- PIMCO believes that over the coming years, housing-related assets have the potential to outperform the conservative assumptions embedded in their current market valuations.
- As the uncertainty in the housing market wanes, risk premiums in asset prices may reflect a recovery well before the market fully heals.
- A variety of housing-related investment opportunities may outperform in a housing recovery, while cushioning against risk in an economic downturn.
Trends in economic data indicate the worst of the housing crisis may be past: Home prices appear to be stabilizing or increasing in some of the hardest-hit markets, mortgage delinquencies have declined, loan modifications are showing greater success rates, and new construction is gradually recovering, driven largely by multifamily demand. Unlike last year, many institutional investors have begun to actively participate in the distressed property market, and the Federal Reserve continues to be strongly committed to supporting housing and the economy. In light of these developments, PIMCO believes many housing-related assets are positioned to outperform the assumptions currently embedded in their pricing, allowing these investments to offer attractive return potential over the secular horizon. Among the many opportunities available, some of the most compelling are those that offer the highest return potential in a housing recovery, while cushioning against the downside if the economy enters a double-dip recession.
Housing uncertainty is waning
The housing crisis made previously existing models and forecasting methods obsolete. Predicting future housing trends became challenging for market participants, as delinquencies and negative equity reached levels not experienced since the Great Depression. With no historical model to reference, housing forecasts were often based on short-term trends, extrapolating recent weak borrower behavior into the long term. The limited data available to quantify the risk and the uncertainties in market responses made it particularly challenging to forecast ultimate borrower behavior, especially the trigger points at which borrowers able to make their payments might decide to strategically default. In 2009, forecasts about the ultimate number of liquidations ranged from six million to 11 million; the difference between these scenarios has enormous implications for the economy.
Given the uncertainty, negative sentiment, and dispersion of potential outcomes, risk premiums in housing-related assets have been, and remain, high. Now, as the bulk of the turbulence from mass-default risk and ever-changing government programs passes, housing is becoming a more quantifiable risk factor. Experience with delinquencies and modifications has narrowed the range of likely cumulative defaults, and better understanding of liquidations, short sales and rental conversions has helped clarify the exit. Improved clarity likely will reduce the risk premium attached to housing uncertainty, even before the housing market heals fully. In time, lower risk premiums will not only bolster existing housing-related assets, but also should lead to new housing-related investment opportunities. Many market participants underappreciate the possibility that the housing market could enter a gradual recovery and overemphasize the risk of a new vicious cycle.
We are aware that substantial risks remain. Approximately four million properties remain in delinquency or foreclosure, and 11 million have “underwater” loans whose balance is greater than the value of the house, according to PIMCO analysis. Meanwhile, access to mortgage financing remains restricted primarily to only the most creditworthy of borrowers. The housing market also is affected by broader economic risks to employment and growth, regional and local effects, and by government policies that will be decided after the November elections. Much depends upon the pace and form in which distressed loans are liquidated, so the market remains fragile and prone to sudden shocks. While PIMCO’s base-case forecast is for national home prices to decline somewhat further before stabilizing, we believe the market is embedding too great a risk premium into housing-related investments, making them attractive portfolio additions.
The market is reaching several turning points
Housing market behavior is driven by a complex interplay between consumers, lenders, investors and regulators, with many moving parts. Even though the media scrutinizes every new data release, it often is difficult to place the numbers into an historic and economic context and understand their investment implications. Four key themes that we believe market participants do not appreciate fully are likely to shape the market in coming years and drive returns on housing-related investments.
The “shadow supply” is not as terrifying as commonly thought, and can likely be liquidated or resolved without causing much market disruption. In the past two years, the number of seriously delinquent or foreclosed loans has declined from approximately 5.5 million to four million, with nearly three million liquidations and 1.5 million new delinquencies (according to PIMCO analysis), all while house prices declined only 6% as measured by the CoreLogic House Price Index. The market can return to health even before all remaining four million are liquidated; should the shadow supply continue to shrink, concern about it also will diminish. Meanwhile, the homeowner vacancy rate declined to 2.1% from its high at 2.9%, and the rental vacancy rate is at 8.6%, the lowest level since 2003 based upon second quarter 2012 Bloomberg data.A return to the long-term delinquency rate of 2% (one million units) is achievable, according to our research, within another two to three years if the rate of liquidations continues at its present pace and new delinquencies continue to slow (see Figures 1 and 2). In fact, the performance of outstanding loans is improving, as loans originated after 2008 were underwritten using much tighter lending standards and are now defaulting at a slower pace than pre-crisis loans, even in a declining house price environment. It is therefore likely that improvements in the delinquency rate will accelerate. Similar considerations apply to the negative equity problem: Of the 11 million underwater loans, only two million are underwater by more than 20% and not already delinquent. While a portion of these underwater loans will default, many are eligible for principal reduction/forbearance modifications or HARP (Home Affordable Refinance Program) refinances, both of which have shown very encouraging recent performance. Recent transfers to specialty servicers and subservicing arrangements are further improving the scale and performance of modifications. The current rate of liquidations is creating a level of visible inventory that is historically compatible with house price stability (see Figure 3).Even though the numbers associated with the shadow inventory may seem large, the market can likely absorb the actual expected number of defaults with minimal impact by simply continuing current trends.
