term investors as the economic landlord investors to provide the monthly subsidy cash flows to either credit worthy homeowners or property owning small business owners in the farming approach to wealth creation since they normally would have more longer term liabilities to match. Those mortgage risk holders that had provided the initial monthly subsidy cash flows could resell the SwapRent contracts to these institutional investors. These SwapRent contracts could enhance their portfolio returns and reduce unnecessary risks over the long run from being able to further increase portfolio diversification due to the new found ability to treat residential real estate as a separate investable asset class. This is because of the fact that SwapRent rates would make this new asset class a yield bearing commodity. Of course they would be free to sell these SwapRent contracts again to any other free market based investors located both domestically and around the world at any time as well in the secondary SwapRent marketplace in order to either take profit or cut loss. This would open up the window to attract world-wide capital to flow into our country for home equity financing, the same way the stock market has brought equity capital to our corporations and also how GSEs have brought world-wide debt capital to our home financing in the past.

The key new economic concept for this proposed program to work well is to change from an ideological focus on preferential rescue treatments for distressed homeowners that causes moral hazards to a “free market based swapping of a part of future appreciation for a generous current monthly income cash flow” offer which is open to all property owners and targeted at a few specific high concentration foreclosure-infected neighborhoods that the banks have exposures to.

As the property owners who do not even need any additional monthly income from swapping a part of future appreciation of their own properties also get motivated due to greediness since they do not expect the property market would appreciate by horizon dates anyway (e.g. 2, ,3, 5 or 8 years, etc.) given the current economic conditions and the lack of prudent government policy, these additional monthly income would become their discretionary disposable income that would make them the ideal consumers with a new found consumption power to purchase the goods and services from the small business owners in the local communities.

As also mentioned before, a 100% ownership of future zero appreciation by horizon date is still zero, a partial shared 50% ownership of future 20% or 30% appreciation of their own properties driven by the new fresh capital injection into local communities induced by the SwapRent program will translate into a 10% or 15% gain for them. It seems a much better deal. Meanwhile with the new swapped current monthly income streams they could enjoy the additional flat screen TVs purchased at local malls, lease another new electric hybrid car from local car dealers or eating out more at local restaurants. Wouldn’t that be the American way as usual without piling up any more debts?

In a sense, the more participation by local property owners to the SwapRent program the more additional fresh new capital would be injected into the local community through the new economic landlord investors. That is exactly the reason why this SwapRent program has to be open to all property owners to participate, not just for the distressed homeowners. Let the free market forces rein and the economic prosperity will happen.

Credit and taxpayer’s money may not be the only ways to finance our country’s economic growth. Aside from the current monetary and fiscal policies to manage economic growth, the new outside the box solution could be a tradable economic version of home equity financing. Just think about what economic benefits a stock market has brought to corporate financing through its ability to attract world-wide capital. It is hard to imagine what our world would have been like without the invention of a stock market for corporations.

With this realization, the roles and economic functions of a SwapRent contract and REIDeX that were originally created to accomplish for home financing were purposely made to perform the similar roles and economic functions that a stock certificate and the stock market have already accomplished for corporations for centuries.

When these new tradable equity based home financing objectives have been met, residential real estate properties will soon join corporations to become the dual engines of economic growth of our capitalism society, one for small business and the other for big business. Home financing through debt alone can not make that dream happen, as has been clearly illustrated by the current crisis. Without the stabilization factor of equity, debt financing only creates boom and bust cycles. Therefore instead of a policy of continuing to push banks for more credit at this very moment to repeat what brought us here, it may make better sense for our government to consider helping the private sector entities look for new ways to increase the equity-based home financing.

The best way to make this de-leveraging process happen smoothly is perhaps through the debt-for-equity swap concept built in the SwapRent transactions and facilitated through the new HELM consumer product in order to help homeowners keep their homes, small business owners create jobs, consumers continue to spend and investors contain losses on mortgage assets all at the same time in this all-in-one single effort to ensure a speedy economic recovery for our country.

