On the House: Opportunities in Liquid Real Estate

The Tradex Group – White Paper Series

February 11, 2013

By Michael Beattie, Chief Investment Officer

On the House:  Opportunities in Liquid Real Estate

The U.S. real estate market is an under-appreciated, and overlooked investment opportunity – and financial advisors who take that stance risk missing out on a real portfolio game-changer for their clients.

“Huge” maybe an understatement.

The total market size in LRE is about $10 trillion, with hedge fund firms holding approximately $60 billion in assets.

Interest is burgeoning in real estate, thanks to a “perfect storm” of economic and industry trends that are breaking in favor of investors, especially those looking for growth and liquidity.

Fleeing Safe Haven Investments

The growth in real estate portfolio opportunities comes at a time when investors are clamoring for higher yields, and stronger growth appreciation.

Increasingly, money managers view the fixed income market as an inefficient, and even unattractive market (much more so than stocks), but see real opportunity in leveraging that inefficiency by beefing up their liquid real estate holdings.

While it’s true that many investors have fled to the ‘safe haven’ of government bonds in the past few years, don’t expect that flight to continue, as inflation picks up steam thanks to the Federal Reserve’s sustained policy of quantitative easing, which is starting to eat into fixed income returns.

With bond market returns sliding back to just 1% or 2%, a well-placed investment in LRE should make a steady double-digit return in 2013, and potentially more than that if the real estate market picks up steam and/or interest rates rise.

Enter liquid real estate, which could prove to be the newest safe haven for both income and growth-minded investors.

Consider these emerging factors in the U.S. real estate market:

Commercial Mortgage Backed Securities On the Rise – Industry estimates point to $48 billion in the CMBS sector in 2012, a figure that analysts say will rise in the first quarter of 2013, as more debt matures and lower fixed income yields fuels demand for MBS investments. By and large, if the commercial real estate market is healthy, rentals are up and occupancy is robust, then the market is more liquid, and thus more appealing to investors.

Maturities Story Grows More Positive – Back in 2005 and 2006, just as the real estate bubble hit, millions of investors poured cash into commercial mortgage backed holdings. Now, after the downturn, a heavy dose of those CMBS maturities are coming due in the next six-to-nine months, and that’s attracting more and more private equity firms. Such investors are looking to buy up distressed properties, usually in the form of single-asset purchases, and then sell them off at major gains, on a piecemeal basis.

Multi-Family Market Growing Rapidly – Large urban areas like Los Angeles and Miami are already seeing strong demand for multi-family properties, as institutional dealmakers pour more capital into purchases. That’s fueling more demand among key investors, and is driving up the value of multi-family properties.

Global Investors See U.S. Real Estate As “Save Haven” – Foreign investors, especially those in the already-rattled Pacific Rim and in Europe, view the U.S. commercial real estate market as a viable opportunity this year. China investors (especially banks), in particular, see the U.S. real estate market as a better bet, risk-wise. With ample cash on hand, foreign investors have to put their money somewhere, and increasingly, that somewhere is here. With more capital flowing into the domestic market, deals are closing faster, and more units are under construction (see China Development Bank’s move to finance the construction of 200,000 multi-family homes in Southern San Francisco).

Three Areas For Opportunity

How to leverage solid opportunities in real estate? Three opportunities take front and center.

Consider that the trend of “serious” delinquencies for U.S. RMBS has improved across all sectors in the fourth quarter of 2012, according to a new mortgage market index from Fitch Ratings. Additionally, the agency expects RMBS delinquencies to continue their descent throughout 2013.

Fitch says its 60-plus day delinquency index was pegged at 28.6% at the end of Q4-2012, down from 29.1% in Q3. That represents a downward slide of  30.6% from Q4-2011.

According to Fitch, the improvement “reflects positive selection in the remaining pools, loan modification efforts by servicers, and positive home price trends.”

