By Leonardo Rostoker and Michael J. Seiler
Traditional investments such as the stock market have witnessed unprecedented volatility in recent years. Since January, families have seen their life savings decrease by roughly 25 percent. Employees gearing up for retirement now have to delay their plans to spend more time with family and travel the world.
Rising interest rates have put downward pressure on bond prices, so this second traditional investment path is also unattractive. Should investors keep their money on the sidelines in cash and wait for the economy to correct and then start to recover? This could take years. And with inflation spiraling out of control, with every month that passes, wealth stored in cash will continue to lose purchasing power at a rate not experienced in 40 years.
The disappointing performance of traditional investments has encouraged a broadening of portfolio asset consideration to include “alternative investments”. Real estate often is described as falling into this category despite the fact that the total market capitalization of residential and commercial real estate is roughly equal to both the stock and bond markets. Unlike shares of common stock, real estate assets are unique, illiquid, lack divisibility, have higher transaction costs, fewer numbers of buyers and sellers, a more gradual price discovery process, and mostly trade in private markets. Because all these characteristics reflect a less efficient market, opportunities to identify abnormal returns are far more possible in the real estate world, given the right investment team.
While stock and bond investments focus on long-term holding periods, several real estate plays involve relatively short investment horizons. A “value add” proposition describes where professional money managers enter into a real estate space with an idea, possibly a technology/tax advantage/improved management strategy/etc., to bolster returns on an asset without substantially changing the fundamental risk. These value creation strategies can translate into greater returns for investors at a time when more traditional assets suffer from the whims of Wall Street investors and unpredictable government policymakers.
Consider investments in residential mortgages, for example. Out of control inflation has caused the rate on a 30-year fixed rate loan to increase from 3 percent to 7 percent in just the last nine months. When rates increase, borrowers are less likely to default because they know they are holding onto an ability to continue to borrow money at a lower than market interest rate. And when rates decline, borrowers can refinance into lower rate mortgages by prepaying their debt without penalty. Accordingly, residential real estate has seen incredibly low rates of default despite the recent economic recession.
To further mitigate the price risk of holding residential real estate mortgages, loan originators can lower risk by lending for shorter periods of time. That way, they can “mark-to-market” by effectively resetting the portfolio every couple of years and not lock into rates, long term. This solves the “maturity mismatch” problem that troubles traditional bank lenders.
Another way to mitigate downside risk when lending is to issue mortgages with a lower loan-to-value (LTV) ratio. This greater down payment requirement reduces the incentive for borrowers to strategically default, making investments in mortgages much safer. As collateralized loans, residential mortgages with higher equity positions rarely see defaults because payment cessations make no sense when defaulting will cause borrowers to lose their stored homeownership wealth. Add to this that people need a place to live, and investors can easily see why greater down payments eliminate all but extreme default situations.
Mature secondary mortgage markets lower the risk of mortgage portfolios as government sponsored enterprises (GSEs) stand ready to purchase conforming loans from originators. When loans are kept in portfolio, more streamlined regulations for non-owner occupant borrowers allow for faster court resolutions when serious delinquencies do occur. And when circumstances beyond the lender’s control result in defaults, the sophisticated distressed loan market provides an exit strategy for investment managers.
While no investment is without risk, there are several safeguards put in place to mitigate the risk of investing in residential real estate mortgage pools. Even when the stock and bond markets return to favor, “alternative” real estate investments should remain attractive because they typically trade in private markets, thus avoiding the unnecessary volatility caused by noise trading stock market investors. And because real estate has a low correlation with more traditional asset classes, including real estate in a mixed asset portfolio tends to lower overall portfolio risk while presumably bolstering returns.