An Alternative Rent-to-Own Housing Model
TL;DR When a renter pays rent, their landlord uses that money to pay the mortgage, taxes, and expenses. Each time a mortgage payment is made the landlord is granted a little more equity in the property as the loan is paid back. What if renters were rewarded with this equity instead? This article outlines a framework to do that.
The rental housing industry is antiquated, inefficient, and distributes wealth unequally. There are four pillars of the argument against traditional renting practices: 1) housing is a human right¹, the need for an affordable place to live exists because shelter is a primary need; 2) the rental cycle is devastating for families that are rent burdened. The barrier to saving for a down payment, the cornerstone of the traditional home ownership process, is extremely difficult, if not impossible, for rent burdened families; 3) With an increasingly transient population, that is, people relocating more often and holding jobs for shorter durations of time, the decision to settle down and purchase a home is delayed for later in one’s life; 4) When residents of a city are not owners, decisions about the future of that city lie at the bottom line of the balance sheets of those with ownership control. This leads to the displacement of people from their homes, gentrification, and increases concentrations of wealth².
How does the current housing system work? The most common models of providing housing today include renting, rent-to-own, owning through a mortgage or private lender, and cooperative housing, each having their own financial implications and effects on lifestyle flexibility.
If we focus in on renting as of 2016, 36.6% of all US households rent, with the remainder under ownership agreements. When this is broken down by race/ethnicity we see, “58% of black household heads and 54% of Hispanic household heads were renting their homes, compared with 28% of whites.”³ Not only is the ratio of renters to homeowners skewed based on ethnicity, but “72% of renters said they would like to buy a house at some point. About two-thirds of renters in the same survey (65%) said they currently rent as a result of circumstances, compared with 32% who said they rent as a matter of choice. When asked about the specific reasons why they rent, a majority of renters, especially nonwhites, cited financial reasons.”⁴ The idea that renting is largely a choice is false, and continuous external pressures seem to ultimately control this decision.
As rental prices have increased, wage growth has risen only modestly, “median renter household income rose just 0.5 percent from 2001 to 2018, while rents rose nearly 13 percent.”⁵ The more pressure that exists on paying higher rents with lower wages, the more difficult it becomes to save for a down payment.
One tool that’s been implemented and debated is rent control. Although seemingly straight forward, the policy of rent control receives mixed reviews from economists in terms of its effectiveness. In the short term, it provides a way to resist rent hikes. However, studies show that long term consequences include limiting housing supply by discouraging investment in rental properties, and a mismatch of Tenants and rental-units as people become unwilling to give up their rent-controlled apartment if their needs or family size change.⁶ Still, at the end of the month, the rental payment for housing evaporates as it becomes someone else’s equity.
Why is owning important at all? It’s a common trope that owning a house is better than renting for financial reasons in the long run, but it’s much more nuanced than that of course. Below is a quick comparison of the advantages and disadvantages of home ownership.
- Wealth creation through equity
- Certainty and control of residency
- Property value appreciation
- Tax deductions on interest payments
- Mortgage payment consistency
- Authority over improvements
- Down payment needed
- Good credit needed
- Property value depreciation
- Unexpected repairs and maintenance
- Inflexible lifestyle
- Property tax increases
Home ownership is not only a financial concern however, it’s a concern of security and social values. Security from eviction, preservation of diverse communities, protection from rising rental rates and frivolous improvements. Mobile home parks exemplify a situation where the lack of ownership can lead to displacement and decision making that negatively affect people’s homes. Although mobile homeowner’s own their structure, they do not typically own the land it rests on. A company called Resident Owned Communities (ROC), headquartered in Concord, NH, provides legal and financial guidance for mobile home communities so that together they can purchase the land they live on to resist evictions due to land sale and development that would generate more income for a property owner. In a way, the Tenants are the ones who are evicting their landlord and gaining control of their community. We must assume that the sale price of this land to the mobile homeowners would have to be equal to the price that a developer assessing the land for development is willing to pay, unless they take action before the threat of new ownership exists.
