Quick Programming Note: Your chance to get a lifelong Giants fan (me) to don an Eagles or Patriots jersey and root for one of those teams, while doing just a little bit to end homelessness is quickly running out. For those of you interested in humiliating me for a really good cause, here’s the GoFundMe link. HomeAid is an incredible charity that was founded in 1989 with the stated mission to end homelessness. Your donation will go straight to families in need!
Legal Disclaimer: Nothing that I write here should EVER be considered investment advice. Do your own due diligence before investing in anything. If you make an investment solely off of something that you read in a blog that often features funny pictures and borderline vulgar Florida crime stories then you are an idiot and deserve what ever is coming to you.
Now that the fun part is out of the way, I want to write a little bit about interest rates in general and a segment of the real estate universe that will likely benefit from their upward march in particular. The falling interest rate environment over the past few decades has undoubtedly been great for real estate owners as we have seen the value of real property (and pretty much everything else) go up as the cost of capital has fallen. However, since late last year, the dreaded “I” word (inflation) that has been missing in action for years despite the protestations of gold bugs has become a topic of conversation again. The Federal Reserve has raised short term rates, causing treasuries at the short end of the curve to move upward substantially leading to concerns in the real estate world about both the cost of capital moving higher along with an increase in residual cap rates, ultimately leading to a potential decrease in value. However, there is one segment of the real estate market that should do quite well if rates continue to increase: servicers. John Dizard of the Financial Times posted an excellent piece about why they view Mortgage Servicing Rights or MSRs as an excellent hedge against rising rates. The article focused on residential mortgage servicing but some of the same dynamics should be at play in the commercial servicing segment as well. First a bit of an overview on how servicing rights work from the Financial Times (emphasis mine):
Briefly, though, an MSR is the right to earn fees by “servicing” a bundle of US mortgages. That means collecting the payments, mailing out the paperwork, and, if necessary, putting them through the foreclosure process and at least temporarily covering those costs. That will earn the MSR holder about 25 basis points on the outstanding principal of the mortgage. The principal and interest payments go to the owners of mortgage-backed securities.
The servicing rights come to an end when a mortgage is refinanced, most often in a period of falling interest rates. That means that the stream of income from the MSRs typically becomes shorter in a falling rate environment, and longer in a rising rate environment. This “negative convexity” makes MSRs a good thing to own when rates go up.
In today’s world, the yield on investment can amount to around 7% – 8.5% on your investment which can be enhanced with leverage. However, the key is that these steady cash flow streams become more valuable as rates go up. We could be entering a perfect scenario for servicers. Here’s why:
- Property owners are less likely to refinance into a higher rate if they don’t have to. Sure, they are going to refinance (or sell) if their loan is maturing but, if rates truly are going higher, the days of refinancing to a lower payment are likely over for the foreseeable future. This means that marginally less loans will be getting refinanced, which leads to more steady streams of income from servicing rights.
- (For Commercial Loans Only) The hurdle for capital gains treatment has gone from 12 months to 36 months under the new tax bill meaning that hold periods for properties are likely going to increase as investors look to continue to avoid getting taxed at earned income rates.
- (For Residential Mortgages Only) The new tax law reduces the mortgage interest write off from $1MM to $750k. However, existing home owners are grandfathered in. This means that a home owner can continue to claim an interest deduction on a loan of up to $1MM until he or she sells or refinances. This gives home owners in high cost markets an incentive to stay in place longer and again leading to marginally less rollover in a servicer’s portfolio.
Mortgage servicers got hit hard back in the Great Recession days and their multiples plunged after they cam under scrutiny for the subprime debacle and faced legal issues for the bad deeds of a few but have been recovering for a while. According the the FT (emphasis mine):
Back in the bubble days of 2007, MSRs could be valued at about six times their annual fees. By early 2009, they were going for a multiple of 2 or 2.5 times. Even worse, there were many expensive legal actions against servicing firms, some of which had done careless work. MSRs became a radioactive asset.
