Are Investors Overpaying for Liquidity With Residential MBS Bonds?

By Jan Brzeski, Managing Director and Chief Investment Officer, Arixa Capital Investors are desperate for yield, a fact that is well known by investment professionals everywhere. Yields have trended down steadily for decades, causing Wall Street to look further and further from the mainstream to find new types of loans to securitize. In this article, we’ll look at loans secured by investor-owned homes. Yields on these bonds range from 2-4% based on recent market activity. However, by owning the underlying loans in a non-traded structure—such as by investing in private debt funds that aggregate such loans—investors can likely generate about twice the yield and return. I believe that investors are overpaying for the liquidity offered by these bonds and should take a closer look at private debt funds to receive better value. The single-family residential (SFR) investor-owned market The SFR property type typically includes both single-family homes and 2-4 unit properties, based on how the US-government-backed agencies Fannie Mae and Freddie Mac designate these properties. About one-third of such buildings are owned by investors, with the balance held by owner-occupants. This market is vast, serving 25 million rental households in more than 20 million investor-owned 1-4 unit buildings with a value of more than $4 trillion. A related market is investor-owned homes being renovated for resale, or in some cases being renovated so that they can go into service as rental properties. One owner-operator of rental homes is Progress Residential. They recently issued a bond secured by about 2,000 mortgages on rental homes, paying investors a blended yield of just under 2%.^[1] There have also been a variety of securitizations of loans to “fix and flip” operators who buy, renovate, and resell homes. Yields on bonds that aggregate these fix and flip loans are a bit higher than those on the rental loans, but still under 4%. Now let’s take a look at returns in private debt funds that originate and invest in similar loans. An example of the underlying collateral for one such loan is shown below. Example of a Single Family Residential (SFR) Renovation Project in West Los Angeles The loan on this home represented 75% of the cost of the project, which included the purchase price and the renovation costs. The value of the project increased due to the improvements, so that the final loan amounted to about 65% of the value. The interest rate on this loan was a little over 8% and there were some fees paid to the loan originator, on top of the interest rate, which is customary in the industry. Private debt funds currently pay around a 7% return to investors after deducting an asset management fee. Using rough numbers, a rate of 8.25% less a 1% asset management fee and a bit of cash drag leads to a 7% net return for investors. Another option is to use some bank debt, known as structural leverage, to lower the cost of capital and increase returns to investors, to about 9% or so. This increases the volatility of returns in case of any loan losses, but over the past decade, it has proven to increase returns on average. In summary, investors in private debt funds can earn 7-9% by investing in private debt funds that hold very similar loans to the ones backing residential mortgage bonds yielding half of that amount or less. So why don’t more investors participate in private debt funds? Benefits for investing in bonds The number one reason investors prefer publicly traded bonds is their liquidity, but that is not the only reason. Below are the main benefits of bonds for investors. Liquidity. Most rated bonds can be bought and sold in hours or one business day. In contrast, if you make a loan to your friend, you need to hold that loan in your portfolio until it pays off in a year or so. There is also a middle ground of investing in funds that hold this type of loan, which frequently offer liquidity in a matter of weeks or a few months following a redemption request. Due diligence. Buying a rated bond comes with a certain degree of due diligence included. The books and records of the portfolio of loans will likely be audited by an established audit firm annually. The bank acting as underwriter of the bond will conduct a certain amount of due diligence on the company that is managing the underlying loans, which may or may not be the originator of those loans. A prospectus for the offering describes the investment and risk factors, and regular financial reporting will be provided. Diversification. A mortgage bond is typically backed by hundreds of loans. This provides some security in that if one or two loans default, the effect on the whole portfolio will be muted. If there is geographic diversity in the portfolio, then an economic shock in one region won’t affect the whole portfolio, as opposed to a single loan or a fund that only invests in loans in one city. Scale. It is much easier for a large investor to deploy significant sums of money by buying bonds vs. trying to accumulate individual loans on their balance sheet. The public markets and rated bonds will likely attract some of the largest lenders to become issuers, meaning that as the industry grows, there should be more bonds available and the ability to put significant sums of money to work. Being a fiduciary is more than avoiding new ideas at any cost While the above benefits of bonds are meaningful, most investors do not really need liquidity so badly that they should accept much lower returns for this reason alone. In fact, in today’s low-rate environment, many investors don’t need liquidity nearly as badly as they need higher income. Many investment advisers are fiduciaries such as RIAs. In my experience, they often avoid private debt funds because of their fear of making a mistake or having to go outside of their existing area of greatest experience, namely public markets. These same fiduciaries often end up holding the low-yielding bonds discussed earlier in this article because their formulas allocate money to fixedincome, and a rated bond fits into that asset allocation approach. However, being a fiduciary—and just doing a good job for your clients or employer as an investment expert—may sometimes require putting in extra work and going slightly beyond one’s existing comfort zone. In the examples given in this article, the rewards are so meaningful—doubling the investor’s income and return—that to not thoroughly investigate the options would be a dereliction of duty. Of course, RIAs and other wealth managers can always justify avoiding private debt funds by arguing that they aren’t qualified to understand such funds. However, the resources are out there to better understand how these vehicles work, such as my firm’s recent white paper on the subject. Alts professionals, and specifically CAIA Charterholders, have the opportunity to act as a bridge between the traditional investment management world and private vehicles such as debt funds. They have the expertise to understand alternative investments and should speak up when they see an arbitrage opportunity like the one outlined in this article. If one were to look for an example of an alternative investment clearly beating out its public-market equivalent, in a way that isn’t too difficult for non-experts to understand, investor-owned home loans and the related residential MBS market may be a good place to start. ^[1] Source: Bloomberg, announcement on 2/11/2021 regarding PROG 2021-SFR1.