My wife and I live in Seattle, WA. We currently rent a one-bedroom apartment in a 3 story, 15-unit building. Property sales and taxes are public information. Taking the current landlord’s sale price of the property in 2005 and applying a standard mortgage term, rate, assume a 20% down payment, an estimated mortgage payment can be calculated. Adding to this the known real estate property taxes, estimated insurance (1%), maintenance (1%), vacancy (7%), and property management and marketing fees (10%), we arrive at the cost of ‘delivering’ the rental unit to a Tenant. Utilities are paid directly by the Tenants with no markup. Subtracting the cost of delivery from the cost of the rental payment, is revenue. An estimated income tax of 30% is applied to this and the after-tax profit is computed . Our apartment is estimated to be ‘delivered’ at a 48–58% markup after tax, in addition to the unrealized gains on paper that currently exist should the current landowner decide to sell the property today at its assessed value. The property at today’s assessed value has appreciated 240%, or an annualized increase of 13%.
This illustration is not intended to ridicule profit making during the creation of rental units. In fact, without the lure of profits, there’s little incentive for developers and landlords to take the risk of providing housing in the first place. It’s also important to recognize that this case study may not be representative of the situation at large, and the sample was taken at a time when demand for housing is high and the economy is relatively strong. Most certainly there are many examples where profit is lost by owning and managing a rental property. What’s important is how we think about the imbalance created through the relationship of those who own property and those who don’t.
My proposal for a solution lies in a company that owns and operates existing housing properties for the purpose of distributing equity in exchange for monthly payments. I’ve nicknamed this company Staircase.
The idea is simple. Reward those who contribute money to a mortgage payment with equity shares, in this case it’s the renters who supply the monthly cash flow needed to pay the mortgage. Over time as the mortgage is paid, equity shares that were held inside the mortgage get released into the hands of Tenants. When Tenants want to move, they can sell their equity shares on a secondary market where the value of each share is correlated to the value of the property. Alternatively, Tenants could hold on to their shares as part of their investment portfolio and continue receiving dividends entitled to share holders.
In typical mortgage payments, the interest to principal ratio decreases over time. What’s exciting is that the difference between the cost of earning a unit of equity by paying the mortgage and the price on the secondary market should tend to increase over time. In other words, Tenants collectively gain advantage over time since the debt payment on the property is constant while it’s anticipated that real estate value rises and more equity is earned in each successive mortgage payment. Tenants are always acquiring equity from paying down debt, and not the secondary market, which maintains a stable price for purchasing equity. Instead of each Tenant beginning a mortgage anew like a coop, Tenants piggy back on the mortgage of alumni Tenants, which reduces costs during ownership transfer and mortgage origination costs.
With the right incentives, we’ll find a willingness of people to buy shares on the secondary market that are purely in an investor’s self interest. This is important because the system does not rely on charity or subsidy and operates on the same forces in which our current system works. The first most obvious incentive of why someone would want to purchase shares is that real estate is a real world asset with tangible value and has a history of price appreciation. Secondly, equity shares would entitle holders to rental cash flow from the property that are in line with market rate expectations for similar properties. This works much like a dividend of a REIT or stock.
If 100% of equity ownership does reach the secondary market, Tenants benefit from reduced rental payments, since debt ownership and interest owed are no longer applicable. Shareholders would continue to receive cash flows and the dividend amount would approach the capitalization rate of the property. If and when the building is sold, the proceeds of the sale are transferred to share holders proportionally.
In order to make this system as efficient, transparent, and trustworthy as possible, the system uses the mechanism of fractional ownership to facilitate the frequent transfer of ownership. This process utilizes a public blockchain to manage the shares of a property, also called tokens. These tools also allow for more automated regulatory compliance.
Below is a graphic of the different parties and components that make up the ecosystem. Their definitions are described in more detail below.
A decentralized public blockchain featuring smart contract functionality would be the infrastructure layer that would allow the efficient automation and transparency of debt, equity and dividend transactions. Most likely Ethereum or a purpose built security token blockchain like Polymesh.
A token, or share, is a digital representation of fractionalized ownership of the Series LLC. The token is governed by securities law and is a legally compliant tool for managing the ownership of real world assets.
Share/token dividends are paid in stablecoins. Stablecoins are digital currencies that attempt to minimize volatility and are often pegged to a fiat currency like US Dollars or the Euro. Think of them as a digital version of a dollar. It’s the responsibility of the share/token holders to make the exchange to the fiat currency of their choice if desired.
