NREI Commentary 82518

I subscribe to the weekend digest of the National Real Estate Investor which gives me the opportunity to read the week’s most attention-grabbing articles over the weekend.

Below are the articles I found thought-provoking and worth discussing:

Wall Street Investors Increase “Big Short” Bets on CMBS Retail Loans

The “big short” on RMBS in anticipation of the 2008 financial crisis was an extremely unpopular bet as the market felt US housing was a safe store of value and the sky was the limit. In the movie, The Big Short, other investment banks couldn’t hold back their laughter when they were pitched by the various protagonists to take the other side of these short trades, betting against the housing market. In contrast, the market today is well aware of the secular trends negatively affecting retail and there is almost no investor optimism incorporated into the prices of retail assets.

For a bet to pay off big like the “big short” did, it has to be an extremely unpopular position, held in amounts great enough to create headline risk and of course, be proven right. Since everyone knows the headwinds facing retail, further evidenced by the amount of short positions already on retail related CMBS, there shouldn’t be a huge collapse in prices. If these loans do default, the returns won’t be as dramatic as the returns from shorting RMBS before the financial meltdown since the “premiums on retail-backed CMBS loans are actually quite large – upwards of 400 and 500 basis points” (Mattson-Teig). This means traders have to pay five to six percent per year to hold that short position.

However, the interesting point is that most of the CMBS loans in question are from 2012 and 2013 and have ten-year maturities. The question becomes whether these troubled loans can be rolled over in 2022 and 2023, assuming they do not default before then. My biggest takeaway from this article is that identifying the next “big short” like Ryan Gosling’s character (and Christian Bale’s), Jared Vennett, did in the movie is a lot harder than it looks. It requires holding a radically contrarian viewpoint, often for a long period of time, until finally the idiosyncratic bet is proven correct, if ever. I add “if ever” because it is rare for a contrarian viewpoint to be correct because the consensus viewpoint is exactly that: the average of the positions taken by the smartest analysts in the world. A “big short” position today would be something like shorting Dallas-Fort Worth multifamily. I don’t think too many of us are prepared or willing to do that.

Lenders Continue to Fight for Market Share with Multifamily Deals

This article is an echo of the typical characterization of the multifamily market for the past few years: too much money, too few deals. While this trope is usually referring to borrowers, or sponsors, this article focuses on the competitive lending market where various debt sources are fighting to make permanent loans on multifamily. Fannie and Freddie continue to lead this space, providing the most multifamily loans by volume. Just as sponsors are accepting lower prospective IRRs (paying higher prices), lenders are offering loans with tighter spreads in spite of the Fed’s raising of rates due to increased competition to make these loans. However, permanent loans are often priced based on the 10-year treasury which is less affected by the Fed’s actions than the 2-year treasury (this could potentially cause an inverted yield curve, which often presages a recession – potentially self-fulfilling prophecy at this point; tail wagging the dog – but that’s another story). The 10-year is stubbornly staying below the 3% mark, allowing investors to still lock in really attractive rates in spite of the Fed being closer to the end than the beginning of their tightening cycle.

One thing this article mentioned is Freddie Mac’s brand-new mezzanine financing program, “Freddie Mac’s new mezzanine loan program provides another 10 or even 15 percentage points of leverage to borrowers with properties which meet Freddie Mac’s standards of workforce housing”. This is worth some research as it would be great if we can slap another 10 to 15 percent on a deal that has great coverage based on the conventional 75% LTV loan. Freddie Mac’s website says they will go up to 90% LTV with a combined DCR “as low as 1.05x”. There is a catch; rents must be kept “affordable” for the life of the mezzanine loan. I was curious what affordable meant, however I quickly got my answer, “at least 50 percent of rents affordable to households earning 100 percent of Area Median Income or less. Borrowers then agree to limit rent growth on 80% of the units” which is a fairly large catch.

The next question is what is the limit on rent growth? Again, I quickly found my answer in Freddie Mac’s official PDF: rent growth is “limited to no more than the greater of 2% or the annual increase in the CPI plus 1% for the term of the Mezzanine Loan”. This is an interesting debt covenant and could be used to identify unique opportunities. For example, if you don’t anticipate rapid rent growth in a stable submarket with higher cap rates, then it would be favorable to pursue Freddie’s mezzanine program. The PARC (Preservation of Affordable Rents Covenant) allows for rent increases of CPI plus 1% as well as allowances for “certain uncontrollable expenses and one-time capital expenditures”.