Gradually, though, the regulatory environment has improved, and the litigation costs for the mortgage business are mostly in the past. US regulators are likely to raise the ceiling on bank holdings of MSRs to 25 per cent of capital, reducing the forced selling. The Trump administration is nicer for mortgage bankers and servicers. MSR valuation multiples have risen to about 4.25 times the fee income.
Even so, MSR intensive Reits such as PennyMac Mortgage Investment Trust and New Residential Investment Corp are still yielding more than 11 per cent. Usually returns in that range tell you that something bad is about to happen. I believe the “something bad”, that is, the decline in rates and the regulatory risk, has already happened.
It’s been a long road for servicers since the bottom fell out ten years ago. However, if rates really are headed on a sustainable run higher, coupled with the other two factors mentioned above, the servicing industry could be in a very good position going forward.
Toxic Brew: Love them or hate them, there is no doubt that the market likes the Trump tax cuts. Consider this a reminder that politics and investing are a toxic brew when mixed.
The Pause: The Federal Reserve opted not to increase interest rates this week but raised their inflation projections and indicated that more hikes are on the way.
Accelerating: According to an Atlanta Fed forecast, the economy could grow at a breakneck 5.4% pace in the 1st Quarter of 2018.
Drawn In: Individual investors are coming back to the stock market, led by young people with interest in cryptocurrencies and cannabis stocks.
It Was the Best of Times…: Retail may be struggling on a national level but the most valuable malls are still raking in billions in sales.
Inflection Point? The home ownership rage rose in 2017 for the first time since 2004.
Told Ya So: Minneapolis changed it’s zoning code back in 2015 to allow for residential projects near transit to be built with less off-street parking than previously required. The result was a reduction in rents and more mid-rise, non-luxury development.
Out of Favor: Manufactured homes should be flying off the shelves at a time when housing has become so expensive. However, a combination of restrictive zoning, financing difficulties and lower potential for appreciation have the industry stuck in the doldrums.
In Decline: The iconic bungalow courts of Los Angeles are vanishing thanks to soaring land prices.
Growing Pains: Amazon’s order-to-shelf inventory management system means that less food is spoiling in Whole Foods storage rooms. However, it also means that the high-end grocer is chronically running out of certain items.
Under Scrutiny: The SEC recently froze $600MM of crypto assets from a company that boxer Evander Hollyfield had endorsed that was suspected of ICO fraud as regulators continue to close in on the space.
Charts of the Day
Great update on the state of the housing market in the US from The Daily Shot.
• Home prices continue to climb at two-and-a-half times the wages, with more Americans being priced out of the market. The Case-Shiller housing index rose faster than expected last month.
• Nonetheless, the homeownership rate is now on the rise as some of the higher-income Millennials are starting to buy. This trend is likely to continue as long as mortgage rates remain low.
The number of owner-occupied units is climbing at the fastest rate since 2005.
As a result of this rising housing demand, the number of seasonal housing units is falling (often converted to full-time units).
• Of course in some of the more expensive areas, homeownership rates are still falling. Here is California, for example.
• Rental vacancies were starting to climb as more Americans chose to buy. But soaring home prices sent more households into the rental markets last quarter. The vacancy rate is now back near multi-decade lows.
• The housing shortage is worsening. Here is the annual growth of the US housing stock – there aren’t nearly enough homes being built.
As a result, the total stock of housing, adjusted for the population growth, is near the lowest level in decades.
For the Birds: A (possibly insane) woman flying out of Newark Liberty International Airport tried to bring a peacock on a United Airlines flight for “emotional support.” United was not amused. The whole emotional support animal thing has gone way too far. (h/t Ryland Weber)
No Words: A man is suing the Hustler Club in New York for $1 million in damages, claiming that a stripper punched him and knocked out a tooth. Perhaps it was something that he said?
“I guess it is sort of insulting to tell a woman she is a bad mother,” he admitted. “I felt we had that kind of rapport.”
And Now For Some Good News: Pizza is generally healthier for breakfast than cereal is. You’re welcome.
Landmark Links – A candid look at the economy, real estate, and other things sometimes related.
Visit us at Landmarkcapitaladvisors.com