A Typical San Juan County Family

If you think that housing is not a problem in San Juan County, let me introduce you to John and Mary. They are a young couple, in their late 30s with two children, a boy 4 and a girl 2. Pretty much the ideal family. Most importantly, they love life here in the islands. John has a job that he enjoys at a local utility company and is also a volunteer fire fighter. He is looking forward to participating in sports programs as soon as his son is old enough. Mary is a teacher with a part-time interest and ambition in the arts. She volunteers at the Orcas Center when she can take time away from being a full time mother as well as a full time teacher. They are presently renting a two bedroom apartment and are saving to purchase a home. They have $22,000 put aside as a down payment and their combined income is $65,000. They have no major debts and a great credit rating. They are now finally prepared to purchase a home.

They decide to do their homework ahead of time and get pre-qualified for a mortgage. They would prefer to minimize their risk in today’s housing market by getting a 6%, 30 year fixed rate mortgage, rather than a variable interest mortgage, where their payments could rise in the future. With their income, savings and credit rating, (and neglecting closing costs) they are qualified for a $220,000 home – their down payment, closing costs and a $200,000 mortgage. Their monthly payments for all housing expenses including mortgage payment, tax, insurance and utilities would be approximately $1,600, not a lot more than they are paying for their apartment and within the HUD guidelines of not exceeding 30% of their gross income.

Only one problem. There is only one 3 bedroom, 2 bath house available on Orcas Island, and it is priced at $275,000.

Perhaps they can find a lower mortgage rate, so they shop around. About the best rate that they can find today on a fixed rate mortgage is 5% and that is not expected to last long. Stretching their eligibility a bit, they can now qualify for a $225,000 mortgage or a home priced at $247,000.

Still not good enough.

They are reluctant to consider an adjustable rate mortgage in today’s market, but perhaps they should take the risk. The best that they can do is a 4.5% ARM with an initial adjustment in 3 years and adjustments every year after that. The mortgage program has a cap of 5.25%, so they have some protection against overreaching their expected income when the adjustable rate increases as they fully expect it to do. They now qualify for a $235,000 mortgage or a $257,000 home.

This is still not only not good enough, but it is questionable if they even qualify since their savings would only amount to an 8.5% down payment. And, they are taking the risk that the mortgage payments will increase faster than their incomes.

Very disappointing! Perhaps they should wait another year in order to save enough to increase their down payment. Not a very attractive prospect because with an appreciation rate of at least 8%, which is the last ten year annual average increase, or and perhaps as much as the10% current rate, the equivalent of that same house will cost between $297,000 and $302,000. That is far beyond their ability to save enough to make up the difference.

This family is falling further and further behind, even though they are doing all the right things, maintaining a good credit record and saving as much as they can.

What about affordable housing? Unfortunately, their income places them in the HUD middle income category of approximately $57,000 to $72,000. There are no affordable housing programs in San Juan County available at their income level. In fact, there are no public funds available for a family of 4 with a household income above $48,000.

What alternative do they have?

As much as they love the islands, it is impossible to ignore the opportunities close by. A quick check of the multiple listing service reveals 21 homes with 3BR, 2BA in Bellingham alone in the price range of $200,000 to $225,000. These are all easily within their price range. One of these is a new home close to the waterfront, 1,500 sq. ft. and includes a 2 car garage. Another home is older, but larger with 4 BR. There are similar listings in Skagit and Island Counties. Nearly 50 homes are listed in this price range on the nearby mainland communities.

This family is not alone in this dilemma. In 1990, 30% of the population of San Juan County was between the ages of 25 and 44. That is typical of the demographics of the United States and Washington State in particular. Today, only 20% of the population in San Juan County is in this age group. While the whole population of the county has increased by 47%, the number in this age group has actually declined as they are leaving the county. The cost of housing is a primary factor in this migration out of our county.

Can anything be done with creative financing?

The San Juan Islands are not the only region where this is a problem. John and Mary are not willing to give up so easily, so they decide to search for other financing options. But, they are also practical. Any alternative approach has to be competitive with what they could do on the mainland.

One approach that has been used in many communities is called Land Leasehold. In this approach, a third party retains ownership of the land and leases it to the homeowners. In San Juan County, approximately one third of the value of the whole property is in the value of the land. The homeowners finance and own the structure and pay a lease fee to the landowner. If the lease fee and the mortgage interest rate are roughly the same, the homeowners save the equivalent of about ½ percent compared to what they would have to pay if they financed the entire amount. This is still not enough to help in this case.

Alternatively, employers will often own land that can be put into a trust and used for employee housing. For example, the public school district owns land that could be leased to employees at a very low rate in order to attract and retain employees. Since Mary is a teacher, this might be an option. It is not unusual for a school or university to grant a 99 year lease to homeowners for a token fee. This is the best deal that our young couple could expect to find. Under this approach, their 6%, 30 year fixed rate mortgage of $200,000 with $22,000 down payment and closing fees would allow them to purchase a $220,000 structure on school land valued at perhaps $110,000 for a total equivalent value of $330,000! In the current real estate market in San Juan County, this is enough to afford a highly desirable 3 bedroom, 2 bath home. Alternatively, John’s company may elect to undertake the same kind of project in his behalf.

This is a very desirable solution with the only problem that John and Mary will never own the land under their new home. For some, that is not acceptable. It is also unclear what effect this might have on resale value. Land leasehold is basically the same approach that is used in the local Community Land Trust organizations for low and very low income affordable housing where there continues to be a waiting list for home availability, but there is no local experience with moderate and middle income households.