Assuming slightly higher inflation (or just a reversion to the mean) over the next 10 years, you would still be able to bump rents by 3% per annum which is probably unachievable anyway for a stable, lower growth area which will offer the higher cap rates necessary to take LTV to 90%. Furthermore, if rents do run up higher it will probably be due to inflation which is covered in the covenant. This means inflation risk is hedged as far as the mezzanine loan is concerned. However, your terminal cap rate may have to be thrown out the window if inflation really does rear its head. I think this is a very interesting strategy which merits further research, considering we don’t mind investing in affordable housing in low growth, secondary/tertiary markets since we typically incorporate a conservative 2% rent growth in our underwriting as well as a 100 to 150 basis point widening of our terminal cap rate to the prevailing market cap rate.

While additional leverage may sound exciting, I am worried what this says about the market we are currently in. It’s probably not the best thing for government sponsored entities (GSEs) to be proudly marketing 90% leverage and “DCR as low as 1.05x” as if it were a six-pack ab product company advertising in a late-night infomercial. I wonder if Freddie has a buy one, get one free? Leverage does not add “alpha” to an investment, it only amplifies the results, positive or negative. However, some deals I underwrite project worse IRRs as the leverage increases. These are usually low cap rate, class-A deals to begin with but a situation where increased leverage brings decreasing incremental increases in prospective return (diminishing marginal returns) or even decreased prospective returns overall is a poor use of leverage. I don’t think additional leverage is prudent in that case. On the other hand, if additional leverage brings increasing marginal returns (2^nd derivative of growth for you calculus fans or acceleration for physics folks), then additional leverage may be appropriate. As long as our prospective return increases and remains commensurate with the risk (including the additional leverage) then we would pursue max LTV. I believe we would carefully scrutinize the coverage ratio to quantify the additional leverage risk and certainly would hold ourselves to a much higher standard than a 1.05x DSCR. We would also need to develop a stress test of some kind to ensure an adequate margin of safety à la Warren Buffet.

How Can HNW Investors Benefit from the Opportunity Zone Program?

This article by John Egan is about the new and exciting topic of Opportunity Zones. Opportunity Zones are designated neighborhoods and submarkets in which the government would like to encourage investment. They have done this by creating Opportunity Zone funds, incentivizing investors “to spur investment in distressed communities throughout the country,” according to the Treasury Department. High net worth and institutional investors can defer the gains from asset sales of any type into an Opportunity Zone fund and begin receiving immediate tax benefits. In short, the tax benefits are the most substantial if this rolled-over capital is held in the opportunity fund for 10 years. Holding for 10 years allows the exemption of taxes on the capital grains produced from the Opportunity Zone investment, which were previously the gains deferred into the Opportunity Zone fund.

Geographically, Opportunity Zone funds are limited where they can invest but largely unrestricted in what they can invest in. An interesting point to note is the government created 8,700 Opportunity Zones which are mostly low-income census tracts and distressed communities in need of capital. This could be a huge opportunity (we’ve been saying this word a lot, haven’t we?) to get in early and begin identifying the best Opportunity Zones. Early investment in these distressed areas around the country could result in attractive risk-adjusted performance especially when taking the tax advantages into account. Returns will potentially be abetted by additional investors pouring capital in due to the incentives created this year by the government.

Lastly, Opportunity Zone funds can provide investors with an opportunity for a “feel-good” investment, which is a growing trend, namely the activist investing niche. While I think investing is difficult on its own and putting further parameters of activist investing may be unnecessarily more difficult, Opportunity Zones could be a more straightforward way to make a difference in communities across the country while earning your return.

A Year After Devastating Storm, Houston Area Votes on Record Bond

Hurricane Harvey is the second costliest natural disaster on record, inflicting $125 billion in damages. This article doesn’t have too much real estate related information but it is interesting to note the record investment which may be voted into existence. Currently a majority of Houston residents support the $2.5 billion bond referendum which dwarfs the $400 million raised by Miami voters in response to Hurricane Irma. If this bond referendum is passed there would be a 1.4% increase in property taxes. I believe this measure will be a boon for multifamily investors and Houston as a whole.