Student loan debt, wage stagnation and a red-hot housing market have made investing in real estate difficult for many Millennials. According to Aaron Hankin in a recent article for Investopedia, student loan debt alone has delayed “more than 50% of would-be home buyers under the age of 36” from entering the market. Purchasing shares of a real estate asset instead of buying a house allows Millennials to enter the real estate market without incurring major financial risk. There are many avenues by which to invest in fractional real estate. Buying a co-op apartment on your own, purchasing a timeshare with a bunch of relatives or crowdfunding the construction of a commercial building are all pathways to fractional ownership. Some investors have also started buying shares of virtual real estate in the Metaverse. Below, we consider the pros and cons of fractional ownership for Millennials.
Building Wealth By Owning Real Estate
According to David Greene in an article for Forbes, “real estate builds wealth more consistently than other asset classes.” Many readers will assume Greene is referring to homeownership in his article – which he is. However, homeownership is not the only way to build wealth by investing in real estate.
Of course, owning a home does have the potential to increase one’s net worth. In most cases, homeownership allows investors to build equity, hedge against inflation and save money on taxes. Homeowners who choose fixed-rate mortgages are able to stabilize their monthly expenses in a way renters rarely can.
With property values soaring in today’s hot housing market, nearly half of all US homeowners are now equity-rich. In a February 2022 article for CNBC, Diana Olick writes that the “profit on a typical home sale last year was just over $94,000.” This represents “an increase of 45% from the profit in 2020 and 71% from pre-pandemic profits.” Last year, “annual home price gains averaged 15%.” For context, the annual inflation rate hit 7% in December 2021.
The Need for “Alternative Wealth-Building Strategies” Amongst Low and Middle Income Investors
Unfortunately, home ownership does not guarantee wealth accumulation. This 2004 HUD study prepared by Dr. Thomas P. Boehm et al. found that homeowners often “slip back” into renting after owning a home. Some do so permanently. Owning a home can be risky, especially if homeowners over-leverage themselves whether by choice or by necessity. Oftentimes, homeowners pour all their money into a single immovable asset. Their money remains mostly illiquid until they sell or refinance – the latter of which is not always possible or advantageous.
In a recent article for The Brookings Institution, Senior Fellow Jenny Schuetz explains. According to Schuetz, “housing is not diversified or liquid, and the returns on investment vary widely across geographic markets and timing of purchase.” Furthermore, our continued focus on homeownership as the best path to building generational wealth has hurt certain demographics.
Schuetz notes that throughout American history, “racial discrimination in housing and mortgage markets [has exacerbated] the wealth gap between Black and white families.” Explaining that “home ownership carries financial risks for individual households,” Schuetz points to the need for “alternative wealth-building strategies.” Schuetz makes a series of policy recommendations that would both “redesign homeownership subsidies” and encourage more employers to match worker savings accounts.
Fractional Ownership as an “Alternative Wealth-Building Strategy” for Millennials
Until these changes are considered and adopted, Millennials can enter the real estate market through fractional ownership. Fractional real estate ownership usually requires investors to put less money down. Many fractional ownership opportunities provide investors with a place to live while others offer reliable cash flow. Some offer both. Of course, no financial investment is without risk. Below, we explain a few ways Millennials can invest in real estate through fractional ownership. We also outline the risks presented by each asset class.
What is Fractional Ownership in Real Estate?
Fractional ownership is when multiple co-owners purchase real property together. Each fractional owner is issued a deed. Deeded ownership means each fractional owner has a legal right to sell their share in the property or leave it an inheritor in their will. In short, this means that they own a certain percentage of the physical property — not just a share in the corporation that owns that property.
This is where investing in timeshares and co-op apartments becomes a bit complicated. We explain in further detail below. Investors can hold fractional ownership interests in condos, single family homes, vacation properties, rental properties and virtual properties. We outline the pros and cons of investing in each of these fractional properties below. Not all fractional properties can be mortgaged or otherwise financed. However, certain lenders do offer fractional mortgages.
Legal Rights of Fractional Owners
The legal rights of fractional owners differ from those of sole owners. In her article “Fractional Ownership in Real Estate” for Million Acres, Lena Katz explains. Katz writes that each fractional owner has “purchased the right of possession on a limited basis.” Thus, each buyer owns “a slice of the property but may not be able to physically control it.” Those who are uninterested in managing the property or are unable to afford property management might consider this an advantage. Those who prefer to make all property management decisions might consider this a disadvantage.
Either way, fractional ownership allows buyers to either live in their share – as with condos, co-ops and co-owned single family homes – or enjoy passive income from commercial, residential or vacation rentals. Investors should keep in mind that fractional ownership does not always mean co-owners can forgo management responsibilities. For example, most condos are managed by a board of directors which cares for the building and grounds. However, co-owners of a single family home who share a mortgage will need to care for their own property unless they choose to hire a management company.
