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Rarely a week goes by without a client or member of the media asking whether the housing sector has bottomed and, related to this, if it is time to invest in some part of this once predominant sector. The answer to that question is complex in terms of the different pieces and geographic factors. Let’s take a pass at doing a short list and see what top-level themes come out of that sifting process.
The first and most obvious question asked is about the retail housing market and whether speculation in single-family homes and apartments is well-advised. The answer depends on location, location, location. In nonjudicial states such as California, where a court order is not required to execute a foreclosure, markets are clearing much faster than in New York or Massachusetts, where foreclosure backlogs stretch back for years. But exuberance is spreading. Morgan Brennan writes in Forbes:
“Nationally, home prices have dropped about 35% since the housing bubble burst — in the hardest hits areas, 55% or more. Yet new reports from several real estate research firms signify that home prices are finally stabilizing. The data reinforces a notion … that 2012 is the year of the bottom.”
The bottom of the lake can be dangerous if you dive in head first. In Massachusetts, for example, investors in private-label, residential mortgage-backed securities are facing years of delay in gaining control over their collateral. Thanks to the byzantine rules regarding foreclosure and property rights generally in judicial states, the loans are not easily available for properties priced above the conforming limit set by the Federal Housing Administration and other federal agencies.
What investor wants to hold residential mortgage exposure in a state like Massachusetts, where politicians mouthing platitudes about “consumer protection” make foreclosure problematic? Yet there are also reports of a strong rebound in commercial property in Boston. But, again, the rebound in real estate is very much a regional, even local proposition. Outside Boston in the close-in suburbs, commercial and mixed-use properties are in large supply — like Atlanta in 2009.
Luncheon chatter in New York this summer is decorated with tales of Russian, Chinese and/or Brazilian investors carrying suitcases of cash and scooping up distressed condos and homes along the Florida Gold Coast. But in these jurisdictions there is good news and bad. Yes, the lower east and west sides of New York City are hot, with an astonishing proportion of college students in the condo purchase mix. Uptown east and west is a lot quieter than anybody in the brokerage business cares to admit, but activity is clearly up from last year. That is the bright side. If you price to sell, the deals are getting done in NYC. There is even jumbo financing available.
In NYC commercial property, brokers and owners still say the amount of available commercial space for lease is easily understated by a third or more. Bigger players in Manhattan commercial property are hunkered down for a long siege, but leverage is starting to become a concern for at least one of the bigger names. Look for a large commercial property owner to seek restructuring before the end of 2012 and surprise everyone.
The summer season has also been remarkable in terms of the growth rate for new ventures that have sprouted from the ground in the world of mortgage origination and service. There are several dozen new and existing companies in the nonbank financial sector that could be some of the most exciting financial stories on Wall Street for investors and investment bankers like me. Think high-yielding preferred securities and initial public offerings. By way of disclosure, I work as adviser with some of the companies in this sector and may work with any of them in the future.
Large bank incumbents like Wells Fargo have almost 40% market share in residential mortgage originations, but this may be the last hurrah. As Wells, US Bank and others gradually change their business models to fit into the brave new world of Basel III, not to mention the ongoing madness of Dodd-Frank, the nonbanks shall inherit the competitive ground in new originations. This will be a function of both regulatory and financial capital considerations.
Even as customers of the banks themselves, the new nonbank originators will have a big cost advantage and thus better equity returns than banks. For case study fans, imagine Angelo Mozilo and Countrywide Financial before the acquisition of Effinity Bank in 2001. After Mozilo bought the bank, you’ll recall, he was still a customer of Bank of America. Hold that thought about funding sources.
Companies now caught in the banking sector may be sellers of federally insured depositories. Indeed, “not a bank” is going to be one of the key investment themes in the mortgage market of the 2010s and beyond. These platforms will probably own a broker-dealer or trust company for transactional purposes, but not a bank. The models I see evolving in the nonbank servicing sector include granting extensive powers and incentives for the servicer to manage the portfolio, changes that seemingly address a number of public policy goals.
As Graham Fisher & Co. analyst Josh Rosner and many of our friends stated in a 2010 letter to regulators supporting national servicing standards, it is essential that a servicer have the power to modify, short-sell or otherwise maximize the value of a mortgage to the investor and the homeowner. Often the interests of the tenant/owner and the beneficial owner of the note are very close, but the servicer must be able to act in order to make this goal a reality. By providing an incentive to servicers to avoid defaults and maximize the net present value of the asset, servicers can be more profitable and avoid many of the regulatory pitfalls anticipated by the draconian Dodd-Frank law.
Still, loan servicing carries a lot of risk for investors — especially institutional players. A number of name players such as Wilbur Ross jumped into the servicing game early after the great crisis of 2008, just when the Federal Reserve stepped on rates and started a sustained period of rising mortgage prepayments. Even today, with large portions of the portfolios at the top four zombie banks refinanced at least once, there remains a substantial amount of refinancing business that could and likely will occur in the next 12-18 months. Gain on sale for mortgage refinancings gooses short-term earnings for the top five banks and also depresses visible loan default rates. Prepayments likely will remain elevated through into 2014.
So if you are a hedge fund looking to expand into loan servicing, for example, you need ask only two questions: First, how do I feel about competing with the growing ranks of nonbank originators and special servicers who have already picked the bones clean on most legacy assets? You want to put capital to work competing against one of the established players in residential, conforming originations in California? Do you want to originate product in judicial states such as New York or Massachusetts?
Second, do I think loan prepayment speeds will fall before the Fed is done with zero rate policy in about 2014? Do you buy servicing assets now, before prepayment speeds fall and the value of mortgage servicing rights rise?
The answer to these two questions may determine when and how new institutional money enters the emerging frontier of nonbank mortgage servicing and origination. Is it time for new investors to create even more nonbank mortgage origination capacity?
My sense is that the answer to that question, particularly viewed versus the market need for residential mortgage originations, is yes. Assuming that the incumbents continue to grow double digits in terms of volumes, there probably is still market demand to support new residential origination, servicing and loan securitization capacity as well.
When we have banks competing for nonbank warehouse finance with investors lined up to take new, transparent, aggressively serviced nonconforming production, then we can talk of a recovery in the U.S. real estate sector. And it is happening right now.
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