Those trends have resulted in a 5% rise in the average price of a U.S. residential home from January 2012 to January 2013. “Helping the price increase was low mortgage rates and a lower percentage of distressed property liquidations,” Fitch stated.

Another factor supporting a healthier housing sector is the high number of “bad” borrowers flushed out of the mortgage market. All the above trends come at time when distressed RMBS bonds are undervalued, and may well, in many cases, be worth par.

An Opportunity in Agency I/O’s

Mounting signs of vibrant growth in the U.S. housing sector presents solid opportunities in another mortgage sector – Mortgage derivatives ( Interest/Only (I/O) securities). I/O derivatives collect the interest portion of a mortgage payment and offer an option adjusted spread OAS, also known as a hedged return, in the low-to-mid double digits, with no leverage.

The prices of these securities fluctuate based on the CPR (conditional prepayment rate), or the expected amount of prepayments in the underlying mortgage pools. As prepayments increase, prices fall and as prepayments slow, prices rise.  Prepayments in agency mortgages can come from refinancing, which has recently been attractive to borrowers due to historically low interest rates and/or government programs such as HARP and HARP 2.0. Prepayments in non-agency RMBS have a life of their own and tend to have different prepayment characteristics.

In that regard, Agency I/O derivatives are extremely sensitive to prepayment speeds, as more and more Americans refinanced their homes in a sustained era of low mortgage rates. As noted above, though, government programs like HARP and HARP 2 were highly effective in helping homeowners refinance. But as 2013 progresses, now that HARP is winding down, most homeowners who could refinance, by and large, have already done so.

As a result, prepayment speeds are hitting a high water mark, and will likely decline through the rest of 2013, especially if interest rates rise, as many economists predict may eventually happen. As rates rise, homeowners are less incentivized to refinance their homes.

Leveraging “Distorted” Bond Spreads

Another opportunity in the current mortgage security market is via relative value agency RMBS trades.

Due to extreme government intervention, and the steady purchases of mortgages by the Federal Reserve, low coupon agency mortgages are mispriced relative to where these securities actually should be priced. That spread in price creates a good opportunity for investors to take a short position in low-coupon agency mortgages versus a long position in high-coupon agency mortgages.

The key here is adhering to a trading model designed to monitor historical spreads. When these spreads get distorted, the trade is put on - typically with some leverage. As spreads revert to more historical norms, the trade is closed out.  This trade is highly liquid, and should result in better-than-average returns in 2013, given the opportunity created by the government and Federal Reserve interventions.

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Summary: Three Ways To Play Liquid Real Estate

The optimal investment strategies in today’s LRE market calls for a three-pronged approach:

Distressed Non-Agency RMBS/CMBS Strategy - Go long on subprime bonds, in direct opposite of the approach savvy investors took in 2006, when the real estate market was tanking. Focus on distressed RMBS and CMBS bonds that can be stressed to draconian levels of default and extreme loss severities with positive results, and reap the rewards as real estate values appreciate.

MBS Derivative Strategy - The optimal current MBS Derivative strategy primarily consists of IO (interest-only) securities. These I/O securities collect the interest portion of a mortgage payment. The prices of these securities fluctuate based on the expected amount of prepayments in the underlying mortgage pools. Prepayments in agency mortgages have been elevated from refinancings, due to historically low interest rates and/or government programs such as HARP and HARP 2.0, but we believe prepayment speeds have peaked and prices are set to appreciate.

Relative Value Strategy – Another tack for  investors to take is in relative value. Here, the idea is to leverage the spread between US Treasuries and agency mortgages, or expensive agency MBS vs. cheap agency MBS.  Returns aren’t as robust with this strategy, but deploying relative value trades can reduce the overall volatility of a portfolio.

There’s little doubt that the upside in liquid real estate investments is substantial in 2013. In a fixed income environment where yields are wafer thin, a pivot to real estate  - and the price appreciation and interest payments that the sector is offering right now – may result in solid portfolio growth throughout the year.