Why Investors and Developers Choose Fractional Ownership Instead of Whole Ownership
In general, buyers choose fractional ownership over sole ownership because it is “less expensive than buying the entire property.” For example, only a big time real estate investor or firm would be able to afford a multimillion dollar apartment building. Fractional ownership is attractive to both developers and investors. Katz explains that “luxury vacation developments [might] go the fractional route” to raise capital quickly and ensure continuous use.
Each fractional owner might “only want to spend a few weeks of the year” in that resort community. Luxury vacation developments with dozens of owners instead of fewer owners ensure their resort is “occupied more of the year as opposed to mostly empty.” Investors should know that a fractional vacation property is not the same thing as a timeshare. With a fractional vacation property, each investor owns a share of the real estate title. With a timeshare, each user buys time during which they can occupy the property. Co-ops present another gray area, which we explain further below.
Ways to Invest
Condos are first on our list of fractional properties. Many think of condos as single family homes because they often serve as primary residences and can be personalized by their occupants. In many ways, condos are very similar to single family homes in gated communities. Condo owners must pay property taxes just like single family homeowners. Like the owners of those single family homes, condo owners are subject to oversight. While owners of single family homes in gated communities are governed by an HOA, condo owners are governed by either a board of directors or an HOA.
Unlike single family homes – even those in gated communities or tract developments – condos are inherently fractional investments. Each investor owns the interior of their condo, but not the exterior nor the land upon which the building was constructed. As such, condo owners are not responsible for maintenance of the building or grounds.
Benefits of Condo Ownership
There are many benefits of owning a condo, chief among which are lower cost and less responsibility. In her article “Should Your First House Be a Condo?” for NerdWallet, Kate Wood explains. Wood writes that “condos are often priced lower than single-family homes, a difference that can be even more stark in costly areas.”
According to the National Association of Realtors (NAR), the median price of a condo in the US was $272k at the end of 2020 whereas the median single family home cost about $314k. This could be particularly meaningful for prospective buyers who otherwise feel shut out of their desired location. Condos make homeownership possible for a wider range of Millennial buyers in hot markets like Los Angeles, New York, Chicago and San Francisco.
Other Benefits of Owning a Condo
With a homeowner’s association managing the property, condo owners need not spend time or money on maintenance like single family homeowners must. Condos are one of the few fractional properties with multiple financing options. Though a slightly different process than applying for a typical home loan, buyers can get a mortgage on their condo. In her article “How Does a Condo Mortgage Work?” for US News, Rebecca Lake explains.
Quoting VP of Mortgage Network Brian Koss, Lake writes that “‘virtually all mortgages will work with condos.’” Buyers can use FHA loans, USDA loans, VA loans, conventional loans and jumbo loans to finance most condo purchases. Condo buyers will need a 3 – 20% down payment when financing their purchase — just like single family home buyers.
Given the opportunities for borrowing money, the lower cost, the close proximity to amenities and the few maintenance requirements, it should come as no surprise that condos are growing in popularity. According to Sharon Lurye in an article for Realtor.com, the number of condo sales doubled year over year from May 2020 to May 2021. These sales “far outpaced single-family home sales, which saw 70% growth over the same time.”
Drawbacks of Condo Ownership
Of course, there are some drawbacks to condo ownership. While condos are usually cheaper and easier to maintain than single family homes, they are not as versatile. Because condos do not come with their own plot of land, they are often harder to sell – especially to families. HOA management can also present a series of disadvantages for condo owners. A condo HOA can restrict how each unit is used. They can prevent owners from operating a business from their home or using their home as a short term or long term rental.
In his article “Is Buying A Condo A Good Idea Or Should You Just Buy A House Instead?” for Money Under 30, Kevin Mercadante explains. Mercadante writes that HOAs “control what you do for a living and who you live with.” Most condo boards and/or associations “have specific limits on who and how many people can live in a unit.” Even if family members fall on hard times, they might not be allowed to live with you in your condo. According to David McMillin in his article “Are condos a good investment?” for Bankrate, few condo boards allow short term rentals. Quoting Nate Martinez, McMillin writes that Martinez’s team “‘has had a massive amount of properties go into the Airbnb [and vacation rental] space’” over the last few years. However, many condo associations “‘do not allow it.’” In short, condo owners might not be able to use their unit as a source of rental income.
Co-ops are a bit of a gray area in the realm of fractional ownership. Similar to condos, co-op apartments are single units in a larger building managed by an oversight committee. However, there are a few key differences between co-ops and condos. In her article “What Is the Difference Between Co-Ops and Condos?” for The Balance, Elizabeth Weintraub explains. Weintraub writes that co-ops have different “ownership structures, financing options, taxation, prices, and fees” than condos. First, “co-ops have a committee or board, while condos have a Homeowners Association (HOA).” Second, condos allow buyers to own, alter and sell their units “while co-ops sell fractional ownership through shares” of a corporation.
