Myth busting: the truth about equity releases

Despite strong exposure in the media during 2007, there still appears to be some basic misunderstandings of equity release products, and in particular a perception that they will destroy equity value.

This notion was particularly evident in the recent article titled “Reverse mortgages in need of renovation” (Money Management, July 12).

Most dealer groups in Australia have now researched and approved one or more equity release product for use by their advisers, and equity release solutions look set to be a permanent fixture in the retirement advice toolbox.

Sequal has emerged as a strong backbone for the industry, ensuring the interests of clients and their advisers are reflected in product and disclosure standards, and demand for equity release products is growing at 50 per cent per annum.

As a planner investigating the use of residential property equity as a financial asset to support a client’s retirement, there are generically only two ways in which to achieve this: sell the home (either to downsize or to lease back) or leverage the home (either through debt or geared equity option schemes).

The second level of decision-making revolves around what to do with the funds that have been ‘released’, and how the client wishes to receive these funds.

Let’s approach these decisions from the context of a client who fundamentally wishes to stay in their family home (at least for the foreseeable future), does not wish to compromise his or her entitlements to Centrelink benefits and does not necessarily need all the additional funds at once.

There may well be a cohort of retired clients who are happy to downsize from their family home, but in our experience dealing with over 10,000 clients, the opposite is in fact true; the security of having a familiar social structure and the desire to perhaps improve the family home are key drivers in the decision over if and how to release equity.

Sale and leaseback arrangements are available in Australia via home reverse schemes, which involve selling the beneficial interest to all or part of the home at a discount to its market value in return for a rent-free existence.

The home will eventually be sold and the home reversion party will typically receive their share of the full market value of the property.

While there is no interest cost in the traditional sense to the client, there is definitely a cost of capital that needs to be considered when advising a client.

One of the challenges with this calculation is that it is not transparent: the actual cost of capital is a function of the embedded discount to market value at the outset of the transaction time until the property is eventually sold and the underlying movements in property prices.

A further challenge for planners wishing to construct practical financial plans using equity release is that funds under a home reversion scheme are traditionally only available as a single lump sum.

If the client is looking for an income solution, a lump sum of funds may then need to be reinvested, which in turn raises the risk profile of the client’s position (they are exposed to the complex cost of capital calculation referred to above and the underlying performance of the investment). There is currently only one home reversion provider in Australia.

The other option available to planners is to leverage in some form the equity in their client’s property. The leverage is available in a traditional debt form via reverse mortgages, or in a geared residential equity option form via shared appreciation mortgages (SAM) or shared equity schemes.

Traditional SAMs are not yet available to retirees in Australia, but were available for a short time in the UK during the late 1980s and early 1990s.

Clients released equity in return for a geared share of the future capital growth in the property, and were caught unaware when it came time to repay the banks.

The shared appreciation component had escalated during a period of strong house price appreciation, and the banks were entitled to a multiple of this capital growth, leaving an ‘all-in’ cost of capital to customers often as high as 15 to 20 per cent per annum.

Again, we come back to the challenge that financial planners will have in identifying the true cost of capital for the client with these types of products, as the actual cost to the client will be a function of the lender’s shared appreciation multiple and future house price movements.

This is, however, a somewhat simpler calculation than the home reversion schemes, and the expectation is that the shared appreciation multiple for products that may be launched in Australia will be more reasonable than in the UK.

For example, if the shared appreciation multiple is 2x, then for a client whose property appreciates by 4 per cent over the term of the mortgage, the cost of the capital released will be 8 per cent per annum.

This cost may appear reasonable on the surface, but what if property values repeat the past 30 years’ average annual growth rates? If so, clients could be paying in excess of 12 per cent for these funds.

This brings us to reverse mortgages, which have traditionally been the dominant form of equity release products used by financial planners globally.

The reason for this I believe, is that they are able to deliver a higher degree of transparency and flexibility to the planner and the client.

In the recent Money Management article there was a claim that reverse mortgages in Australia lacked innovation and were by nature equity destroyers.

Globally, Australia has the broadest range of reverse mortgage product options available by some stretch. Nowhere else in the world do financial planners have access to a suite of options including fixed interest rates for the life of the loan, capped interest rates, variable rates, line of credits, instalments, protected equity options and specific aged care facilities.

The article also targeted the high interest rates and potential for rising interest rates as a major factor in the risk of equity eroding.

Both these points are without substance; current bank standard variable rates are at 8.07 per cent, and yet reverse mortgages are available on a variable rate basis at 8.20 per cent and a fixed for life basis at 8.50 per cent.

Secondly, the risk of interest rates increasing can now be mitigated through the use of fixed for life rates, or capped for life rates.

In a recent Trowbridge Deloittestudy of the market for Sequal in February 2007, fixed rates were the fastest growing interest rate type on reverse mortgages because planners and their clients wish to remove a key risk from the equation. There are currently over 20 providers of reverse mortgages in Australia.

The cost of capital under a reverse mortgage is also far easier to quantify.

The return to the lender, and the cost to the client, is limited to the interest rate and fees on the loan. Using a fixed for life interest rate for example, a financial planner can forecast with absolute certainty the maximum loan balance for the client at any point in the future, and also the total cost of the funds.

Furthermore, the planner has complete flexibility on how they structure the release of funds to best suit the client’s needs. Clients looking for an income solution need not incur interest on funds they haven’t yet drawn, but can instead draw the funds down at a rate to match their consumption needs.

The last point that should be clarified is in response to the specific comment in the previous article that property prices will need to increase faster than the interest rate on the reverse mortgage in order to avoid equity being destroyed or eroded in the property.

A continued frustration for the entire equity release industry that is working to deploy high quality education and awareness of equity release options is the lack of research behind these trigger-happy comments.

For a generation or two of retired clients who have their assets heavily weighted towards home equity, and who fundamentally do not wish to disrupt their living arrangements, equity release is a valid and practical solution for financial planners to bring to the table.

I wonder if the recent sceptics of reverse mortgages have actually spoken to any of the clients now enjoying a more financially secure retirement, and who have their family fully on board with the decisions made?

Peter McGuinness is chief executive of Bluestone Equity Release.