The latest private credit tool

Good morning, this is Sujeet Indap filling in for Rob today. Did you hear that there is a US jobs report coming out today? Anyway, while you wait on pins and needles, read on for the latest news in the field of private credit financial engineering. Email me your dream (or nightmare) loan product: [email protected].

There goes the neighborhood

There is $35 billion trapped in U.S. residential property equity. And it deserves a much more sophisticated capital market, says Thomas Sponholtz.

A few weeks ago, I received a press release from the venerable Carlyle Group announcing the latest cutting-edge tool in the private lending frenzy. But this ad business stood out for me. Carlyle said it is partnering with finance startup Unison, whose founder and chief executive Sponholtz is a former chief executive of Barclays Global Investors.

Sponholtz has long believed there was room for innovation in home lending, particularly in how Americans could monetize their home equity. Home equity loans, home equity lines of credit, and reverse mortgages were all debt products that, in one way or another, had to be repaid with interest by the home owners.

But what if homeowners get liquidity by avoiding a fixed obligation and instead monetize the upside of their property? And so Sponholtz’s company, Unison, created what it called an “equity sharing agreement” in which the homeowner effectively sells the equity in their home in exchange for cash up front.

But the equity-sharing deal was just the beginning. Carlyle and Unison have now come up with their next frontier idea: homeowners deserve a convertible bond too.

House rules

So far, the initial equity product has about 17,000 customers and its total home portfolio is worth a total of $7 billion.

Unsurprisingly, Unison’s immediate cash isn’t cheap. The company will buy up to a 15 percent interest in the homes, spending between $30,000 and $500,000 per home. The owner will pay for a valuation and Unison will invest at a 5% discount to the assessed value. There is also a 3.9% transaction fee.

And finally, at the time of the sale, which must happen by the 30th year, Unison is owed four times the proportion it put up. To put some numbers, imagine a deal where the firm buys 10% of a $1 million home.

In a decade, let’s say the house is worth $1.5 million. Unison gets $100,000 back as well as 40% of the winnings, or $200,000. Home value increased by 50% over 10 years reflects an annual rate of return of 4.1%. Unison’s $100,000 investment turning into $300,000 reflects a return of 11.6%

(Importantly, the homeowner’s equity gains from paying off the original mortgage are retained by the homeowner and their own equity returns are, of course, determined by the size of the down payment at the time of purchase).

Unison says its returns have been annualized by 21%.

Sponholtz told the Financial Times that he had struggled for years to figure out how to take exposure to owner-occupied residential shares, but that there was no security or direct proxy. Housing was important not just for its gross market size, but also because it was a “dirty hedge” against inflation, the main risk in fixed-income investing, he said.

“House prices rise with inflation. . . you have a really interesting investment that neutralizes negative convexity,” Sponholtz said, referring to mortgage prepayments that go up when interest rates go down and go down when rates go up.

Enter private credit and Carlyle. Unison has had some success bundling its equity-sharing deals into structured products – it recently secured a credit rating for the tranches created. But the pure equity product, by definition, comes with erratic cash flows that have made securitization difficult.

So Unison wondered if it could merge real estate debt and equity into one product. It therefore created the “equity share loan” which resembles a convertible corporate bond with its fixed obligation attached to a call option.

Here’s how it works: A homeowner takes out a second mortgage to get immediate cash — but the interest rate on the second mortgage is lower than the market rate. In return, Unison receives 1.5 times its proportion in the future appreciation of the house (note that this is less than the four times it is owed in the direct equity product described above).

In an example on its website, Unison said it would cut almost 2 percentage points from a straight loan interest rate (which is charged at 5.2 per cent per annum instead of 7 per cent) from the ‘coupon’ in cash owed to him. At the end of the 10-year loan, Unison will, however, receive its 1.5x appreciation share, as well as the total capitalized amount of the initial savings of 1.8% at the cash interest rate (ie 7% minus 5.2%) .

Carlyle estimates the total cost of equity loan capital of 10% to 11%: 6% cash interest, 2% cash deferred “pay-in-kind” interest, and 2 to 3 percentage points of segment kicker equity share.

Unison said its typical customer has a Fico score of over 700 and the usual use of the proceeds is home improvement or paying off credit card debt. The company says its share-sharing product is much cheaper than getting an unsecured loan from the likes of SoFi.

Carlyle has agreed to buy up to $300 million of such loans from Unison, which it can then pass on to its insurance clients.

“We take high-quality assets and make them attractive, helping private markets finance the real economy,” said Akhil Bansal, head of strategic credit solutions at Carlyle.

Sponholtz says Unison has several products in the works, including providing financing to help with down payments (recall this recent Wall Street Journal story about friends buying houses together during the pandemic).

Consumer finance is a tricky balance between innovation and exploitation. Lending money to people, extracting user fees, and using leverage to turbocharge everything is extremely profitable (just Google “subprime billionaires” to see for yourself).

Residential housing is equally fraught given its centrality to the lives of individuals and families. Just last month, Invitation Homes, the single-family home group created by Blackstone, settled for $48 million with the US Federal Trade Commission for charging renters unwanted hidden fees.

More advanced financing should join the gears of capital formation and ultimately housing construction. Unison and Carlyle believe their mousetrap will do this, and America needs them to be right.

A good read

My colleague Andrew Jack examines New York’s worst current scourge: rats.

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