“If you want to go fast, go alone. If you want to far, go together.”

–African Proverb

HOME PURCHASE

As you may recall from the last post, we worked together as a family to help my kids buy a house in San Francisco. My kids could not manage a purchase solely using their own resources. But by working together, we were able to help them accomplish their goal.

To achieve that, we faced challenges in one of the world’s most expensive housing markets. The city is legendary for million-dollar prices for shacks—literally. You can read here about an uninhabitable house that sold for about two million dollars.

So, it was a challenging process, and in this post, we will talk about that, including both the successes we had–and the mistakes we made.

To recap from the last post, these were the hurdles we had to overcome:

• The gap in affordability–the “kids” were able to afford $850,000 to $900,000, while homes that met their needs were closer to $1,600,000
• The ability for both parties to deal with a worst-case situation—if we worked together, we needed a plan for what to do in the case of job loss, natural disaster or any other scenario that might cause major financial issues for either family
• Sharing risk and reward–in other words, we had to be sure that both parties had something to lose and gain, just as in any standard real estate transaction. That feature provides incentive to everyone to make sure the transaction works, and to work through any difficulties together
• A requirement for written contract provisions—when there is use of money between family members, this feature is essential. A written contract provides a road map for what to do when a property needs major repairs, and has any other expenses. Verbal agreements are subject to interpretation, and not recommended.

Here are the ways we dealt with the four issues.

ISSUE 1: NARROWING THE FINANCIAL GAP

Bridging the gap between the home you want and what you can afford usually comes down to having enough income and a large enough down payment. If you have a lot of reliable income or considerable equity, a purchase is easy. However, even well-to-do purchasers can be priced out in a place like San Francisco. So, we had to do a lot of strategizing upfront.

We reduced and adjusted the overall costs by:

Reducing the borrowing cost

• The loan–as was mentioned before, the monthly cost was reduced by opting for a reduced rate on the monthly payment the first 7 years. A conventional 30-year loan keeps a uniform monthly payment that is higher up front.
• Cosigning—what this means is that the lender could count on my kids income PLUS my family income to repay the loan. In turn, that extra security allowed them to fund the loan at a low interest rate that reduced monthly cost. Cosigning was discussed in the last post and is not a strategy I would ordinarily recommend. See here.
• Boosting equity—we contributed a lot of the equity needed to make the transaction work. Not only did it reduce amount borrowed (and therefore paid per month) it gave the lender the comfort to lend at a low rate. The less lender risk, the lower the interest rate.

Increasing Income

The plan was to remove the cosigning requirement at the earliest opportunity. But, to do that, my kids needed to increase their income over time. So here is what they did to reach that goal:

• Got raises through their work—both of the kids are in promising careers. They eventually started to earn significantly more money
• Obtained rental income—there were short term rentals of part of the house. This was made possible by use of Airbnb/short term rental contracts.

ISSUE 2: DEALING WITH WORST CASE UPFRONT

This practice is a theme of mine. The most dangerous situation for my spouse and me was dealing with a catastrophic earthquake and the potential cost of rebuilding.

The house that we purchased had survived several major earthquakes. So, it was unlikely that there would be an issue, but still…

We purchased earthquake insurance despite the cost (which was high). We also ensured there were enough reserves to cover deductibles if we had to rebuild.

ISSUE 3: SHARING RISK THROUGH EQUITY PARTICIPATION—TURNING MOM AND DAD INTO INVESTORS

We used a standardized agreement. See here and know that I receive no compensation from this site, although I feel they do an excellent job. And if you want to consider this kind of financial arrangement, consult with a fiduciary first. Moreover, don’t try this without consulting and using an experienced attorney.

The basic idea is that we became equity investors in the new home while my kids became owners.

Equity sharing is not like a loan. There is no monthly payment to us that the owner (our kids) needed to make. Instead, we got our initial investment back at the end of the term, in this case, upon sale. As investors, we receive some appreciation gains. But we knew that it could be problematic. Appreciation happens when the value of the home increases and the increase exceeds any costs of sale. If the home appreciates, we make money. When it does not, we know that we might take a loss. My kids too.

There are many versions of equity sharing agreements. However, this was the option that worked best for us.

ISSUE 4: HAVING A WRITTEN CONTRACT

Besides describing the equity sharing arrangement, the agreement lays out the following responsibilities:

• Owner—pays the mortgage, handles minor repairs and maintenance, pays taxes and insurance, keeps the paid-off loan principal upon sale
• Investor—not responsible for owner duties; only responsible for the joint issues below
• Both—jointly share responsibility for major repairs and split the cost of any sale.

This agreement between the owner and investor was executed between both families. A document referencing the contract, a Memorandum of Agreement, and Non-Partition Covenant was recorded shortly after that on the property.

WHAT THE SOLUTION LOOKED LIKE: FUNDING $1.6 MILLION

After working out all of these details upfront, my kids found a suitable house. The purchase price was made approximately as follows:

Kids equity: $100,000

Parents equity: $400,000

Loan: $1,100,000

Total Purchase: $1,600,000

If the equity we invested seems like a lot, I told you—we save a lot and have been fortunate with investments. But, as I write this, I know that many families cannot supply so much equity to their kids–or any at all. But, many can. And equity sharing is an option to consider if you can.

And our kids live within their means too. That makes all the difference in a contract like this. As you can tell, I trust them completely. This is not the kind of transaction I would recommend for parents with unreliable kids. Never enter a partnership with an unreliable person, including your kids—maybe especially your kids.

WHAT WORKED, WHAT DID NOT, OUR MISTAKES, AND WHAT TO BE AWARE OF

The first thing we found was that the story of Old House Revenge was true. If your family is considering a first house purchase, the best thing to do is keep unexpected expenses to a minimum—which means you may want to buy a newer home. Some of the unexpected costs associated with an older house are explained here. For example, the house my kids purchased had state-of-the-art electrical and plumbing systems when Nicola Tesla was a kid. If you have the same situation, expect some maintenance expenses or outright replacement to be necessary.

The second issue had to do with cosigning the loan. Once our kids’ income rose, we wanted to go back to the bank and drop my spouse and me from the loan. But the lender did not want to do that.

So, now being older and wiser, I would advise that it is more realistic to expect to refinance the loan later to remove any cosigning requirement. However, that can involve additional expenses. Even worse, when rates are rising, it can mean a bigger house payment—so caveat emptor.

Finally, the old saw applies even in a hot market—purchasing a house makes sense if you intend to stay there. If not, the exit costs can be considerable and may exceed any appreciation on the property.

Ultimately our kids sold the house after a few years. The reasons were sound. They had better opportunities and needed to move. But for any real estate sale, the costs of exit are high. Escrow, real estate fees, and other expenses cost us approximately 7-8 percent of the home sale price to exit.

We still made a tiny profit. Under the agreement, my kids also made a small profit and got to keep the principal of the loan that they had paid off.

Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice is suitable for your circumstances or investment style.

Photo Credit: Maarten van den Heuvel

License: Unsplash