Homeowners who wish to reduce the risks to their home-equity investment, and/or those who have other investment opportunities with higher returns than their home equity, should consider using a REX agreement. This contract is a home-equity risk/ return sharing arrangement that allows the homeowner to effectively sell home equity (without selling the house) and reinvest the money. In this article, we'll analyze REX & Company's agreement, the after-tax financial impacts, and take a look at a few examples that will help potential users to evaluate whether they are likely to benefit from them or not. (For background reading, check out REX Agreements Climb As House Prices Decline.)
A REX agreement is similar to a forward sale contract with a deposit (except it has no maturity date) in that it is an unexecuted contract prior to termination.
Tax-accounting treatment is employed the same way as for an option. When the contract ends with the sale of the house, the upfront payment will be considered part of the sales proceeds, and the final settlement payment from the homeowner to REX & Co. offsets the sales proceeds received. So, as long as the total gain on sale is within the excludable amount on the principal residence, the gain on the hedge will not be taxed.
There is no definitive treatment under the current tax code when the homeowner terminates the REX agreement before a sale. However, a net payment by REX & Co. to the homeowner (i.e., after the five-year penalty period) would surely be taxed as ordinary income. A payment from the homeowner to REX & Co. at termination would most likely be treated as a capital loss, the same as the closing of an option contract.
Because the homeowner cannot collect for house-price depreciation if the agreement terminates in the first five years, the contract is only useful for long-term hedging. Still, even a two- or three-year agreement may be profitable if the upfront cash earns good returns. You only need cumulative after-tax returns on the cash to exceed the penalty in order to come out ahead. Figure 1 below shows the maximum appreciation rate for which the homeowner's profit is exactly zero during each of the first six years - assuming a 50% sharing REX agreement and 6% after-tax returns on the up-front cash received by the homeowner. (Note: These calculations assume that the payments to REX & Co. are not tax deductible.)
|Figure 1: All amounts expressed as a percent of house value|
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At this rate of return on cash, the table indicates that you should not enter the REX agreement unless you intend to keep the house more than two years. Beyond two years, you come out ahead even after paying the penalty for early termination so long as house appreciation falls below the levels shown here. Given the high probability of prices dropping during the next five years, homeowners who do not plan to sell should benefit from a REX agreement.
While the risk-management benefits of using the REX agreement as a hedge are clear, a homeowner should understand the full range of possible financial outcomes. For this we must analyze the results for the various combinations of returns on cash and potential changes in house values. Assuming the REX agreement is outstanding for five years plus one day, the homeowner avoids the termination-penalty payment and will be paid for any price depreciation.
Figure 2 below provides the range of outcomes for a five-year period - assuming the maximum 50% sharing agreement. This table can be extrapolated to sharing agreements with smaller percentages of sharing by scaling down the results accordingly (i.e., a 20% share is 2/5 of the table result). In terms of actual dollars, you would multiply these percentages by the original value of the house at the inception of the REX agreement.
|Investopedia.com © 2008|
Each payoff table column shows how much you would gain (or lose) in five years with a REX agreement, assuming your returns on the upfront cash payment received match the rate shown at the top of the column. The rows correspond to assumptions about the cumulative five-year house-price changes as shown in the leftmost column. As an example, assume you entered a 50% sharing agreement when your house was worth $1 million, and you reinvested the up-front payment at a rate of 6.80% after tax. If the house declined to a value of $900,000 (down 10%) at the end of five years, then your gain from the REX agreement would be $106,000 (10.6% of $1 million).
REX's Point of View
At this point one should wonder why REX & Co. would offer this deal. Because of the long lead times in developing such financial products, it is likely that this was conceived and designed, and the funding commitments obtained, before the housing market cooled down in 2007. The product may eventually be withdrawn if the funding sources become sufficiently pessimistic about housing prices. (Learn more about the 2007 mortgage meltdown in The Fuel That Fed The Subprime Meltdown.)
Benefits to Institutional Investors
Fundamentally the concept has a lot of appeal to institutional investors because these investors will see the REX-agreement investments as providing them with a diversification opportunity. This fits with their fiduciary duties, since they are guided by a tenet of modern portfolio theory that says diversification is very important for minimizing risk for a given level of return. (To learn more, read Modern Portfolio Theory: An Overview.)
With extremely long investment horizons, home-equity investments provide a new opportunity to diversify into an asset class that they could not access previously. They expect the correlation of returns with their other investments to be very low. Thus, in theory, it should reduce their portfolio's overall risk. Whether this is poor market timing will not be known to them until after the fact. Institutional investors often give such issues lower priority than improving on their application of portfolio theory. (Keep reading about diversification in Introduction To Diversification and The Importance Of Diversification.)
Another point worth noting is that the REX agreement effectively provides them with a leveraged investment in housing: they get the rights to a larger percentage of the house's change in value than they must pay cash for up front. The agreement turns out to be the equivalent of the owner loaning a portion of their share to REX & Co. in return for free rent on REX and Co.'s share of the house. This relatively cheap leverage would provide very good returns if houses appreciate at their historic long-run rates.
From a homeowner's point of view the REX agreement can be an effective way to hedge against declines in house prices. This tool provides an opportunity to preserve capital and reduce risks of home ownership without selling your house. In order to take advantage, however, you will need to keep your house at least two years and invest the upfront cash wisely.
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