First Eagle Market & Topical Perspective- Real Estate Lending: Seeking Stability Amid a ...

Despite mortgage rates at levels not seen in more than two decades, home prices in the US have remained elevated. Napier Park Global Capital's Rajesh Agarwal, head portfolio manager of the US Mortgages & Consumer strategy, and Tim Ruberti, loan origination lead, believe this is likely indicative of a structural shift in the housing market that began with the global financial crisis and was exacerbated by the dislocations of Covid-19. Below, they discuss how housing market dynamics are creating what they believe to be durable investment opportunities in residential real estate credit and how Napier Park seeks to take advantage of them on behalf of clients.

Q: The conventional wisdom held that the US housing market was likely to struggle in the face of Federal Reserve rate hikes and higher mortgage rates. After more than two years of tighter policy, however, home prices remain near record highs. What happened?

Rajesh:

Our view, in short, is that the unprecedented macroeconomic conditions of 202022 caused significant structural changes to the housing market. We think these changes are likely to persist.

When analyzing the housing market, we consider a broad range of factors and how they may impact lending opportunities. Affordabilitywhich reflects home prices, incomes and mortgage rates, among other considerations has long been a key metric for those seeking signs of the housing market's direction. Reduced affordability generally curbs the demand for housing, which in turn weighs on prices and ultimately brings a hot market back into equilibrium. Today, however, US housing prices have continued to appreciate even as Real Estate Lending: Seeking Stability Amid a Housing Imbalance page 2 First Eagle Investment (Trades, Portfolio)s affordability has become as challenging as it has ever been.¹ We believe this is due primarily to a significant housing shortage that took root during the global financial crisis and worsened during the Covid era.

After approaching highs not seen since the early 1980s, housing starts fell dramatically beginning in 2006, ultimately contracting about 75% before bottoming in 2009.² While household formation also slowed in response to the economic challenges of the global financial crisis, it soon rebounded and ultimately began to grow at a rate that outpaced new construction. In fact, as shown in Exhibit 1, housing starts have consistently lagged household formation since the mid-2010s, turning what had been a surplus of housing as recently as 2016 into a deficit of nearly 2 million homes by the end of 2023. You can see the housing gap accelerate beginning in 2020, as Covid-related restrictions and shortages of building materials and labor constrained construction activity while various economic supportsincluding stimulus payments and student-loan forbearanceencouraged the formation of new households.³

Tim:

Of course, new construction is only one part of the housing supply equation. In fact, the resale of existing homes represents the vast majority of housing market transactions, and the structural changes in this segment as a result of the pandemic have been even more stark and perhaps may prove more sticky.

The inventory of existing homes followed a trajectory similar to that of new-home starts with the outbreak of Covid, falling sharply as social-distancing conventions discouraged would-be sellers from allowing potential buyers in their homes.⁴ More impactful on the resale market, however, were the rock-bottom mortgage rates that resulted from vigorous central bank intervention. With sub-3% rates readily available throughout 202022, homeowners refinanced aggressively; as a result, around 80% of outstanding mortgage debt today carries a rate of 5% or lower, as shown in Exhibit 2. Today's meaningfully higher prevailing rates30-year mortgage rates have averaged about 7% over the past 12 monthsserve as a major disincentive for homeowners to sell, and this lock-in effect has weighed on existing-home inventories and sales.⁵ Consider the difference in carrying costs between a 7% mortgage rate and a 5% one. If you are buying a $500,000 home with 20% down, your monthly payment on a $400,000 30-year mortgage at a 7% rate is $2,661. At 5%, the monthly outlay would be $2,14719% less.

Unless we have a significant and sustained rally in rates, which seems unlikely at the moment given the path of inflation, it's hard to envision a scenario in which the supply of homes for sale improves materially. We believe this imbalance should continue to support prices.

Q: In light of these affordability dynamics, the participation of large institutional investors in the single-family home market has come under scrutiny from federal and state lawmakers. Do you think legislation is likely? If so, what impact may that have on housing supply?

Rajesh:

The buying of single-family homes by institutions since the onset of Covid has garnered a lot of headlines, and the rhetoric seems likely to continue throughout this election year. That said, we don't believe institutional buying has had a significant influence on broad housing market dynamics, at least at the national level.

Put simply, the footprint of large, institutional landlordsowners of 100-plus units for the purpose of this discussionis too small to have a marked impact on national conditions. These investors own and rent out about half a million single-family homes across the country. Compare this with the 105 million units of multifamily and single-family properties nationwide, a metric I consider apt in that it captures the full residential housing stock, both owned and rented. So, institutional buyers are impacting far less than 1% of the total housing market.⁶

But let's suppose certain aspects of these proposals make it into law. For example, the bicameral End Hedge Fund Control of American Homes Act, introduced in December 2023, calls for institutions to phase out their ownership of single-family homes by 10% each year over a 10-year period, after which they would be banned from owning such properties.⁷ As shown in Exhibit 3, the current inventory of homes for sale is around 1 million; a 10% annual divestment by institutions would increase supply by 100,000, an amount I believe could be readily absorbed given the current depressed state of inventory relative to its long-term trend and ongoing strong demand. While certain local markets where institutional ownership is more pronouncedincluding Sun Belt markets like Atlanta, Charlotte, Dallas, Houston and Jacksonvillecould feel some impact, the marginal supply would be far less significant on a national level. Of course, it will be interesting to see if lawmaker enthusiasm for regulation persists beyond the current election cycle.

Q:Given your constructive outlook for the US housing market, where are you finding the most attractive investment opportunities?Rajesh:

Napier Park has a long history with the ebbs and flows of credit markets, and we believe it's important to remain nimble rather than be dogmatically committed to a particular asset type. This flexibility enables us to rotate our exposures between private and public opportunities as relative value dictates, which in the past has been particularly advantageous during periods of market dislocation. A fear of market slowdown given the rapid increase in interest rates during 2022 and early 2023, for example, pushed spreads wider across public structured credit and provided ample opportunities to buy these securities at what we viewed as a meaningful discount. Now that public spreads have tightened, we believe relative value has shifted in favor of private assets.

Within private assets, we further refine our focus to areas we believe are supported by durable fundamental tailwinds, like constrained supply. In addition, we want investments offering attractive yields and low volatility, as well as short durations and robust cash flows that enable frequent reinvestment of proceeds. Given these parameters, the two segments of the US real estate market that stand out to us are residential transitional loans and land banking. The complexity and liquidity premia offered by these assets currently translate into a yield advantage of 200300 basis points over more traditional fixed income options like leveraged loans and high yield bonds.⁸

Residential transitional loans, or fix and flip loans, fund real estate investors' efforts to purchase residential homes and quickly renovate and resell them at a profit. Commercial banks have pulled back from providing this type of financing in recent years, but a fragmented group of specialty lenders have stepped in to fill the void. The majority of these lenders lack the capital to underwrite and hold these loans at meaningful scale, however, which has created an opportunity for asset managers like Napier Park to construct diversified portfolios of loans selectively purchased from originators.

Providing liquidity to this space enables us to take advantage not only of the supply/demand imbalance in housing that Tim mentioned earlier but also the aging of the US housing stock. As you can see in Exhibit 4, the median age of an owner-occupied home has been climbing steadily and now stands at 40 years, suggesting that renovations are likely required to bring these homes up to modern living standards and maximize their resale or rental values.

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This article first appeared on GuruFocus.