Negative real interest rates have created a new source of demand. Within the past year, institutional investor participation in the distressed real estate market has increased significantly (see Figure 4; note that the National Association of Realtors data does not distinguish between individual and institutional investors), driven in part by the desire to generate yield in a negative real interest rate environment. Well-financed cash buyers do not depend on mortgage credit, and they seek to generate unlevered attractive yields by buying distressed properties to repair and flip, or to rent out.The presence of distressed investors is setting a floor beneath liquidation prices in many regions and explains a portion of the recent months’ strength in house price indexes. Investors also are the best vehicle for efficiently disposing of the shadow inventory: They recognize that borrowers who default on their mortgages will often become renters, so that nearly every unit of distressed housing supply will be balanced by a unit of rental demand.Support for distressed prices is improving overall house price indexes, and we believe will feed back into reduced default risk, more lending and greater confidence.
Record-tight mortgage credit standards will not last forever. Conservative lending standards are impeding many housing transactions, and should they ease, homebuyers will be able to take advantage of record affordability (see Figure 5). The appraisal problems that nearly 30% of homebuyers currently face are the result of recent home price declines that appraisers must adjust for. High credit score and documentation thresholds are due to the risk of putbacks from Fannie Mae and Freddie Mac, currently the primary source of mortgage credit.As home prices gradually stabilize, appraisals should become easier, and clarity in lending requirements from regulators should allow lending to be less conservative. These same factors will allow private lenders to enter credit markets and originate more loans for portfolio or new securitization. Greater credit availability, combined with low interest rates, can shift the demand curve and allow more qualified buyers into the market.
New construction has been too low for years. Housing starts have remained at record lows since 2008, but much of the bubble’s overbuilding has now been absorbed (see Figure 6). New home inventories are less than half of their long-run average, and new multifamily starts remain insufficient to satisfy the growing demand for rentals. Construction is slowly increasing, but it may be too slow to satisfy new demand as the broader economy stabilizes. Major metropolitan markets are already experiencing the effects of low multifamily construction, in the form of rapidly rising rents.The crisis caused household formations to be delayed for economic reasons, as many young adults were forced to live with their parents and retirements were delayed. Household formations are already beginning to increase again, and in a stabilizing economy, demographic pressure from retiring baby boomers, echo boomers starting families and increasing immigration should further boost demand for shelter.The supply constraint in multifamily housing is forcing some of the rental demand to spill over into the single-family rental market. This trend is supportive for prices in both segments, and we believe it will continue as new multifamily construction will take time to complete.
The market need not return to full health in order for recognition of a recovery to start being priced into housing investments. All that is required is a general recognition that the market is entering a recovery that will allow crisis-related problems to be gracefully unwound. Such gradual healing can take place even in a financially repressed economic environment and may act as a tailwind to the broader economy.
In contrast, a vicious cycle would likely be relatively short-lived. The cycle of mortgage defaults, falling house prices and sinking confidence that occurred in 2007–2009 was fed by a large supply of poorly underwritten loans and exacerbated by ever-tightening credit standards. These factors will likely have limited impact in 2012, as post-crisis loans are better underwritten and credit standards no longer have as much room to tighten. While housing would not be spared in a broad-based economic downturn, its status as a real asset with strong social import makes it more resilient to additional macroeconomic weakness. New shocks to housing will likely be met with coordinated action from agencies, regulators and other participants. In sum, we believe the collection of potential market outcomes is now skewed to the upside, rather than to the downside.
Classification of housing-related investments
With financial repression likely to persist for an extended period of time, during which real rates – rates that take inflation into account – are likely to remain negative, real assets are an attractive portfolio addition. Investments in housing-related assets often provide positive real yield and are secured by tangible assets. We believe U.S. housing as an asset class is especially appealing due to its relatively low prices and attractive financing terms.
Apart from purchasing houses directly, there are a number of indirect ways to position for a housing recovery, offering various levels of exposure and leverage. These include buy-to-rent strategies, vacant residential land purchases, nonperforming residential loans, non-agency residential mortgage-backed securities (RMBS – either senior or mezzanine tranches), mortgage servicing rights, new mortgage origination, multifamily commercial real estate, homebuilder equity or debt, apartment REIT (real estate investment trust) equity or debt, commodities futures such as lumber or copper, and many others (see Figure 7).