What about Shared Equity? An approach that has been used in commercial real estate for a long time has recently been applied to residential real estate. Basically, a third party investor provides part of the money needed to purchase the home in return for a share of the appreciation. This third party might be a relative, a friend, an employer or a completely independent individual. There are many unique approaches to Shared Equity, but our future homeowners investigate two very different strategies.

With 8% to 10% per year appreciation in San Juan County, an approach based strictly on appreciation is very tempting. Let’s say that an investor puts up $55,000 to make up the difference between what the homeowners can afford and the price of the $275,000 home. In return, the investor expects the homeowners to refinance in 5 to 7 years to pay back the investment plus a share of the appreciation. Let’s say that the homeowners and the investor agree to an 80% to 20% split based on how much each of them has at risk. After 7 years, the property will have appreciated at 8% per year to yield a “profit” of $157,000 for the homeowners and $39,000 for the investor. Including the principal that the homeowners have paid against the mortgage and an expected increase in income, it is possible to refinance for a new mortgage of $275,000 and pay off the investor. The high appreciation in San Juan County has worked to the benefit of both the homeowners and the investor.

The deal is much more complex than implied here and involves a number of creative tax solutions to work. The advice of a very good accountant or tax attorney is advised before attempting this. For example, the homeowners must pay a “fair market rent” to the third party investor, but the investor may use this money to pay “business expenses” such as a share of the real estate tax, insurance, various fees, and even utility bills that the homeowners would otherwise have to pay. In addition, the third party investor can charge depreciation against his gain and roll over the investment into one after another with deferred capital gain tax on his profit. The homeowners still enjoy a tax deduction for the mortgage interest and their share of the real estate tax. If the homeowners elect to sell rather than refinance, they can receive up to $500,000 in capital gains with no tax. Compared to the same investment on the mainland where appreciation is 4%, the homeowners receive nearly $100,000 more by investing for only 7 years. Therefore, join ownership with an investor can actually provide as much or more appreciation as full ownership on the mainland.

Like all highly speculative deals, this has considerable risk. For example, it is most sensitive to homeowners’ income and assumes that John and Mary receive promotions sufficient to raise their income by 4.6% per year. A drop to just 4.3% pushes the refinance date out to 8 years and each tenth percent drop after that pushes it out another year. It also assumes that appreciation continues at an 8% rate over that term and that a new mortgage can be obtained at the same 6% rate. What happens if the homeowners cannot afford to refinance and do not want to sell? These questions all need to be addressed as part of the initial agreement. Moreover, as the difference between homeowners’ income and property values increase, it becomes increasingly difficult to make this work. Ultimately, the investor has to assume a sufficiently high percentage of the deal that the homeowner’s income increases will never practically be sufficient to buy out the investor.

For example, only five years from now, that same property would list for $404,000 at 8% appreciation. Assuming everything else increases at a 3% rate of inflation, another young couple at the same point in their lives would have a salary of $75,000 and might have saved $25,000. They would qualify for a mortgage of $240,000. To afford the same house, the third party investor would now have to bring $139,000 to the deal. But, the homeowner’s salary is not sufficient to pay fair market rent on the investor’s share. Even if the rent were reduced, they would NEVER be able to buy out the investor, even if the homeowner’s income increased by up to 6% per year!

What can be done to reduce the risk to both the homeowners and the third party investor?

An alternative approach to shared equity attempts to both minimize the risk and provide perpetual affordability. The approach provides a modest annual income to the investor and protects his investment against inflation while giving the homeowners the same increase in value that they would receive on the mainland.

Under this, yet more complex plan, a “Starter Fund” is needed, in this case, $16,000. The purpose of this fund is to assure that the third party investor is paid a modest income in rent for the share of funds provided. This might be paid by an employer or by a charitable organization. Briefly, the investor provides the $55,000 as before and the homeowners provide $22,000 for down payment and closing costs plus a mortgage of $200,000 to purchase the $275,000 house. The investor asks that the homeowners pay 7% rent or a little over $300 per month initially in exchange for the use of the $55,000. Since the homeowner’s income is fully encumbered with the mortgage payments and other housing expenses, this is initially paid out of the Starter Fund. As the homeowners’ income increases, this subsidy is reduced and the homeowners gradually assume responsibility for that debt, within the 30% of gross income budgeted for housing. In this case, it would take 10 years before the homeowners assume all of this payment. However, after only 8 years and income increases of only 3.5% per year, the homeowners can refinance and payoff the investor. This is because the value of the property is capped at same appreciation rate as the mainland, namely 4% and the third party investor’s appreciation is capped at the rate of inflation, namely 3%. If the creative tax solutions of the previous approach were used, the return for everyone is somewhat improved.

No one gets rich under this approach, but the homeowners earn exactly as much as they would on the mainland and the investor receives a reasonable return plus a safeguard on his principal against inflation. But, what of the starter fund? If and when the homeowners sell the property, they are not only restricted to a cap on appreciation at 4%, but they also have an obligation to pay back the starter fund plus an increase sufficient to provide the same financing arrangement to the next buyer. For example, if they were to sell at 8 years instead of refinancing, they would have to pay back $22,000 out of the roughly $86,000 increase in appreciation that they will have earned. On the other hand, if they remain in the house, it will cost only a total of $2,000 extra for the 8 years or $250 per year to stay on the island. Does that cost justify living on the islands rather than on the mainland? Only the homeowners can make that decision.

The message in this story is that there is still hope for middle income working families in San Juan County, if we start now to find solutions. While the days of simple mortgages are over, there are financing approaches that might see us through to the future..