The investor should receive more
than 20% of house value when he exits the relationship because you get to live
in the whole house, not just in the 80% of the house that you paid for. The
challenge is to calculate that amount in a fair way, without making it too
complicated.
The key is the rental value of the
house -- what the house could be rented for if you put it on the market. This is
the best measure of the value to you of being able to live in the house. From
this, deduct the costs of maintenance, which you are responsible for, to obtain
the net rent. You owe the investor 1/5 of the net rent every month.
Note that you do not deduct
the mortgage payment from the rent, because that is solely your responsibility.
If you had paid cash for your 80% share instead of borrowing it, you would owe
the investor the same amount.
It is important for you and the
investor to agree on an initial rental value, or on a procedure for determining
it. This includes agreement on whether the initial rent will hold for 7 years,
or if the rent is to be adjusted over time. If it is to be adjusted,
furthermore, you must agree on an adjustment procedure. As an illustration of
one possibility, the rental value could be adjusted every year in line with
changes in the rental component of the Consumer Price Index.
The amount due the investor each
month can be handled in at least three different ways. The simplest way is for
you to pay it in cash. If you did that, his share of ownership would remain at
20%. In all probability, however, both of you will prefer to defer any payments
until the house is sold or the 7-year settlement point has been reached.
Assuming payment is deferred, you
could treat it as a debt to him that accumulates over time. If you adopt this
approach, you both need to agree on the interest rate that is applied to this
debt. Then at termination, he would get 20% of the property value plus the
accumulated value of the debt. With this procedure, the investment is a
combination of equity plus debt.
A second way, which the investor
will prefer if he wishes a strictly equity investment, is to use the amount due
each month (or each year) to purchase an additional share of the equity. In this
case, you have to agree on whether the value of the house used in this
calculation is the initial value or the current value.
This decision is related to the
earlier decision regarding rental value. If the rent is adjusted every year, the
property value should be as well. Much the simplest approach, however, is to use
both the initial rental value and the initial property value throughout the term
of the deal. It isn�t as accurate but it is simpler and less costly. It avoids
having to get the house appraised every year.
A potentially thorny issue that
ought to be faced at the outset is how you treat an improvement in the house
that enhances its value. If you pay the entire cost of an improvement, the
investor receives an unjustified windfall. You would expect the investor to
contribute to the cost in proportion to his ownership share.
From the investor�s point of view,
however, there is a danger that an improvement will not increase the value of
the house by enough to cover the cost. You might want to build a swimming pool,
for example, but as an investment pools are a loser. It may be OK with you
because you like to swim, but the investor will not want to subsidize an
enhancement to your lifestyle.
It follows that the investor is
unlikely to agree in advance to contribute to any improvements that you might
want to make. You are going to have to negotiate these when they arise. For the
deal to work for both parties, you should have a good relationship.
29 August 2005 Postscript
An investor who read this article
suggested another approach that he uses. Instead of receiving a portion of the
total house value for his investment, he receives a portion of the increment in
value. For example, he provides 10% of the sale price as down payment and
receives 50% of the increment in value over the period covered by the agreement.
This is a much simpler approach.
Copyright Jack Guttentag 2005
