Discovering new asset classes: NonPerforming Notes

Thanks to the subprime lending fiasco, the nation’s economy tanked, home prices fell, interest rates took a nosedive to historic lows, and inventory was plentiful — especially in the foreclosure market. We’ve been able to pick up REO properties at a good discount, then renovate and get a healthy profits on resale. Buying rental properties at the foreclosure auction or via a short sale has provided us the ability to reposition these properties for generous cash flow.

Over the past 12 months we’ve seen a shift in the distressed real estate market. The ability to buy distressed properties at a low enough discount to earn a healthy profit is starting to diminish. It seems that the banks are releasing less REO inventory and what is put on the market is getting picked up quickly either by hedge funds or even the savvy owner/occupant looking for a bargain. Many of the REO properties are coming online with some basic renovations already completed by the banks. This trend has been recognized by my peers here in western Washington as well as others across the country.

Making sense from distressed debt

What we have found is that the financial institutions including FNMA, FHA and HUD are shifting away from foreclosures and starting to sell their debt — which are the mortgage notes on their books. When faced with non-performing loans, lenders often prefer to sell the note rather than go through the foreclosure process for a variety of practical and financial reasons. Selling a note often is a quicker process than foreclosure for a lender, and it also enables a lender to avoid paying insurance and real estate taxes on a foreclosed property. With the cost of foreclosure averaging $25,000 it makes more sense to sell the note, especially on properties with a value under $70,0000.

What we now find is that, from an investment perspective, it makes more sense to buy the distressed (non performing) note rather than the actual property. By purchasing the note at a substantial discount, we no longer inherit the liabilities associated with property ownership (tenants, contractors, taxes, insurance, etc.), and we have more exit strategies available, from loan modification with the borrower, to foreclosure and resale to the public.

Bloomberg Businessweek recently published an excellent article that describes the favorable economics behind purchasing nonperforming mortgage notes. The article references a former Lehman Brothers exec, David Sherr, who is now running One William Street Capital management LP, a $2.7 billion investment firm and a huge buyer of non-performing loans, or NPLs, tied to delinquent borrowers who haven’t yet lost their homes to foreclosure. A letter to investors released by the firm (also referenced by Bloomberg) states that, in their view, NPLs offer the “cleanest exposure” to housing.

NPN’s are becoming the investment of choice for private equity firms which enjoy MUCH greater latitude than HUD, a major seller of these loans, when it comes to modifying the loan for the borrower. Private equity investors can employ various methods to get the loan “re-performing”– thereby helping the borrower to stay in the home and resume the payment stream. The private investor, having worked with the borrower to get the loan modified, has now repositioned the investment to provide cashflow and thereby added value to the asset. At the same time, with housing prices moving ever upwards, LTVs drop and, since the loans were bought at substantial discounts to begin with from banks forced to charge them off, the investor’s yield skyrockets.

Why the shift to NPNs?

Major factors driving this ongoing mass selloff of NPNs include newer regulations for banks (rendering it extremely cost-prohibitive to continue holding these loans, thusly expanding the already-mushrooming volume of chargeoffs/divestitures), as well as an average 24% increase in housing prices from 2012 which greatly increases the value of the underlying security. At the same time, the inventory of foreclosures (a traditional favorite investment for hedge funds) is now drying up (they’re at the lowest level since 2007) and, alternatively, investment capital is now flowing rapidly to NPNs.

Put another way, NPNs are now at the forefront and assuming center stage as the investment of choice for these billion-dollar hedge fund firms AND there are big opportunities for smaller, individual investors as well who know their way around this market. “The supply of NPLs is going to be very substantial for the next several years,” said Michael Vranos, Chief Executive Officer of Ellington, which oversees $6 billion.

The full article is available online at Bloomberg here.