A person who’s primary residence is the property owned by the Series LLC. The Tenant has a typical on boarding process and rental payment structure. The Tenant is offered ownership of shares/tokens in exchange for a portion of the rental payment. A Tenant does not have to participate in the system, and can opt out at any time. The Tenant custodian is available for management of the Tenant’s digital wallet.
Ownership entity of the property that offers legal protection to owners and separation from other assets owned in the series.
There are a few options here. One, is that the lender is a bank or other traditional financial institution that is used to secure mortgage funding and willing to allow tokenization of the property while under a loan agreement. Mortgage payments would be made to this lender. A more advanced model would be to use a two token waterfall model, which would create both a debt token and an equity token. The debt token would have seniority and always be paid out before dividends are paid to equity token holders. When debt is paid, a debt token is burned and an equity token is minted. In this model the entire property value would need to be raised by those holding debt or equity tokens. Third, a lending pool could be used to draw a fixed rate stablecoin loan to purchase a property. The infrastructure may not be available to do this just yet, but on chain mortgages are inevitable.
A local third party property management company responsible for the day to day operations of the property and Tenant management. The property management company is also responsible for collecting rental payments and transferring money to a digital wallet that is used to buy shares/tokens for Tenants and pay dividends to share/token holders.
People who have been white listed by KYC/AML (Know Your Customer/Anti-Money Laundering) regulations that have either bought shares/tokens directly from the Series LLC, through the secondary market, or have had shares/tokens bought on their behalf by the Tenant custodian. These share/token holders are legal owners of the Series LLC that own the property and are entitled to dividends as a result of rental income that exceeds the costs of operating and maintaining the property. Share/Token holders may have limited governance in the future with the potential for Tenants to receive weighted voting power on property decisions.
The Tenant Custodian is a third party that manages the digital wallets of the Tenants. It offers complete management of creating and managing these wallets for the duration that someone is a Tenant and also the transfers money (digital or fiat) to those that are no longer Tenants of the property. Tenants can be as involved or not as they want to be. Tenants can manage their own wallets, but must assume the responsibility associated with this.
This market allows for peer to peer trading of the shares/tokens to white listed addresses. The benefit of this market is increased liquidity, which increases the ease of buying and selling shares/tokens and offers a trading volume that is essential for the reoccurring monthly buys from Tenants. In contrast with traditional real estate investments that lock capital into a property with plans for a pre-determined sale years in the future, this market also provides investors an exit strategy that is always available and reduces the churn of the buy/renovate/sell strategies that push property values and rental rates higher.
In order for Staircase to operate and coordinate these activities, revenue is needed and would be clearly communicated. The quantity of revenue needed to sustain itself will need adjusting over time as the model is refined. The primary revenue stream would be the premium on token value at initial token issuance (10%) and a percentage fee on the gross monthly rental income of each property. This initial premium provides money needed to tokenize and initiate a property as well as provide profit to Staircase to incentivize the work. This fee model aligns with other companies in the space.
Staircase also plans to use it’s own cash for down payments or as a sponsor co-investment for initial property purchases. This investment would represent an equity stake and grants Staircase to monthly cash flows from the rental as share/token holders and allows for the potential profit from selling shares on the secondary market.
In order to better understand the cash flows of a property under this system, a 4-unit multi-family property that is currently up for sale was analyzed as if it were bought today and folded into the system described above. Below are the key takeaways from these projections. Snapshots of the spreadsheet are included at the end of this article for review.
All information used in this scenario comes from a real property listing in Seattle and property specific historical data containing actual expenses. The building identified has 4-units, with varying rental rates among them. The proportion of a unit’s rental rate relative to the cumulative rental income is used to proportionally allocate expenses. In this scenario we focus on a single unit where a Tenant moves in and stays for 3 years and has a consistent rental rate and unit valuation for the entire residency. The monthly rental rate is $1,635 and the capitalization rate of the property is 4.58%.
At the end of a three year residency, the Tenant sells their shares into the secondary market, which, in this scenario the value of the property stays the same, and would be sold for $16,300 before any taxes.
