Leverage: To buy the house or buy the fund
by Ron D’Vari, CEO; James Frischling, President; & Asim Ali, Director
Market view from New Oak FinancialWith increasing expectations for the U.S. economy and jobs growth, growth in the residential real estate market is also expected to continue, but at a much slower pace than 2013. While the most direct way of investing is purchasing properties and managing them, there are less cumbersome ways of benefiting from this potential growth.
While analysts call for the Housing Price Index (HPI) to rise in 2014 only in the low single digits, considering still historically low interest rates, investors can use leverage to achieve attractive low double-digit returns with a good income component. Investing in public or private single-family rental REITs or non-performing residential loan funds is one way to get exposure without direct operational infrastructure investment.
The apartment sector is ahead of the single-family residential sector, with valuations reaching levels requiring leverage to as high as 85% to 90% using mezzanine debt. Sophisticated mezzanine lenders are themselves operators but consider the current multi-family valuations too high and the mezzanine debt a more attractive bet as “heads I win, tails you lose.” If the borrower performs, mezzanine debt will make its contractual double-digit return through coupon and preferred income. If the borrower is not able to derive the necessary net income from the apartment, they either have to supplement it to service their debt or hand in the key. In the latter case, the lender would still reach their target return through more optimal property management and ultimate capital appreciation with rising rents. Given the markets, both outcomes offer attractive returns over other income-oriented investments.
If this is all too complicated, investing in banks may be the easiest alternative, as they are expected to benefit from rising medium-term and long-term interest rates, cheap deposits, and an improved housing and credit environment.
New Mortgage Rules For 2014: Are They Reality Based?
The new mortgage rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act go into effect on January 10 and are designed to protect both the borrowers and lenders. At the core of the legislation is the requirement that lenders ensure their borrowers can repay their mortgages. In creating the new rules, the Consumer Financial Protection Bureau took a page out of the credit risk reality-based playbook – only lend to people who have the ability to pay you back.
While it might seem obvious for lenders to conduct the due diligence needed to ensure that borrowers have the ability to pay back their loans, it’s clear that heading into the mortgage crisis the mortgage market didn’t always operate that way. The new rules bring some much-needed standardization to the mortgage market and create an important class of mortgages known as “qualified mortgages”. There are numerous provisions that determine whether a mortgage is in fact “qualified”, but the simple definition of a “QM” is that it’s a mortgage the borrower can afford. Again, lending 101 is being embraced.
A key driver of the lenders acceptance of the new rules is the litigation risk it removes from the mortgage market. If lenders apply the rules properly, they are protected from legal recourse by borrowers or investors if the mortgage goes bad. The amount of time, energy and money being spent on mortgage disputes as a result of the downturn in the market is staggering and limiting legal actions against lenders helped gain acceptance.
Lending is a function of risk and reward. The new rules will help standardize parts of the mortgage market and that’s a good thing, but the opportunity to operate outside qualified mortgages will create opportunities for capital providers to pursue greater returns. No risk, no reward.
Regulatory Conundrum: Financial Safety vs. Financial Innovation
The deluge of regulations overrunning the financial services landscape raises an important policy conundrum for regulators: how to balance financial innovation with the financial security of a general economy predicated on stable and functioning credit markets.
A principal goal of financial innovation (and deregulation) is to allow financial markets access to new investment opportunities that carry higher risk as well as higher expected returns. The obvious downside is that greater risk-taking leads to higher incidences of loss that can become large enough to trigger a systemic credit risk. With overly restrictive financial intermediation, the real economy would be impacted negatively. With tighter credit availability, business investment would be curtailed and ultimately output and jobs would suffer.
The degree of financial regulation has direct implications on the potential for growth. Regulators must tread carefully between risk-taking, financial stability and steady supply of credit.
This regulatory policy conundrum is central to the current debate around the final details of Volcker Rule and the Dodd Frank: for example collateralized debt obligations backed by trust preferred securities. Somewhat ambiguous financial regulations may have led to excessive leverage leading up to the 2008 financial crisis. However, poorly designed regulation can be as damaging as no regulation, having the unintended consequences of choking off prudent risk taking and credit to legitimate small businesses and consumers.
Ill-conceived regulatory provisions to prohibit proprietary trading or making it capital intensive to warehouse, structure and invest in securitized vehicles will undoubtedly constrain origination and availability of credit to legitimate borrowers and limit optimal economic growth. However, exemption of similar activities in government guaranteed mortgages and government debt leads to distorted allocation of risk and intermediation capacity. This will undoubtedly reduce long-term GDP expectations and may not even result in a robust financial system.
