It's not a gift, it's an investment

Family member seeks healthy return for help with down payment, mortgage

By Jack Guttentag
Inman News

Gifts of equity within the family are common. Parents often provide the down payment on their child's first home purchase. Many parents, however, can't afford a sizeable gift -- among other things, they may be concerned about the adequacy of their assets for retirement. Yet they might welcome an opportunity to help their children if it took the form of a reasonably safe investment yielding an adequate rate of return.

A house purchase by a family member may provide such an investment. Over the years, I have advised a number of families who asked me about how to set up a plan that would meet their particular needs. I even wrote a few articles describing such plans. On reading these articles now, however, I am not very pleased because they provide limited help when the individual circumstances differ from those in the article, as they often do.

Usually the investor contributes to the down payment, but some home buyers may need help with the monthly payment as well. In addition, sometimes the investor is a co-occupant, though not necessarily for half the house.

I have come to believe that there is a large untapped market for intrafamily investments in house purchases. The reason that so few actually materialize is that every deal is different, and designing it properly is very complicated. To remedy this, I have developed a spreadsheet that accommodates a wide variety of preferences of the home buyer and the investor.

The spreadsheet calculates the percent of the home equity (property value less mortgage balance) that is owned by each party at the end of each year. The respective ownership shares depend on the amount they each contribute to the initial cost of the home, the amount they each contribute monthly, the rent that is credited to the investor, and the interest rate that is used to calculate the future value of each party's contributions, including the rent credit.

The spreadsheet has two purposes. First, it is a simulation tool that allows the buyer and investor to see how each will fare under alternative combinations of interest rate, rent credit, investor contribution and property appreciation rate. They can try different scenarios to find the one that leaves them both satisfied.

Second, the spreadsheet provides the accounting record of where the parties stand at any point in time. They can watch their equity shares change over time, and can use the simulation capacity to forecast what they will be in the future.

The spreadsheet is a tool, not a contract. To use the tool effectively, the parties should have a contract that addresses four major issues.

Rent Credit: The parties must agree on the rent payment credited each month to the investor. The rent credit ought to approximate what the home could be rented for in the market, net of taxes, insurance, utilities and routine maintenance, all of which the occupant should pay. If both parties are occupants, the rent credit disappears or, if they occupy different amounts of space, is scaled down.

In addition, there must be agreement on how often the rent will be adjusted, and how. One possibility is to adjust the rent credit every year in line with changes in the rental component of the Consumer Price Index.

Interest Rate: The parties must agree on the interest rate used to calculate the future value of the contributions. The rate should approximate what the investor could earn if the funds were placed in investments of comparable risk. In many cases, the mortgage rate might serve quite well as the investment rate.

Property Improvements: Because of the potential for conflict, it is useful for the parties to agree beforehand on how improvements are to be handled. The spreadsheet treats expenditures on improvements in the same manner as other payments, recording a credit to the party making the expenditure. However, investors and occupants won't necessarily have the same interest in an improvement. For example, the occupant might want a swimming pool, which might add little to the value of the property.

One approach would be to reduce the credit on improvements initiated and paid for by the occupant using a credit schedule based on general experience. For example, an added bedroom might be a 100 percent credit while a swimming pool might come in at 40 percent.

Termination: Most investors, even within the family, want to terminate the deal and get their money after 5-10 years, so a termination provision needs to be included. Assuming the buyer has not sold the house before the termination date, the investor must be paid off. This may require the buyer to do a cash-out refinance based on the equity remaining after the investor has been paid off.