The effective rental rate, which is the monthly rate calculated after taking into account any profits from the Tenants accumulation of property equity, is lower than the rent initially paid during those three years. For simplicity this does not take into account any dividends the Tenant would have received by being a shareholder themselves, which would further increase savings. The effective rental rate equates to a savings of $454 per month (27.8%) for the entire duration of tenancy before taxes.
Investors and holders of equity shares/tokens in the secondary market, that is equity not locked up in mortgage debt, resulted in a 1.41% return on the circulating supply of the secondary market in each of the first three years. Assuming no change to rental income or unit valuation, when a new Tenant moves in, and the original Tenant’s equity shares enter the secondary market, the dividend falls to 1.22% and the cycle repeats.
If there were no change to the unit valuation and the rental income, the dividend as a percentage of the circulating supply would decrease and approach the fully diluted dividend percentage as shares were injected into the secondary market. The fully diluted dividend rate would be the lower bound ever expected to be experienced, because if a property became fully diluted, the mortgage obligation would cease to exist. In performing analysis on potential properties, the fully diluted dividend would need to be considered and be acceptable as a minimum return to investors to be eligible for inclusion in the system. This is from a monthly cash flow perspective only and does not include upside or downside potential on the building valuation.
What if the returns aren’t enough? There are emerging ways that we can put the stagnant value of the housing asset to work if monthly cash flows aren’t attractive enough for investors, but these should be seen as supplemental only. One way is using the equity tokens as collateral to borrow another asset that can be put to work to boost earnings. It may also be useful and worthwhile to use equity tokens to provide liquidity where shares/tokens are traded, earning fees and boosting the liquidity of the market. These more complex arrangements don’t come without risks and is territory that’s under explored, but these are not new ideas. These methods are being experimented with by others.
What’s missing from this financial model is a detailed analysis of the operating side of Staircase and how those costs stack up against the assumed values used as revenue in the model. These include the ongoing operating expenses of Staircase as well as costs associated with tokenizing each property. These will not be insignificant and shouldn’t be overlooked. However, there are other projects in this space that are proving that enough financial incentive exists to tokenize properties at this scale. The fee extracted from the rental payment in this model is consistent percentage wise with companies with similar business models, such as RealT.
The aim of the project is to make renting an outdated method of providing shelter and allow renters to build equity without the commitments and barriers imposed by purchasing a housing unit in traditional manners. Increasing transparency and liquidity of the rental housing market could dramatically improve the inclusion of people historically kept out of the real estate sector. If housing equity were to be more easily transferred, more people could become financially and geographically stable, and more people could become connected to the valuation of their city, which allows them to influence future development and benefit from investment. This in turn leads to a more just and equal participation in generational wealth creation, helping reduce inequality embedded in our current housing system. Housing should not be an industry for excessive profits, it’s time we reorganize the flow of money and value when it comes to a place to call home.
Frequently Asked Questions
Is this legal?
This will depend on geographical location and the final structure of the ownership shares. The system will need to conform to all applicable local and national laws governing real estate ownership and securities. A fully tokenized system will face hurdles in US jurisdictions since US securities regulation is strict regarding the ability of low income individuals to own investments defined as securities. Tokenized real estate is regarded as a security.
If this system is granting additional benefits to Tenants, who loses benefits?
The system essentially puts a cap on profits from those that provide initial capital. An unbounded upper limit of profit is the issue in affordable housing, rewarding capital providers with a competitive return on an investment is necessary and beneficial.
If this is possible, why hasn’t this been done before?
Coordination among strangers is difficult and the incentive structures don’t currently exist to provide benefits to property owners to transfer property equity to Tenants. The belief is that the incentive structures can be created if an organizing force coordinated around Tenant’s collective goal of property ownership while at the same time satisfying the primal functions of capital demands. Most systems attempt to satisfy one side or the other, either prioritizing the returns of capital markets at the expense of Tenants, or prioritizing Tenants and sacrificing the incentives that drive investment. Only recently have we had the ability to make ownership of assets like real estate liquid enough to achieve the goals of both sides.
Is this similar to a rent-to-own agreement?
Yes, except without the commitment and constraints normally imposed by those agreements.
How does Staircase make a profit?
Staircase collects a fee at initial issuance and an ongoing fee as a percentage of rental payments. Staircase also has the ability to invest in shares/tokens which provide cash flow.