In addition to their risk exposure profiles, housing-related opportunities can be categorized based on their cash flow profile. Investments like buy-to-rent or mortgage servicing rights are income-generating, with generally stable cash flows of varying durations, whereas vacant land, nonperforming loans and commodities futures are negative carry, with ultimate performance depending significantly on the strength of the recovery and the quality of the execution. Moreover, investments offer varying possibilities for structural or financial leverage, ranging from standard repo financing for debt securities to structural leverage offered by the government in bulk buy-to-rent transactions.
A deeper dive into three investment opportunities
Appropriate opportunities within the housing space exist for diverse investment objectives and levels of risk tolerance. We find three investment strategies to be particularly attractive in the current environment.
- Real-estate-owned (REO) buy-to-rent has received significant attention recently, in part due to the initiation of a pilot program by the Federal Housing Finance Agency (FHFA) in which a pool of 2,500 Fannie Mae properties was sold to investors who committed to convert them into rentals and hold them for a number of years. If rolled out beyond the pilot, such a program would be positive for the housing market, as it would allow distressed properties to transact smoothly from the shadow inventory to large-scale investors without increasing the visible supply of properties and affecting house price indexes.
REO buy-to-rent offers positive carry in the form of high rental yields, and potential (albeit difficult to achieve) structural leverage through cash-flow-structuring arrangements. Any further recovery in house prices contributes directly to the upside, while holding a real asset potentially offers a hedge against inflation, and the ability to adjust rents annually can help offset additional risk. However, investors must be mindful of the operational complexity and illiquidity of a single-family rental portfolio. Managing a nationally diversified portfolio of rental properties presents unique challenges of surveillance and scaling, and procedures for maintenance and leasing must be designed to help protect earnings. PIMCO estimates that investors capable of managing and maintaining a rental portfolio may be able to earn attractive yields in certain distressed markets with high rents.
- Nonperforming residential loans (NPLs) are increasingly being offered by large bank servicers who lack the capacity or ability to service them effectively in the face of a changing regulatory environment and higher costs. For investors like PIMCO, such pools offer opportunities to accelerate cash flows by finding alternative resolutions, including modifications tailored to the borrower’s capacity, deed-in-lieu of foreclosure arrangements, or expedited short sale or foreclosure proceedings. Thanks to strong surveillance systems and focus from special servicers, PIMCO seeks to find a resolution that is acceptable to the borrower while increasing cash flows to investors, or accelerate the foreclosure process. Completed liquidations may be converted to rentals as part of a vertically integrated housing recovery business.
NPLs may be viewed as negative carry, since typically each loan’s cash flow only occurs when a resolution is found, even though the pool as a whole offers a cash flow stream as loans are resolved continually. NPLs offer direct exposure to the short-term performance of the distressed housing market, and due to their acquisition discount, small improvements in the price of distressed housing can be magnified on a hold-to-maturity basis. However, cashflows can be difficult to predict because they depend on the timing and type of resolution and the effective disposition of the especially challenging cases. Due to their short weighted average life, inflation protection and exposure to long-term house prices are both lower. Liquidity is very low, and leverage is typically not available, except in occasional cash-flow-structuring arrangements.
- Non-agency RMBS securities are now typically five to eight years seasoned, and “burnout” effects are becoming more prevalent. Many of the worst borrowers have either already defaulted or are seriously delinquent, and those borrowers who have successfully weathered the crisis are much more likely to continue making payments. Already-delinquent loans are often seeing their servicing transferred to specialty servicers who have appropriate staffing and incentives and are improving modification performance and increasing liquidation recoveries.
Non-agency RMBS are positive carry and fairly liquid. In addition to traditional financial leverage, structural leverage is available in the form of mezzanine securities, whose performance is influenced by small changes in recoveries on the underlying collateral. Bondholders may be able to benefit if house price appreciation allows more borrowers to prepay or if liquidation recoveries increase beyond the conservative assumptions typically used in market pricing. However, non-agencies trade in line with broader credit markets and are thus subject to mark-to-market volatility and periods of reduced liquidity.
In conclusion, with real 10-year yields negative, the potential to earn attractive real returns, even before benefiting from house price appreciation upside, makes housing-related assets desirable additions to many portfolios. As in every recovery, we expect the market to begin pricing in new scenarios well before housing has returned to full equilibrium, allowing for potential investment gains to be realized sooner.
Each type of investment faces challenges with respect to scale, investment management, risk profile and exit strategy. At PIMCO, we are continuing to position for an eventual housing recovery, while being mindful of its foundations. We are patiently seeking diverse opportunities that offer substantial upside exposure while remaining resilient to occasional tremors.