Joshua Anderson, Emmanuel S. Sharef
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 waningThe 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 pointsHousing 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 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 investmentsWith 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 opportunitiesAppropriate 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.
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.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Investing in distressed loans are speculative and the repayment of default obligations contains significant uncertainties. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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