Following a period of historically low levels of existing home sales, serious questions remain unanswered with respect to the current state of the residential housing market. Has the market crashed? Will the market crash? What constitutes a housing market crash? Does a significant drop in housing transactions define a crash (I bet our local real estate agents would think so)?
Perception matters, and the health of the housing market differs depending on who is asked. Real estate brokers and home buyers may perceive the market as unhealthy because housing transactions have been curtailed since the onset of Fed tightening. However, profit-seeking investors view market health through the lens of supply-demand dynamics, home value trends, and credit market conditions. From their perspective, this market is rife with opportunity.
Understanding private residential credit
Before investors can incorporate a residential credit strategy into their portfolio, they need to understand the market and where the potential is to produce gains. Market participants tend to associate private credit with the $1.5 trillion non-bank corporate lending market. They forget about the estimated $4 trillion private residential credit sector, which is a subset of the broader $13.4 trillion U.S. mortgage market. Within the private residential credit sector there are a multitude of product types with varying degrees of risk, return, and duration profiles. The market offers everything from distressed loans to high quality performing credit products, as well as short duration construction loans and long duration 30-year consumer loans.
This variety and scale offers investors numerous portfolio construction options tailored to their specific risk tolerances and return objectives. At any point in time, housing market conditions play a significant role in determining the opportunity set across the spectrum of residential credit products.
Housing market dynamics create the opportunity
In 2022 and 2023, the market was focused on the impact that rising interest rates would have on demand for housing. What everyone missed was the disproportionate effect it would have on supply. The U.S. originated $10.5 trillion of loans from late 2019 to early 2022, with average interest rates of approximately 3.5%, according to the Mortgage Bankers Association. As a result, consumers are not rushing out to sell homes only to lose their low-rate mortgages. We can see the impact on supply-demand dynamics in headline metrics such as existing home inventory, which is 53% below the historical average, and supply-demand parity indicators such as months’ supply of existing homes, days on market, owner occupied vacancy rates, and months to sale since completion of new homes, all of which are at or near historically low levels. All metrics indicate an overwhelmingly undersupplied housing market relative to today’s demand.
Why it’s an attractive portfolio strategy
As credit investors, there is a desire to finance things that are in high demand and/or low supply. Property markets across the U.S. are undersupplied, and, therefore, providing short duration, high yielding (10%+ asset yield) construction loans to builders is attractive for multiple reasons:
- The tailwinds in the undersupplied housing market support the construction loan thesis.
- The operational complexity component to residential construction loans limits competition and price risk, providing investors with a yield premium relative to other sectors.
- The dispersion of economic outcomes over the next 12 to 24 months is wide, and maintaining an allocation to high yielding short duration loans provides the flexibility to pivot into opportunities as conditions develop.
There are other private residential credit opportunities besides construction loans that are borne out of the current market conditions. Most investors like to buy assets at discounts and, historically, investors could access distressed residential loans at a discount to the loan’s contractual debt. Today, investors can purchase high quality performing loans at a discount targeting 8.5% to 9.5%+ asset yields, with land and building structures as tangible collateral.
All of this ties back to the $10.5 trillion of loans with 3.5% average interest rates. These loans trade in the secondary market for a variety of reasons, and, due to the current rate environment, investors can acquire them at 15% to 30% discounts. Not only does this create a large margin of safety between the purchase price of the loans and the underlying property value, but it also creates a path toward outperformance through active asset management strategies focused on accelerating the recovery of the purchase price discount.
A bright spot for investors
We believe that residential housing is likely to be a bright spot in the coming year, as troubles in commercial real estate, banking, and legacy tech valuations take the spotlight.
While the dispersion of outcomes is wide, the probability-weighted outlook today is arguably better than those faced circa 2021 when rates were low, credit spreads were tight, and prices were high. Unlike the 2020-2021 period, we believe that the distribution of returns in many residential credit products is positively skewed in favor of the investor in today’s environment.
