Co-produced with Beyond Saving
We have been highlighting opportunities in residential real estate for the past few months. Residential housing is shaping up to be one of the best opportunities of the year as very strong fundamentals fail to be reflected in the prices of many residential-centered investments.
In March, nobody knew what impact COVID-19 would have on society, even as it became increasingly clear that it would have a radical impact on our daily lives. Many believed that residential prices would collapse using a variety of very plausible-sounding theories. We’ve heard things like “buyers will be afraid to buy,” “mortgages will be too hard to get” and even suggestions that the market would be flooded with supply as people attempt to dump Airbnb homes that are no longer profitable.
With the benefit of hindsight, we now know that all of those theories were wrong. Housing price growth slowed down in May, but by July prices were rising at the fastest pace in more than two years.
Residential real estate is not just muddling through, or maintaining – it’s booming! Let’s take a look at why it’s booming and a few of the options that investors have to take advantage of it.
Look To The Rates
2020 is going to be a headline year in the history books for a variety of reasons. One aspect that’s going to be particularly analyzed in the future is the scale and speed at which the federal government provided stimulus to the economy.
While previously, government stimulus was spread out over time, in response to COVID-19, stimulus was larger and much faster in a matter of months, not years.
In addition to direct stimulus, the Federal Reserve quickly implemented two strategies that had a significant impact on mortgages.
- The Federal Reserve cut the federal funds target rate from 1.5%-1.75% to 0%-0.25% very quickly in March.
- The Federal Reserve announced “unlimited” buying of US Treasuries and Agency Mortgage Backed Securities (MBS) before the end of March.
As a result of these actions, liquidity was very quickly injected into the financial system and mortgages in particular were favored due to declining Treasury rates and direct purchase from the Federal Reserve.
Source: Mortgage News Daily
Since the vast majority of buyers finance homes for 30 years, the mortgage rate when the home is bought has a huge impact on the amount ultimately paid for the house as well as the size of the monthly payments. When mortgage rates go down, home buyers are willing to pay a higher price for houses.
As a result, declining mortgage rates are going to put upward pressure on house prices.
In 2009, we saw the Fed take similar steps, with the target rate a 0-0.25% and they were buying MBS, yet housing prices were heading down anyway. The huge difference was the number of houses going into foreclosure, which flooded the market with lenders looking to liquidate houses at prices well below market value. Low mortgage rates increase demand but say nothing about the supply side of the supply/demand equation.
This time is remarkably different. For starters, homeowners came into 2020 with a lot of equity in their homes:
The majority of mortgages are under 80% loan-to-value. This means that if someone owns a house currently valued at $300,000, they owe less than $240,000 on their mortgage.
In 2009, that was not the case as many loans were issued at over 100% LTVs, so when prices dropped a very large portion of houses had negative equity. In Q4 2009, 26% of all mortgages had negative equity. Today, only 3.2% of all mortgaged houses have negative equity. To reach 2019 levels of negative equity, house prices would have to drop more than 30% on average.
With the vast majority of mortgages well below market value, foreclosure rates should remain low as selling the house in the market is a better option for the borrower than going through the foreclosure process. Foreclosures always will happen in any environment, but the key is that they are rare enough to not have a material impact on housing prices.
One unique feature we have seen in response to COVID-19 is a large number of “forbearance” programs. These are allowed for all “agency” mortgages by law, which make up the majority of mortgages, and most non-agency mortgages followed suit.
It’s worth noting that many sources report loans in a forbearance program as “delinquent,” so these mortgages are being reflected in the delinquency rates, even though the people who are not paying are doing so with permission of the servicer and are not at risk of foreclosure.
Here’s a look at the current loans in forbearance:
Source: Black Knight
Last week, the number of loans in forbearance declined by 649,000 as the majority of these contracts expired after six months. Forbearances are at under 3 million mortgages for the first time since April, while the peak was close to 5 million.
