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8.19 An Alternative to Mortgage I


Host:  What is an alternative to the dilemma faced by many home owners- with mortgages coming up for renewal and the interest is very high?  What is SER?


Jamal Badawi:

SER means Shared Equity and Rental for home ownership.  In a way it is a substituted or possible alternative to the traditional that we have used for too long for home ownership through mortgage loans which involves interest.  It is shared equity in a sense that instead of investors giving a loan to the homeowner they are investing in shares in his home.  This means that they would be entitled to a share in the appreciation of the value of the property.  We call this shared equity and rental because both the home owner as well as those who contribute the cash to buy the house or to retire the mortgage are also entitled to a share in a rental value which would be charged to the home owner.  Since others hold a share in the home they get a share of the faire rental value of the house.  This system is designed in a way that would allow the home owner to gradually build up his or her equity as time goes on or he would just pay rent.  So in order to build up his equity he can buy shares and then the amount he pays in rent would gradually decline.


Host:  Could you show us in specific figures how SER works?


Jamal Badawi:

The are a number of steps that explain the system.


The first step, one has to find out what is your own equity as an owner.  Of course this could be a house coming up for renewal so one gets the fair value of the property by appraising it.  We are supposing that the fair value is $50,000.  Suppose you need to retire a mortgage on the property for $40,000.  This means that one holds an equity on the house, based on the fair market value of the difference between the value of $50,000 and the mortgage of $40,000 which is $10,000.  We are not talking here about equity as interpreted by mortgage companies which is usually one’s contribution to the principle not the fair market value.  This system talks about an equity based on the fair market value of the house.


The second step is to divide the market value into shares.  For example a reasonable share would be $1000.  This way the value of the house will be represented by 50 shares.  Step three is that one can simply sell these shares to investors who have interest in buying them.  The amount of investors depends on the needs of the people involved, their financial capabilities.  For example the $40,000 could come from 10 investors putting $4000 each or 4 investors putting $10,000 each.  The beauty of the system is that it is very flexible and it can be applied to a group of friends, or any other group.  In step four the money is used to retire the mortgage or buy a home.  This system can apply to a mortgage that one wants to get out of or it can apply to the case where someone wants to buy a house.  If someone wants to buy a house for $50,000 and he has $10,000 in cash which is the equity and would need $40,000 in shares.


The next question is what kind of benefits the investors would get?  Step five starts with the determination of the fair rental value of that property.  We will suppose that the fair rental estaminet is $450 a month which we multiply by 12 so that we get the annual rental cost of the property.  The total would be $5,400.  Since the whole system operates on the system of sharing it follows then that basic expenses like taxes, insurance should be shared by all share holders and should not be left to the home owner alone.  When a person rents a home they don’t pay the taxes nor the insurance this is the responsibility of the landlord which is the share holders in this case.  When we deduct $900 (tax and insurance) we are left with $4,500 as the net rental income for the year.  If we divide it by 50 shares it comes out to $90 per share.  So one investor would get $90 for each $1000 share.  Under this system the home owner doesn’t have to pay the whole $4,500 to the investors because they also hold a number of shares.  In our example it was 10 shares.  This means that he can deduct his own shares out of the rental.  This means that the net cash he pays out to investors is $3,600 a year (40 shares @ $90 each).


Step six is how much am I going to pay as a home owner.  There are two types of payments that the home owner has to make.  First there is the $3,600 for the rent which is paid to the investors.  If the owner only pays the rental it means that he will not build up his equity.  The assumption here is that he buys back 3 shares a year which would go towards his principle.  So in one year the owner will pay the $3,600 plus the price of three shares.  As we said each share is a $1000 which means that $3000 would be paid by the end towards equity.  So the owner pays a total of $6,600 at the end of the year at a $550 a year.

Host:  This is very practical for the home owner but what about the investors, what are the advantages that they get from participating in the program?


Jamal Badawi:

I agree that the system is far superior from the point of view of the home owner than the conventional system.  It suffices to say that in this system in year one alone the owner is adding three shares to his principle.  As we know under mortgage payments most people pay thousands of dollars in monthly payments and only get a couple hundred dollars towards their principle in a year.  In our example from the point of view of the investor; he is not loosing either.  In this case we are simply eliminating middle men from the operation.  The investor gets a return on his shares in rental values which in this case is $90 per share (profit).  The second aspect is that the share holder shares in rental and equity.  This means if the value of the property goes up then the investor would be entitled to reap some of the value of the appreciation of the increased value of the property.  In other words the value of the share that he holds becomes greater.  In this case $90 per share comes to about 9% and the appreciation in the value of the property is usually no less than 10%.

