How innovations in equity finance could make home ownership safer and more affordable.
Equity finance is an innovative way of helping consumers reduce the risks of home ownership while providing additional funding for house purchase. It can also make buying more affordable and potentially bring greater market stability.
So far, most equity finance initiatives have been government sponsored. This report looks at reasons and opportunities for the development of private sector products for a wider range of households, who are looking to manage their housing assets or debts more safely and effectively.
This report reviews:
- the reasons for introducing equity finance into home purchase;
- the products being developed to deliver equity funding to households
- the challenges that have to be overcome if equity funding is to play a significant role in the market
- and the benefits that would flow from such innovation.
Home ownership in the UK is traditionally debt funded, which has proved risky in recent years. Yet demand for owner occupation remains strong. This project considered the possibilities and practicalities of balancing traditional debt funding with innovations in equity finance, which funds home purchase by sharing investment risks and rewards between home-buying households and financing institutions.
- Equity finance can help to make home ownership more affordable and less risky, individual wealth portfolios less housing-centred, and housing markets less volatile.
- Government has led on equity finance, aiming to improve affordability and support the construction industry through a range of equity-sharing products.
- Private-sector initiatives are less well developed, but cover a wider product range. As well as equity share they include shared ownership and rent-to-buy purchase plans. There are also savings and investment vehicles linked to house prices, which can allow tenants as well as owners to benefit, and a house price insurance product, designed to protect home buyers against negative equity.
- Most equity-linked products cluster at the margins of the market. They have not achieved scale. This reflects institutional and regulatory inertia, practical difficulties in bringing products to market, lack of liquidity in funding streams, lack of clarity around costs and benefits to consumers, and the Government’s continued emphasis on debt finance.
- Equity finance has made progress towards bringing in more funds for housing while reducing risks for households and government. But it has a long way to go and faces many challenges. However, the benefits are such that equity products ought certainly to form part of the future funding stream for UK housing.
Equity finance funds home purchase by sharing investment risks and rewards between home-buying households and institutions, usually financial organisations, landlords or government. It potentially reduces the costs of owner occupation, and can create the capacity to spend from housing wealth without adding to mortgage debt. This radical edge merits closer attention.
The case for equity finance
To the extent that risk-sharing in housing markets occurs at all, it mainly takes the form of credit and interest-rate risk-sharing mortgage contracts, supplemented by a suite of insurances to protect lenders and borrowers from the costs of default. Hence most risk-sharing in housing markets relates to debt; there is as yet practically no investment risk-sharing. This is problematic not only because housing markets are volatile (so investment risks are high), but also because home ownership increasingly forms an asset base (so home-owning households are vulnerable).
Equity finance addresses this gap in risk management by enabling home-buying households to share the costs and profits of their housing investments directly or indirectly with one or more institutional partners. As a result, price volatility risks to households are reduced, with the additional potential to enhance affordability, balance wealth portfolios and help stabilise the wider economy in the long run.
Current policy focuses on restoring ‘business as usual’ for high loan-to-value debt funding. However, there are at least five reasons for looking to equity finance to bring balance and completeness to the housing market:
- The general lack of debt finance is likely to persist into the medium and long term; new funding sources are needed.
- House price volatility and investment risks are likely to grow in the face of constrained supply and an uncertain macro-economic future; these risks need better management.
- Households are increasingly vulnerable to housing investment risks, especially as they come to depend more on their own assets throughout life and into older age. This creates need and demand for more comprehensive risk-sharing products.
- Thinking creatively around cash flows is essential, especially if the goal is to enable entry to home ownership for households whose incomes are likely to rise over time. Product innovation is critical.
- Most fundamentally, equity finance turns attention to the relative costs and attributes of different tenure arrangements and the possibility of using equity finance to better meet the variety of needs and demands.
The UK has led on developing equity finance, in funding shared-ownership projects and equity share schemes. The impetus has come mainly from government, with the aim of widening access to home ownership, overcoming initial affordability problems and supporting the construction industry. Private-sector equity finance, in contrast, is in its infancy, with only a handful of products at or close to market. Funding is also at an early stage, making it hard to judge viability, sustainability or likely scale.