Applying for a co-op is much more complicated and difficult than buying a condo, as “co-op shareholders vet each other during the admissions process.” In a condo, the “walls, the floors and the ceiling” of the unit belongs to its owner. With a co-op apartment, only the contents inside the unit belong to the shareholder. The building owner has a legal claim to everything else. The gray area of whether co-ops represent a type of fractional ownership or not lies in the fact that owners only “purchase the right to occupy the unit, not the unit itself.” This same argument is made about timeshares, where each owner purchases a certain amount of time spent in the unit. Whether an owner can sell their co-op apartment depends on the type of cooperative there is part of. Below, we consider the pros and cons of investing in a co-op apartment.
Advantages of Co-Op Apartments
In her article “Housing Cooperatives: A Unique Type of Home Ownership” for Investopedia, Lisa Smith identifies a few of the benefits of owning a co-op. First, Smith writes that “co-ops can be less expensive than apartments since they operate on an at-cost basis, collecting money from residents to pay expenses.” Second, some co-ops allow their members to “buy and sell shares at whatever rate the market will bear.” This means that co-op members can profit from their investments as condo owners and single family homeowners do. Third, co-op buyers “are entitled to all of the tax deductions enjoyed by homeowners, including the deductions for interest and real estate taxes.”
Disadvantages of Co-Op Apartments
To offset these advantages, there are also a number of disadvantages to owning a co-op apartment. First, financing is more complicated and can be more expensive. In his article “What Is a Co-Op? The Benefits and Drawbacks to Cooperative Housing” for Realtor.com, Craig Donofrio explains. Donofrio writes that co-op buyers do not take out mortgages but rather co-op loans. While these loans are “basically the same as a regular mortgage,” most share loans “require a down payment of 10% to 20%” rather than the low 3% offered by some government-backed home loans. The maintenance fee charged by a co-op’s board could also be too expensive for some buyers. According to Donofrio, boards charge a fee to “cover communal expenses such as repairs, maintenance, and taxes…[which] ranges from negligible to substantial.”
In addition to these disadvantages, you might not be able to pass down your co-op to a surviving relative if you were to pass away. You might also be unable to list your co-op shares on the open market or use your apartment as a rental unit. Quoting David Howell in his article “Condo vs. co-op: Know the differences before buying one” for The Washington Post, Lester Davis explains. Davis writes that “‘it is much more challenging for a co-op owner to decide to rent their property.’” This is because co-op owners must “‘get approval from the co-op board, and sometimes there are stipulations included in ownership documents that prohibit rentals.’”
Crowdfunding Commercial Developments
Next on our list of fractional ownership opportunities is crowdfunding commercial development projects. In their article “How To Invest In Real Estate“ for Forbes, Miranda Marquit and John Schmidt explain how this works. Unlike REITs and other portfolios, crowdfunding lets real estate investors choose specific projects. According to Schmidt and Marquit, “real estate crowdfunding platforms pool money from multiple investors to fund development projects.”
Unlike REITs where buyers purchase securities, investors purchase shares in real property when crowdfunding a development project. As the Metaverse expands, opportunities to crowdfund virtual real estate developments will likely increase. We will delve into virtual real estate investing later this week.
Pros of Crowdfunding Real Estate
In his article “Real Estate Crowdfunding: What It Is And How It Works” for RocketMortgage, Scott Steinberg introduces investors to the benefits of crowdfunding. Steinberg writes that “real estate crowdfunding makes it possible to grow or build your wealth and get started in the world of property ownership and rental with minimal upfront investment.” This minimal investment means minimal risk. Taking advantage of crowdfunding opportunities allows investors to invest in “larger property holdings than they’d typically have access to” because less startup capital is needed.
Whereas most single family homeowners cannot afford to buy a duplex, apartment building or office space outright, crowdfunding allows them to “hold commercial real estate…in addition to residential properties.” Those who invest in real estate crowdfunding are not responsible for maintenance or upkeep, nor do they need to qualify for a mortgage. Usually making an upfront investment, crowdfunders avoid hefty monthly payments. Crowdfunding investments also “tend to offer higher returns than publicly traded REITs.”
Cons of Crowdfunding Real Estate
Of course, there are some drawbacks to crowdfunding real estate. First, investors rarely see immediate returns – nor do they receive a monthly rental check like duplex owners do. If your investment pays off, you might not make any money for several years. You might also be unable to retract your investment or access your money before an approved date. Crowdfunding is also typically riskier than investing in REITs, even if the initial investment is lower.
Steinberg identifies a few other disadvantages. According to Steinberg, the platforms that manage crowdfunding projects “may charge fees…which can diminish your returns.”
