Single family residential real estate investment has not traditionally been an institutional endeavour. However, many institutional alternative allocators, such as pension funds, endowments and foundations (Sponsors), are developing renewed interest in investing in the distressed single-family sector – expecting a more favourable risk/reward return profile than is offered by other alternative investments.
Sponsors typically access distressed residential space through investment vehicles such as hedge funds, private equities and specialty finance companies as the sector requires highly specialised knowledge and infrastructure in order to capture the promised returns. Such investments utilise one or more basic types of underlying strategy, such as: 1) non-performing mortgage loans, 2) purchasing real estate owned (REO) by banks and finance companies post foreclosure, 3) financing purchases of REOs by other funds or entities (REO Finance) or 4) through non-agency residential mortgage-backed securities (RMBS).
US Housing Outlook
To invest in non-performing mortgage loans, real estate owned equity and REO finance space, the allocators must first have some sense of the stability of home prices.
While most US housing indicators and rallying home builders’ stocks are implying the worst may be over, housing recovery may be shallow and still present some risks.
The most prominent of these risks is the sputtering US economy in the face of several large global economic phenomena: 1) deep-rooted Spanish financial issues threatening to prevent practical solutions to the European crisis, 2) China’s challenges to stimulating its own internal economy while keeping real estate speculation under control, and 3) the possibility of a food crisis due to heat waves in the US affecting basic food staples globally.
The unemployment rates currently being faced by the US are also having an impact on the housing outlook; it would be hard to imagine a steady US housing recovery without an improving employment market. Ongoing uncertainty about the US economic growth and corresponding slowing jobs market puts the steady housing recovery at risk.
Even under better general employment, speed of recovery would continue to be hindered by the shadow inventory of over 3.5 million seriously delinquent loans. There still are, by many measures, over 11 million mortgages that are under water.
Despite these potential setbacks, the most recent positive housing data has encouraged many investors to allocate to the housing sector, including new allocations to distressed mortgage loan and REO funds. Our view is that the real worst may finally be over for US housing, but the path to full recovery will take at least several years. Nevertheless, if one waits for the actual recovery, the opportunity may no longer be as attractive. In light of very low yield environment, an asset-based investment in non-performing loans and REOs could still make sense.
Non-performing residential loan strategy
When the “credit bubble” in the residential mortgage market burst and led to almost six years of falling home prices, many holders of un-securitised non-performing mortgage loans were ill-equipped to deal with the magnitude and complexity of managing these assets. They subsequently sold these loans at deep discounts making such investments easily attainable.
Many investors equate investing in foreclosed homes with non-performing loan pools (NPL). However, the due diligence, pricing, bidding, working out and monetising of NPLs is much more involved than dealing with just the property. NPL and REO portfolio management pose vastly different challenges, expertise, geographical presence, and infrastructure. However, they both depend on the value of the underlying homes, the history of the loans and the borrowers’ critical credit metrics.
Both non-performing loans and REO strategies are highly illiquid and are best structured in a private-equity style fund format with natural liquidity through fund cash flows and no withdrawal rights. These funds are typically closedafter a period of capital raising and draws are made to buy assets and build up the portfolios. There will be a period of reinvestment after which proceeds of all sales, prepayments, and property foreclosure sales will be returned to investors, less base and incentive fees.
Whole loan investment provides the investors with a degree of transparency, control and flexibility not found in RMBS securities investments. Loans can be hand-selected and underwritten prior to purchase, and investors have direct control over servicing and loss mitigation strategies. The discounted purchase price and full servicing rights provide a broad array of loan resolution opportunities that can be tailored to specific situations. In addition, most qualified funds have highly specialised staff in areas of residential loan and property due diligence, valuation, acquisition and special servicing including foreclosure and REO sales.
Many specialised residential loan funds have developed unique approaches to the acquisition, special servicing, and disposition of individual whole loans. The distressed loan space requires “hands-on” asset management of each loan prior to purchase and continues until each loan has achieved its maximum value via refinancing, short sale, modification, or foreclosure and REO disposition.
The initial/pre-closing due diligence and pricing of the initial portfolio can be very expensive but could lead to further liabilities if not done properly. Therefore, a well designed approach to the process and continuous monitoring would pay for itself many times over in performance.
One of the determinants of performance in NPL investing is sophistication and cost effectiveness of the due diligence in acquisition. As most of the time the portfolio sales are in competition, the cost of lost bids can reduce performance. The more sophisticated fund managers have developed proprietary desk-top re-underwriting valuation and pricing systems to be able to obtain and integrate updated information on a large number of properties and borrowers. Furthermore, these funds have secured a network of local resources to assess the dynamic condition of the real estate and job markets across the nation.
It is difficult to invest in large pools of loans that are restricted to specific geographic locations. Some of the smaller funds are focused on buying individual loans or small portfolios from local banks. These funds have typically simple structures and are offered to individual investors and family offices. The operators tend to be local and have no real fund administration and independent auditors.