Why would a property developer choose to be a part of this system if they stand to make less profit?
A property developer most likely won’t choose to participate and that’s okay. Staircase will acquire properties directly, circumnavigating the need to convince current property owners and developers to get involved. The benefit of this is that it allows a proactive approach to including properties into the system opposed to relying on convincing current property owners to adopt it. Affordable housing developers, other organizations, and city programs with similar missions may be great partners.
What happens if property value increases/decreases, and who performs the valuation?
This value is reflected in the share/token price and gains or losses are incurred by all shareholders/token holders. Actual gains and losses are only real at the time of sale. Property valuations are done by third party assessors or by the local tax assessor on a regular schedule, which would be publicly available information. The actual market cap of the token is not tied to the property valuation and will fluctuate with market demand.
Does a Tenant’s rent go up or down every year depending on the value of the property?
No, only for extreme cases would a Tenant’s rental payment be changed from one year to the next. The goal is for the Tenant to maintain a consistent payment once a rental agreement is signed. If property value increases, which in turn increases property taxes and the cost of delivering the unit, the cash dividend to investors is what’s at stake for a loss, which is in alignment with traditional rental property investing since many factors contribute to the final cash flow of a property. If a Tenant moves out, and the cost of delivering the rental unit has increased, the unit will be advertised in alignment with the market rate and the increased cost of delivering the unit, repositioning the capitalization rate.
Can Tenant equity be used for rent payments?
This could be possible and extremely helpful. A tenant may be able to pay rent in equity shares in times of hardship or loss of income, preventing eviction. More analysis would have to be done to see if there are good incentives to do this. A benefit to investors is that Tenant equity could be used as a backstop for revenue in the event of a failure to pay rent or be used as collateral like a security deposit.
Can Tenants opt out of the system?
Yes, tenants don’t have to participate. The ability to choose is important. In this case, the rental rate does not change, and no equity is exchanged for the rental payment. The equity that is earned from their share of the mortgage payment is granted to either, Tenants, Investors, Staircase or a combination of these.
How is property ownership shared?
Investors and residents own shares/tokens of a company that is created specifically to own the property.
How are building maintenance and improvements handled?
Maintenance is handled like any other typical rental, a request is made, and the property manager is responsible for fixing the situation. Maintenance items are paid for by a maintenance account which is allocated money from monthly rent payments. Improvements would be handled on a case by case basis.
What happens when a tenant has built equity up to the worth of their housing unit?
Ideally, there’s no more mortgage to pay. The monthly mortgage payment would disappear, which would be set at different values for different properties and units. Maintenance, property management, taxes, repairs, and investor dividends are still reoccurring payments that need to be made.
Does paying rent help Tenants credit score?
Yes, rental payments would be reported to credit agencies in order to build Tenant credit, which is a valuable part of building financial independence.
Why use a blockchain and tokens?
This system could work without a blockchain, but it would be cumbersome. Utilizing a blockchain and smart contracts would increase the efficiency and transparency of the management of ownership shares and distribution of returns. Tokens that are available on chain can also reach a larger investor base and increase the liquidity of the ownership shares, easing concerns of investors that fear having an illiquid asset. Future goals include being able to plug into the wider array of financial tools and building blocks being developed in the digital asset space.
Each token is a representation of a real world asset and is not like an ICO. The distribution of tokens is not the primary method in raising funds for down payments on property, since a property can only be tokenized once purchased or the debt itself is tokenized in partnership with a lender.
Financial Model Data
: Universal Declaration of Human Rights (UDHR) adopted by the UN General Assembly in 1948.
: CityLab, “Is Housing Inequality the Main Driver of Economic Inequality?”, Richard Florida, April 13th 2018.
: PEW Research Center, More U.S. households are renting than at any point in 50 years, Anthony Cilluffo, A.W. Geiger and Richard Fry, July 19, 2017.
: PEW Research Center, More U.S. households are renting than at any point in 50 years, Anthony Cilluffo, A.W. Geiger and Richard Fry, July 19, 2017.
: Center on Budget and Policy Priorities, Census: Income-Rent Gap Grew in 2018, Alicia Mazarra, June 27, 2019.
: Brookings, What does economic evidence tell us about the effects of rent control, Rebecca Diamond, October 18, 2018.