Stick With Properties—For Now

Stephon Martin

It is an interesting time in real estate—we stand on the precipice of the ending of a national foreclosure moratorium, interest rates are extremely low, the housing market is red-hot, and the commercial market is still unpredictable. What should a real estate investor do now? While there are a number of options that can lead to success, there is one caution—stay away from whole loans.

Cautioning against whole loans almost goes against the very nature of this blog, which promotes all profitable methods of real estate investment. Whole loan trading and valuation is the very reason why I started this blog and whole loan investing can be a great way to find hidden value real estate. That said, the following are various reasons why whole loan investment is not the best strategy in the current market:

The Moratorium

To a note holder or a real estate investor, the term moratorium conjures up thoughts of long cashflow dry spells with missed payments and little recourse. Some of that may be true, as 7.2 million households have taken advantage of CARES Act forbearance options, however, moratoriums are not mortgage forgiveness. The deferred payments are added to the mortgage at the same rate as the mortgage and will be paid off upon refinance or sale. The bigger issue regarding the ending moratorium, however, is the legal instability that it brings.

A cursory perusal of the blogs of some of the law firms most active in mortgage litigation, such as McGlinchy, Perkins Coie or Bradley, makes it clear that most of the procedural practices for the implementation of the CARES Act were left to the individual banks to establish. Unfortunately, lack of statutory clarity frequently leads to litigation and with borrowers’ houses at risk, it's fair to expect that the amount of CARES Act litigation may ramp up in the months following the end of the moratorium. Unlike property, which typically protects its purchasers from litigation through bona fide purchaser for value laws, purchasing a note does not cutoff liability for the actions of prior owners, placing the purchaser in a similar legal position as the original lender and all prior purchasers. Although some of this liability can be mitigated through covenants and indemnifications in the note purchasing documents, buying into the potential liability based on the actions of other parties in an uncertain legal environment creates an amount of risk that is very difficult to quantify.

Low Interest Rates

Interest rates were low before the pandemic, but they hit historic lows during the pandemic. For whole loans and note purchasers, a low interest market requires a new approach, as most of the recent secondary market inventory was originated at low interest rates and is being offered at low yields. These low yields also make older, higher interest rate inventory more desirable and thus more expensive. Surprisingly, mortgage origination volume has significantly increased in the past five years and rose almost every quarter during the pandemic, insuring that there is no shortage of pandemic-originated whole loan inventory. Furthermore, higher interest rate inventory is relatively more scarce, given that 30 and 15 year-fixed rates have been under 4.5% for over 24 months, further adds to the expense of higher-interest mortgage inventory. Coupled with the inflation trending upward, passing 4% in June 2021, and 30 year T-bills yields seemingly trending downward, buying into low interest mortgages, especially performing fixed mortgages, seem to be a losing proposition.

Naturally, Adjustable Rate Mortgages can provide some performance in the current low interest rate environment, depending on how they are indexed and their collars, caps, ceilings and floors. That said, due diligence is at a premium in this market, as an ARM that was underwritten with a view of the interest rate market that is not reflective of today’s conditions will perform no better than a fixed mortgage.

Red Hot Housing Market

Rising home values may be great for property owners, but for mortgage purchasers, the accompanying low interest rate environment creates some mixed results. Typically, low interest rates equate to more buyers in the market, creating a “seller’s market.” Sellers in turn respond by placing more houses on the market, inventory increases and the market shifts. Post pandemic, it has become apparent that after an initial period of massive movement, demand has outpaced supply, leading to a lack of inventory in the residential market that has fueled a price bubble. This scarcity of inventory, coupled with the record originations numbers mentioned above makes it clear that the current whole loan market is driven by property owners refinancing into today’s very low rates.

In effect, the nature of residential whole loans originated during the pandemic has reverted them to stable alternatives to risk-free investments. A whole loan purchase has once again become a purchase of a high balance loan at low to moderate interest rate. Unfortunately, interest rate yields at such a low level are typically not attractive enough to offset the impending legal and payment risks that seem to be imminent as we head to post-pandemic “new normal.”

Commercial Fundamentals Shaky

Commercial mortgages are also being underwritten at very low interest rates, but for different reasons. Questions about the performance of real estate fundamentals as the pandemic subsides continue to dominate every commercial real estate asset class, except multifamily. To further add to the problem, unlike in the residential market, commercial real estate inventory has increased significantly, as many business shrunk their physical presence during the pandemic or relocated. This increased inventory only serves to depress values, increase area cap rate demand and further destabilize confidence in the commercial real estate market. For commercial, the risk is less underwriting risk and more market risk. The character of the post pandemic market has yet to reveal itself and so any underwriting projections on asset performance are largely speculative beyond year one. As a reminder, purchasers of commercial real estate notes are locked into underwriting assumptions for the life of the loan, unless terms are modified by the lender and borrower. Current market uncertainty makes a long term view of the market very shaky. Commercial real estate mortgages do have one saving grace, however—they are typically sold and purchased individually, reducing portfolio risk and increasing the chance that deal idiosyncrasies lead to value.

So Now What?

In this market, property is the clear answer. Although finding a suitable property can be difficult right now, for various reasons, the legal protections that come with property purchase cannot be matched. Furthermore, property continues to boast the benefit of forced appreciation. Although notes can experience a similar effect through loan modifications and other loss mitigation methods, as stated above, whole loans are currently subject to a level of risk that does not justify their returns. The distressed note inventory that would lend itself to modifications is even more risky and less justified in this market. If whole loans must be on the menu, then ARMs may be the flavor of choice, as they are designed to mitigate unfavorable mortgage markets. Careful due diligence is required, however, to ensure that the mortgages in the portfolio are structured to behave favorably in the current market.

That is my take on whole loans in today's market. Please feel free to leave your comments below.