The important thing to note is that the vast majority of mortgages that are removed from forbearance are now “performing,” meaning that the borrowers are current on their payments.
Source: Black Knight Mortgage Monitor
A very small number of mortgages are going from forbearance programs to becoming delinquent. This is crucial because the market has been treating forbearances as being equivalent to delinquencies, yet only 5% of mortgages coming off of forbearance have become delinquent.
So while the headline delinquency numbers were over 7% for July, those numbers are comprised primarily of forbearances, not actual delinquencies.
Here are a few of the mortgage related opportunities that we have in the HDO Portfolio:
1) PIMCO Dynamic Credit Income Fund (PCI) is our favorite CEF which is benefiting from mortgages. PCI invested in mortgages originated prior to 2009. These are mortgages that managed to survive the last recession, after paying on their houses for another decade, the loan-to-value has improved and PIMCO estimates their portfolio is at approximately 60% LTV average. Currently, mortgages make up approximately 50% of their holdings. Investors can gain exposure to mortgages as well as the benefit of PIMCO’s elite team in managing the portfolio. PCI currently yields over 10.7%.
2) Chimera Investment Corporation (CIM): We have two of the CIM preferred shares in our Portfolio:
- Chimera Investment Corp. 7.75% Series C Fixed/Float Cumulative Redeemable Preferred Stock (CIM.PC).
- Chimera Investment Corp. 8.00% Series D Fixed/Float Cumulative Redeemable Preferred Stock (CIM.PD).
- Unlike PCI, which invests in mortgages through mortgage-backed securities (MBS), CIM is primarily invested in whole loans. This means they directly benefit or are impacted by borrowers paying their mortgages. CIM frequently finances their holdings by creating and selling MBS. This provides CIM with significant upside potential if mortgage default rates remain low, but it also means higher risk. The CIM preferreds currently yield about 10%, and the dividends cannot be suspended unless all common dividends are suspended. This provides a very nice cushion, just in case mortgage defaults are higher than expected. A 10% yield is a great one to own for income investors. More aggressive investors might consider the common share of CIM which is yielding 13.9% and is trading at nearly a 20% discount to book value.
3) PennyMac Mortgage Investment Trust (PMT): Another preferred stock that we really like is PennyMac Mortgage Investment Trust, 8.00% Series B Fix/Float Cumulative Redeemable Preferred Shares (PMT.PB). PMT is the REIT arm of Pennymac Financial Services (PFSI) a large servicer and originator of mortgages. PMT owns a good balance of “Credit Risk Transfers” (CRTs) which provide returns based on the default rate of agency mortgages. The lower that defaults are among agency mortgages, the higher the return. They also own “Mortgage Servicing Rights” (MSRs), which are best to own in a rising mortgage rate environment. While we don’t expect mortgages to rise substantially anytime soon, we also believe that they are likely at rock bottom, so further losses in book value from declining mortgage rates are unlikely. Both PMT-A and PMT-B preferred shares currently have a stripped yield of 8.7% and were recommended in yesterday’s report.
Many investors were scarred by the mortgage crisis and they are carrying those memories more than a decade later. This has impacted the prices that residential mortgages trade at, even though the fundamentals point to a very healthy housing market and low real mortgage delinquencies.
As income investors, we are taking advantage of this situation by buying companies that have exposure to residential mortgages. These companies will benefit as the mortgages they hold are repaid and/or come out of forbearance and will benefit when demand for buying mortgages as an investment option returns.
The market’s fear has created an opportunity. While the market piles into increasingly expensive companies and places bets on whether this stimulus or that stimulus will pass, hoping that someone tomorrow will pay a few percent more for the same stock, we are investing in undervalued mortgage stocks and collecting high dividends. Investing in the housing sector today is a defensive strategy, providing a good entry point, and away from the overvalued FAANG and tech stocks that we prefer to avoid today.
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Disclosure: I am/we are long CIM.PC, CIM.PD, PCI, AND PMT.PB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.