Again, this proposed SwapRent program could be operated on top of any other plans already in place or currently in the pipeline. It is only supposed to be complementary, not competing with any other homeowners rescue or economic stimulus plans. There are also no conflicts with other plans.

Book Project: SwapRent – A new alternative housing finance system – What it means to you

This entry was originally posted at SwapRent.com Blog on 12/03/2009.

I am preparing to publish a book on SwapRent as a new alternative housing finance system. The book manuscript on SwapRent (The SwapRent Story.pdf) is available for relevant peer reviews upon request.

The new alternative system is not meant to replace any existing lending based systems but rather a new complementary addition running in parallel with the conventional housing finance system. The natural selection process will automatically determine which system will be more popular and conducive to our economic society in years to come.

Here are some unique features of the new alternative SwapRent housing finance system and their advantages:

1.) A new non-lending based housing finance system
- Attractive to both Muslim consumers for religious reasons and Western consumers for practical reasons

2.) A new co-ownership equity financing for homeownership
- No more possibility of a repeat of subprime lending fiasco made worse by securitizations

3.) A tradable economic version of shared homeownership
- Will increase housing affordability for low income families on a world-wide basis

4.) A free market based mortgage loan rescue method without taxpayer’s money to bailout homeowners
- A timely solution to our global economic and financial crisis

5.) SwapRent as a new economic policy tool
- To stimulate the economy and let Fed manage monetary policies more independently

Here below is an outline of some preliminary book chapters:

SwapRent – A new alternative housing finance system: What it means to you
The SwapRent Transactions for Homeowners, HELM and FARM – A New Alternative Housing Finance System

Part One: Introduction

1. Background and Introduction of the SwapRent Concept
2. How Does A SwapRent Contract Work
3. The Benefits of SwapRent Transactions for Homeowners and Property Investors
4. How Could SwapRent and HELM Help the Distressed Homeowners Keep the Ownership of Their Homes?

Part Two: A Review of the Existing Housing Finance Systems

1. A Review of Existing Housing Finance Systems in Selected Developed Countries
2. The Problems with Current Western Housing Finance Systems
3. How Does Islamic Banking and Finance Deal with Housing and Property Investment Issues
4. Housing Affordability vs. Affordable Housing – What it means to urban planners
5. How Will SwapRent Based New Housing Methodologies Make a Difference

Part Three: Technical Aspects of SwapRent – Pricing and Risk Management

1. A Brief Review of the Basic Concepts of the Time Value of Money
2. Derivatives on Real Estate (Property Derivatives)
3. The Pricing Methodology of A SwapRent Contract
4. Variations of SwapRent – AG and DP SwapRent Transactions
5. REIDeX, the SwapRent Marketplace
6. Risk Management Aspects for Financial Intermediaries
7. ALM and SwapRent-based Structured Investment Products
8. Regulatory, Legal and Tax Issues

Part Four: Micro Level Applications and Examples

1. Simple Potential SwapRent Application Examples
2. SwapRent Embedded HELM vs. Conventional Shared Appreciation Mortgage (SAM) or Shared Equity Mortgage (SEM)
3. FARM – A New Type of Housing Finance Products without the Possibility of Foreclosure or Property Repossession
4. HELM vs. FARM The Two Opposite Entry Points of Economic Ownership
5. SwapRent and HELM vs. Conventional Reverse Mortgage
6. SwapRent Embedded HELM vs. Home Equity Loan

Part Five: Macro Level Applications and Their Implications

1. How to Unclog Legacy Assets Trading Liquidity – Short-term mortgage loans arbitrage trading opportunity through offering SwapRent transactions to homeowners
2. Advanced Application Example – How SwapRent program could reduce the re-default rate and create local neighborhood prosperity
3. Residential Real Estate As A Separate Asset Class – The significance to institutional investors such as pension funds and insurance companies
4. The Potential Role of State, County and City Governments – Local Government Sponsored Enterprises (LGSEs)
5. Using SwapRent as An Economic Policy Tool – How small business owners could use SwapRent transactions to create jobs at grassroots level

About

Ralph Liu advises clients on both state of the economy and occasional investment views.