REO and REO finance strategies
Foreclosures are saddling traditional mortgage holders with unprecedented REO inventory which need to be managed and sold. Since the credit crisis started many local entrepreneurs across America attend REO auctions held in physical locations or on electronic platforms. REO assets are regularly being auctioned at 65%-85% of market value, depending on the market, as measured by independent appraisals and/or broker price opinions. Local entrepreneurs specialising in REO purchase and resale have historically operated from personal resources or “friends and family” financing.
Entrepreneurs’ lack of general access to institutional capital has historically restricted them from growing their operations to absorb REO assets available in the market place. As a result, the more experienced amongst them with access to larger REO portfolios and operational scale have been seeking more reliable sources of funding.
REO investing offers value to those that can acquire them at significant discount to the broker-provided opinion (BPO) estimation of value. Often BPO values don’t fully reflect the current conditions of properties and actual occupancy. The fund strategy’s success depends on actual feet-on-the ground to examine each of the properties at the time of the auction, giving a good sense of repairs needed as well as a clear strategy to remarket the properties.
Larger funds and private equity firms tend to approach the sector by partnering with smaller local entrepreneurial REO management firms. This provides the funds flexibility to take views on individual geographic areas and even get as granular at the property level.
Other larger funds are establishing relationships with government-sponsored enterprises and larger banks to buy these in bulk. In order to price portfolios they typically have to build home pricing and potential resale models, as well as work with various national networks of brokers to obtain BPOs. Further, they use a network of resources to repair, and resale or rent the properties until the local markets recover.
While the REO opportunity has been fairly attractive, the actual investment by larger managers remains more limited than initially anticipated. This is partly because of a general lack of interest by banks to sell in larger quantity and also, in cases of fund-entrepreneur alliances, due to the cultural differences and operating restrictions larger funds operate under.
Legacy non-agency RMBS offers the least cumbersome, and most liquid, way for hedge funds to access the distressed residential debt sector. This strategy doesn’t require loan level diligence, re-underwriting or special servicing (i.e., workout, foreclosure, and REO management).
Over the last four years many traditional investors have had to limit their exposure to non-agency RMBS, giving rise to opportunities for hedge funds to make higher returns from this potentially rich investment opportunity.
Non-agency RMBS provides opportunity for non-traditional investors who have the ability to withstand some ratings volatility and mark-to-market and to achieve attractive unlevered returns with relatively good downside protection under conservative loss scenarios based on the purchased price and the level of discount.
While this investment strategy requires little to no comprehensive national infrastructure, it does require comprehensive RMBS and fixed-income analytics, often at the loan level, extensive historical loan database, cash flow analysis, pricing, relative value, risk management and trading.
In order to access the non-agency RMBS space, investors have been allocating to relatively young specialised RMBS funds as a pure play. These managers tend to come either from sell-side trading or have been investing in the credit mortgage space with larger hedge funds or traditional managers. These managers need to be proficient in their ability to run cash flows for the universe of the non-agency RMBS at the loan level and perform relative value analysis. Further, they need to have a good sense of the macro drivers of housing and housing credit. Non-agency RMBS hedge funds are mostly total return in style, so investors expect some level of trading and swap from their managers to add value.
Alternatively investors uncomfortable with the smaller specialised RMBS hedge funds are considering larger diversified distressed structured products or multi-sector hedge funds with well developed capabilities in the sector. Some of the same funds are also leveraging their residential capabilities by setting up non-publically traded or exchange-traded REITS to take advantage of the sector. These vehicles offer not only investments in legacy distressed mortgages, but also new originated loans with some leverage to achieve higher returns. By trading both on income and growth prospects they have a higher book value than parity.
Most specialised RMBS credit hedge funds provide some form of liquidity, but only after a set lockout period as these investments are not widely traded and funds don’t want to have to sell positions or carry a large liquidity bucket. Due to their relative illiquidity, hedge funds’ valuation procedures have been a critical consideration for the investors and allocators to the funds. Valuation of the underlying positions and hence fund NAVs will be indirectly dependent on the market expected cash flows and discount rates for similar-risk bonds as bonds trade relatively infrequently. Given the fund flows and illiquidity of the underlying positions, most investors look for well articulated pricing procedures as well as independent validation of those values.
We expect distressed residential properties and loans to remain an attractive but highly specialised area of investing for at least a few more years. We base this view on the fact that millions of residential borrowers are still in serious delinquency status with a large population in the situation of their loan amounts being higher than the actual price of their homes. Given the moderately low expectations for US and global growth, coupled with historically low bond yields, allocators through hedge funds and private equity firms will continue to evaluate the distressed residential space and seek to build innovative ways of accessing the market and monetising the opportunities.
Fig.1 Whole Loan Pricing Model (data points)
Fig.2 Risk Scoring Model (data points)
Ron D’Vari, Co-Founder and Chief Executive Officer at NewOak CapitalAdvisors, has over 29 years of experience in alternative asset management, advisory, solutions, and academics. D’Vari holds B.S., M.S., M.B.A., and PhD degrees from UCLA, and is a CFA charterholder.
Investing in the distressed US residential sector
RON D’VARI, CEO and CO-FOUNDER, NEWOAK CAPITAL
Originally published in the August 2012 issue