Equity finance: product range
There is a large number of innovative products, but none yet available at scale. It is unclear whether many have the potential to achieve this. They fall into two main groups:
- Savings and investment products, which potentially form a gateway to home ownership by encouraging larger deposits and reducing loan-to-value ratios on conventional mortgages. They are divided according to whether or not they are contractually linked to specific mortgages, and whether the returns are linked to interest rates or house prices. The latter are particularly innovative in protecting deposit savings against volatility.
- Home purchase products, which enable buyers to share the costs and risks of buying, holding and occupying homes. They comprise three groups: shared ownership, where properties are jointly purchased and the occupier pays rent on the investor’s share; equity share, where investors buy an equity stake and receive a return, sometimes deferred until the property is sold; and home purchase plans, which are ‘rent’-to-buy arrangements that spread the purchase costs across an agreed payment period, with the provider levying an occupation charge.
Whether equity finance innovations can gain sufficient traction to spread from the margins to the mainstream depends on several factors, notably the sources and volumes of funding. Most funding to date has been from government for niche products. This is unsurprising since the market is not used to delivering equity finance, set-up costs are high, and returns are uncertain. To operate at scale in the future, there are three possible funding models:
- Retail to retail, for example using savings schemes linked to house prices to fund equity share. This is the equity finance equivalent of using deposits to fund mortgages. Providing the pattern of equity investments matches that of the house price index, it is feasible and appealing.
- Investor to retail, for example using institutional indirect property/property fund investments to finance home purchase products whose revenue streams provide the return.
- New financial instruments, for example independently traded contracts linked to house prices, enabling product providers to manage their risks using financial markets. Such products may be necessary if the equity finance market is to achieve scale, but reputational and other risks may be prohibitively high.
Even with a variety of providers, assured funding streams and an appetite for change in the world of politics and policy, the future for equity finance depends on overcoming four key challenges:
- Securing significant consumer demand. Equity finance offers qualities that debt funding does not, such as: greater affordability with lower leverage; investment risk management, including potential protection against negative equity; and portfolio balancing to avoid concentrating wealth in a single home. Demand exists for the first of these, but success may depend on cultural shifts creating demand for the other two. The core issue is whether consumers value these attributes, find the products cost-effective and prefer them to more traditional debt funding.
- Ensuring consumer capability and protection. Equity finance is a new concept for most consumers and advisers, whose learning curve will be steep and require active support. Regulation is essential to protect consumers against mis-selling without exposing providers to unmanageable reputational risk.
- Designing transparent, cost-effective products. Few equity finance products are at or near the market today. Two critical design aspects are the apportionment of responsibilities (for repair, maintenance and eventual sale) and price. Transparency is key in both. Regardless of how products are priced, the challenge of securing attractive returns for investors while delivering cost-effective products for consumers is considerable.
- The question of scale and the possibilities for systemic stability. The future for equity finance may turn on the government taking a lead in developing the product range, supporting the principles of equity finance, addressing regulatory matters and perhaps providing guarantees. This may be justified if it is possible to achieve sufficient scale to stabilise housing markets and benefit the wider economy. Currently, however, government is backing traditional debt funding through extensive guarantees, limiting the scope for innovation.
Debt funding will continue to dominate UK housing finance for the foreseeable future. However, equity finance offers a complementary approach that could ease affordability, reduce volatility and add to macro-economic stability. This vision of a housing system in which owner occupiers can separate housing investment decisions from those around housing consumption (purchase of housing services) may be a long way off. But by adding to the product range, equity finance promotes welcome diversity at a time when debt funding is under strain.
There is also the promise of greater financial inclusion – in that renters could have a stake in the housing market too – and easing of the tensions generated by restricted access to home ownership. Equity finance brings a new dimension to risk-sharing in housing markets, potentially changing how households think about housing assets in relation to their overall household balance sheet.
As the dominant provider of equity loan products, the Government is central to this market’s future. However, the policy agenda is driven primarily by concerns with easing access to home ownership rather than by comprehensive risk reduction or any attempt to reform the underlying structure of the housing system.
Whether equity finance will prove to be more or less costly, appealing, sustainable or policy relevant than debt funding is not yet clear. Nevertheless, it is important to find space for both in the UK housing market.
About the project
The research was undertaken in 2012 and 2013. It comprised interviews with key players in the market and the Government, an examination of product literature and a roundtable discussion.