Host:  Can you explain how the investors share in the appreciation of the property?  Do they have to wait till the end of the contract to collect the appreciation or is it something that works annually?


Jamal Badawi:

No they do not collect at the end of the contract.  This system is different than others that are based on shared equity because you don’t have to wait till the property is sold or the contract is finished to collect.  Those systems also involve interest but at a reduced rate.  This system is totally different because there is no interest dealing whatsoever.  Following the same assumption that we had before that as a home owner in addition to rent you are also buying back three shares a year.  When those shares are bought back they are not bought at the original price of $1000.  At the beginning of the second or any subsequent year, the property value will go up (lets assume at 10%) which means that the value of each share will go up by 10%.  So when the home owner wants to buy those shares you will be paying $3300 not $3000.  Again this is an additional reaping of benefits in addition to the rental value that the investor gets from the owner.


Host:  What happens in subsequent years?


Jamal Badawi:

First of all we have the new fair value in the beginning of year two and the assumption is that the value increases by 10%.  This increases the value of the property to $55,000.  The new share value also goes up by 10%.  The number of shares stay the same.  The only difference is that they change hands.  The new price per share is now $1,100.  Then we go to the rental value which is also assumed to increase by 10% which means that the owner would pay $5940 per year.  But also we have to deduct taxes and insurance from this total which we also assumes has gone up by 10% (it may not increase that much).  Then we deduct $990 (taxes and insurance) from the $5940 which ends up giving us $4950.  This comes out to $99 in rent per share.  The rent paid out here is more than that of the first year because the value of each share has gone up.  Step six, as we said before that the owner does not have to pay the whole $4950 because he himself holds a number of shares.  What happens is the amount of rent he has to pay out will decline because he now owns 13 shares instead of 10.  This means that his share is $4950 shares divided by 50 and multiplied by 13.  So his share would be $1287 and he would actually have to pay $3663 for the 37 shares that they hold.  As we mentioned before he has to buy additional shares in order to acquire more equity.  Supposing that he wants to buy another 3 shares he would have to buy them at the new price of $1,100 per share which gives us a total of $3,300.  The total payment will be for $6,963 a year which comes out to a monthly payment of $580.


If we repeat this again in year 3 with the new fair value of the house and going through each step.  At this particular rate of acquisition one can own the home fully in 14 years.


Host:  Is it possible to stabilize the monthly rental (mortgage) payment?


Jamal Badawi:

This can be done without any problem.  If someone says that they can not pay more than $550 a month for the next five years.  This simply means that in the second year one would buy 2.8 shares instead of 3.  This way one can buy less shares in order to stabilize the monthly payments.  However, if we follow the system it may be more advantageous for the home owner because you acquire equity faster and thus reduce the amount of rent that you have to pay to other investors.  Second, the increment is not that great.  The total payment will be 5-6% more than the payment from the previous year.  This of course is less than what most people get in incrementation in their salary.  So if the home owner can afford it it might be better with a slight increase in the monthly payment to acquire the equity faster in order to reduce the burden.


Host:  What are the legalities of the model?  What protects the investor?


Jamal Badawi:

This can be resolved easily and in fact has been tried more than once.  There is a property in the Halifax area which uses this system.  What is done is the whole property is put as collateral in favor of the investors until everything is paid back.  Legally speaking this is called a mortgage document.  Again lets not mix the word mortgage with the conventional mortgage.  A conventional mortgage is a loan from the mortgage company which bears interest.  What we mean here by mortgage as in a legal term indicating that the property is held in collateral and as a guaranty to the investors.  The only thing that one may have to add to the conventional wording of the mortgage document is that the house is held in collateral is to say that the method of payment of the amount contributed by the investors is determined by schedule A.  Then you would put as an appendix with the mortgage document the specific details and claus which determine how the value will be reassessed and the new values of the shares will be calculated.  Then this would be guarantied and registered with the official registry.


Host:  What are the income tax implications of participating in the scheme?


Jamal Badawi:

This may be a new issue that will face the tax department because the income that you are getting as an investor suppose you put $10,000 and at the end of the year you get your share of the rental value which is $900.  This is a matter that we should get a ruling from the tax department on but it appears to me that it can be dealt with in one of two ways.  It could be regarded as income on investment like dividends because that is basically what it is.  If it it is acceptable to the tax department it would enjoy the deduction which is allowed for interest and dividends.  Even though it is not interest it may be regarded as the closest thing to it and there is a possibility that it may be dealt with as interest for tax purposes.  The other possibility is that the investor can report it as rental income.  Other investors who receive the $90 a year for the first year can report this as rental income.  In the meantime they can also deduct from that total income the depreciation.  These are the three possible ways and whichever way would probably not be less advantageous than any other type of income that one might obtain by way of investment.


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