These same platforms might require investors to be accredited or invest a minimum amount. Steinberg writes that most minimum crowdfunding investments range “from $500 to $25,000 or more.”
There are also tax implications for these types of investments. Non-accredited investors will pay taxes on any money they make off these investments at their regular income tax rate. When homeowners sell their primary residence after a few years, they can take a capital gains tax exclusion up to $250k for a single filer and $500k for married filers. Those investing in crowdfunded real estate developments do not receive the same treatment. On the upside, you will not owe property taxes.
Co-Owning a Primary Residence, Rental or Vacation Property
In our recent post “Everything You Need to Know About Co-Owning a House,” we explained this type of fractional ownership. Friends, family members and/or romantic partners might purchase a single family house or duplex together to reduce their share of maintenance costs, property taxes and monthly mortgage payments. Co-owners can either apply for a mortgage jointly or by themselves.
They can pool resources to meet lender income requirements and cover their down payment. Co-owning property allows Millennials to buy both primary residences and investment properties that bring in passive income. As we note in our post “from investment properties like duplexes and fourplexes to primary residences, co-ownership has allowed Millennials to finally escape renting and begin building equity.”
Benefits of Co-Owning a Primary Residence, Rental or Vacation Property
Buying a single family house or duplex with a group of friends or family members could make it easier to qualify for a mortgage. In her article “Buying A House With A Friend: A Guide To Legal And Practical Considerations” for RocketMortgage, Katie Zeraldo explains. Zeraldo writes that “by combining your income (and debts) with your friend, you have a better chance of being approved for a mortgage.” You also have a better chance of getting “a lower interest rate.” A larger down payment could also mean you and your co-borrower avoid paying private mortgage insurance.
If your community allows it, you could also rent out the main house or build an ADU on the property for rental income. Depending on your city’s zoning regulations and permitting requirements, you could use your property for long term or short term rentals. Perhaps best of all, you can split the costs of homeownership with each co-owner. Each co-owner will only pay a share of the property taxes, maintenance costs, repairs, improvements and monthly mortgage payments. How much each co-owner owes should be spelled out in your cohabitation or co-ownership agreement.
Disadvantages of Co-Owning a Primary Residence, Rental or Vacation Property
Of course, there are also disadvantages to this type of fractional ownership. First, your lender might limit the number of applicants – meaning you can only split costs three or four ways. For example, Ben Luthi writes in an article for US News that “Fannie Mae’s Desktop Underwriter…only supports up to four borrowers.” Next, your neighborhood might limit how your property is used – preventing short term rental arrangements or restricting the number of occupants.
Difficulty Selling or Passing Down Shares
The two most significant drawbacks of co-owning a house are the risk of a co-owner defaulting and the difficulty each co-owner might have selling their shares in the property. When owning a single family house or duplex, there are a few ways co-owners can allocate these shares. The first is tenancy in common and the second is joint tenancy. Which you choose determines how much of the property each co-owner has a legal right to and how they can use that share.
In a joint tenancy, each co-owner has an equal interest in their property. If a co-owner dies, their share is inherited by the surviving owner. With tenancy in common, shares can be unequal. This means that one co-owner might have a 30% share while the other has a 70% share. Ownership handled in this manner is typically split based on the financial contributions of each partner. Tenants in common do not inherit shares when a co-owner passes away. Instead, these shares are inherited by willed successors.
Tenants in common cannot legally sell the entire property or their personal shares without the agreement of all other owners. Joint tenants can sell their shares whenever they wish without co-owner consent. Depending on your co-ownership agreement, it could be very difficult to sell your share of the property. If you need to move for a job or other life change, you might spend months fighting your co-owners.
Financial Risk if a Co-Owner Defaults
Lastly, you could be responsible for covering the entire mortgage if one or more of the other fractional owners defaults on the loan. If another fractional owner defaults, you must either make the remaining mortgage payments until the balance is paid or accept the consequences. This could mean a serious hit to your credit.
What About Timeshares?
Though some do not allow investors to sell and trade at will, all of the asset classes listed above — aside from some co-ops — let investors purchase shares in real property. Timeshare owners — on the other hand — do not own real property. The only situation in which this becomes a bit muddy is when an investor owns a deeded timeshare. With deeded timeshares, each investor receives a deed to their unit — valid only for the period during which they plan to stay in that unit.
In general, timeshares are not considered examples of fractional ownership — though other vacation homes certainly can be. Quoting Steve Dering – founder of luxury real estate brokerage Elite Alliance – in the article “5 Properties that Prove Fractional Ownership Is Real Estate’s Hidden Gem” for Architectural Digest, Shivani Vora explains. Dering notes that “‘people often mix up fractional ownership with timeshares where consumers buy a certain amount of time in a vacation home but don’t actually own the property.’” With true fractional ownership, investors “‘own real estate that can be sold, placed in a trust, gifted, or inherited.’”