Key economic trends suggest 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. Many institutional investors are entering 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 and 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 hedging against downside risks, as housing would not be spared if the broader economy enters a double-dip recession.
Housing uncertainty is waning
The severity of the housing crisis made previously existing models and forecasting methods obsolete. With no historical model to reference, housing forecasts were often based on short-term trends, extrapolating recent weak borrower behavior into the long term. Risk premiums in housing-related assets have been, and remain, high.
However, as the bulk of the turbulence from mass-default risk and ever-changing government programs passes, housing is becoming a more quantifiable risk factor. Improved clarity likely will help reduce the risk premium even before the housing market heals fully. 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
Four key themes that we believe many market participants do not appreciate fully are likely to drive returns on housing-related investments over the longer term.
- The “shadow supply” is not as terrifying as commonly thought, and likely can 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 5.5 million to four million, and improvements are likely to accelerate. Of the 11 million underwater loans, only two million are underwater by more than 20% and not already delinquent. While a portion of these will default, many are eligible to be modified or refinanced (data based on PIMCO analysis).
- Negative real interest rates have created a new source of demand. Within the past year, institutional investor participation in the distressed real estate market (repair and flip, or rent) has increased significantly, driven in part by the desire to generate yield in a negative real interest rate environment. Investors 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 likely 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. Slight improvements in house prices should reduce appraisal difficulties, and regulatory clarity should reduce putback risk, leading to greater credit availability. Combined with low interest rates, this 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. New home inventories are less than half their long-run average, while household formations delayed for economic reasons during the crisis are beginning to take place. Construction is slowly increasing, but it may be too slow to satisfy new demand as the broader economy stabilizes.
While housing would not be spared in a broad-based economic downturn, market shocks likely would 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
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.
We see three investment strategies as particularly attractive:
- Real-estate-owned (REO) buy-to-rent offers the opportunity for positive carry in the form of high rental yields, and the direct benefit of potential property appreciation, but maintaining a portfolio of rental properties may be operationally challenging.
- Nonperforming residential loans (NPLs) offer opportunities to accelerate cash flows by finding alternative resolutions, including modifications or expedited proceedings.
- Non-agency RMBS securities tend 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, though they are subject to mark-to-market volatility and periods of reduced liquidity.
In conclusion, the potential to earn attractive real returns, even before benefiting from house price appreciation, 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. 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.
For more information, please see “In Depth: Positioning for a Housing Recovery.”