You are really going to like the new Annual Information Forms (AIF) that publicly traded companies are issuing. They take difficult business models and break them down into plain English.
When a company goes out to raise funds for a new stock issue or a debt financing, we will often get to read the prospectus. It’s full of detail and speciality terms and expressions, but the AIF isn’t. It discusses the business they are in, who their competitors are, why they make money, even who the directors are and how many shares they own. This week I want to review how a reverse mortgage works, so I thought a good place to start would be a review of a company called Home Equity. They are listed on the Toronto Stock Exchange and earn their cash flow from creating a reverse mortgage portfolio.
They just recently applied to become a bank, as this would give them access to even cheaper financing than they currently raise in the debt markets. Searching through their latest stack of financials, I came across the AIF, and that’s where I ran across this tidbit. Canada’s aging population creates an attractive environment for the reverse mortgage market.
Seniors will continue to be one of the fastest growing population groups in Canada. Statistics Canada estimates that by 2016 seniors will represent 17 per cent of the population. Based on data from a 2001 census, 1.71 million homes are owned by this age group, of which 85 per cent are reported to be debt-free, resulting in 1.45 million mortgage-free homes in Canada owned by persons age 65 or older.
At the current average national home value, and assuming an average loan to value of 30 per cent (I’ll explain that in a minute), and a 10 per cent market penetration, this market represents approximately $9 billion in potential reverse mortgage volume.
A reverse mortgage has all the terms and conditions of a regular mortgage, except a payment. Instead of paying the mortgage down, the payments you would normally make compound the debt up, so you owe more as time passes, not less.
Think of it from the lenders perspective. They want collateral and a very high likelihood that they will get back all their principal and interest. Unlike a traditional lender, a reverse lender doesn’t know when they will get paid back, just that they will.
Here’s a typical deal. Bob and Betty own a lakefront home in Vernon. When they bought it 50 years ago, the town folk thought they were nuts. Who wants to drive all the way out there on that pothole road, slip and slide out during the winter and have a big mortgage payment?
Well, you can guess what happened. The big mortgage payment is all paid off, the house and property are worth over $1 million, and the town folk are saying they all knew lakefront was a great buy. But for Bob and Betty, there was no extra for building up a big savings or investment account, and consequently they are real estate rich and cash flow poor.
They want to stay in the lakefront home for several more years, but with higher property taxes and less income what choice do they have?
It’s what we refer to as broke, but not poor. That’s where a reverse mortgage (or similar arrangement) can let them stay on.
The lender looks at the market value of $1 million and agrees to lend them $300,000. That’s known as the loan to value ratio, and in this case it’s 30 per cent.
Reverse mortgages typically have the ratio in this area, so that is very different from a typical mortgage in that most homes loans are in the 75 per cent to 90 per cent range, loan to value ratio, zone. The rate floats, usually 4.5 per cent over the t-bill rate, so around 6 per cent these days.
At that rate, after five years the homeowner would owe $400,000. Note how the mortgage is climbing up in value, which makes you wonder what the value of the real estate collateral is doing.
One interesting career for the mathematically inclined is that of an underwriter. You figure out what rate and terms you can lend at so that your credit rating will stay high. The flip side is an analyst at a credit rating agency who reviews your lending policies and criteria and gives you a credit rating.
That’s why this business of issuing reverses has evolved into the 30 per cent loan to value ratio range. It’s where the risk for the lender maintains the structure with a double AA rating.
The underwriter assumes the real estate values increase by the rate of inflation, so if the CPI is running at 2.5 per cent a year, then that $1 million property is projected to be worth around $1,131,000 after five years.
The mortgage value is up by $100,000, the value of the real estate by $131,000, with lots of room for error either way. So, for example, the net after selling the home and paying off the loan would be around $700,000, plus the value of the $300,000 income portfolio, so we’ll say $1 million net.
About 75 per cent of all reverse mortgages are paid out within the first 15 years of the loan so many reverse borrowers are using the loans to extend the time they can stay in their homes, using the funds borrowed for trips, property taxes, gifting, and new kitchens (where else can you lend money and watch your borrower increase your collateral value?).
There are alternatives that can create similar outcomes for those borrowers focusing on short-term solutions, as in how do we stay here just another five years? You could put up your home as collateral for a line of credit.
Let’s say you just want to have an extra $15,000 a year (which would be like earning 5 per cent after tax on that $300,000 loan).
So for the next five years you keep bumping up your credit line by a $15,000 withdrawal. At the end of the fifth year you owe just over $90,000. In this scenario, the net works out to around $1 million plus $40,000.
There are so many variables in this calculation, as it depends if your intention is to spend only the income you generate, or spend part of the $300,000 loan on consumable items right away. Either way, the concept of borrowing against a debt-free principal residence allows retired homeowners to stay in their home for a few more years.
The exercise of thinking investments through in reverse is good practise, always try to visualize both sides of the transaction. The exercise of reading the AIF for any business you work in or invest in , is an exercise any new investor should try.
Dave Ellis is a certified financial planner and a fellow of the Canadian Securities Institute. He is a vice president at RBC Dominion Securities in Vernon.
If you would like more information here’s the roadmap to get a read on AIF from Home Equity. Go to www.sedar.com. Access the company profiles, under H for home equity
income fund. Scroll through looking for the Annual Information form
published March 28,2008.
Source
No comments:
Post a Comment