Market & Topical Perspectives

There’s No Place Like Home

There’s No Place Like Home

Key Takeaways

  • Continued strong dynamics in the US housing market combined with regulatory headwinds for conventional lenders have generated opportunities to invest in real estate specialty lending with attractive risk-adjusted return potential.

  • With attractive yields, robust cash flows and short durations, we believe residential transitional loans and land banking appear to be especially compelling segments among private assets.

  • Publicly traded real estate-linked credits—including agency mortgage-backed and credit-risk transfer securities and higher yielding opportunities linked to mortgage insurance and non-qualifying mortgages—may provide attractive complements to private credit investments.

  • Investors with the flexibility to opportunistically manage exposures may capture the benefits offered within private and public real estate debt while exploiting the relative-value discrepancies that periodically emerge between them.

Even as a yawning gap between housing supply and demand has provided a tailwind for US residential real estate values, regulatory changes since the global financial crisis have reduced the availability of bank financing for certain types of real estate activities. The resulting disconnect has created an opportunity for a new cohort of private lenders to step in as liquidity providers—and potentially generate attractive, long-term returns for themselves and their investors.

This has included participation in such private-market segments as residential transitional loans and land banking, where yields offer attractive complexity and illiquidity premia over traditional credit assets like leveraged loans and high yield bonds, alongside short durations and robust cash flows. Certain public-market assets, meanwhile, may complement these private investments. High-yielding opportunities may potentially be found in credit-risk transfer securities issued by agencies such as Fannie Mae and Freddie Mac, for example, or in instruments linked to mortgage insurance and non-qualifying mortgages.

While we believe supply/demand dynamics in the US residential real estate market are likely to support durable investment opportunities in real estate specialty lending, these investments tend to have high barriers to entry. Experience sourcing, underwriting and structuring such deals may be a prerequisite for success.

US Housing Market Has Cooled but Remains Significantly Undersupplied…

The US hasn’t built enough homes in recent decades, leading to a significant gap between housing supply and demand, estimates of which vary from 1.6 million to 5.5 million units.1 The lack of affordable homes highlights the need for increased supply in both the new- and existing-home markets. We believe the motivation to close the supply/demand gap represents a strong and durable tailwind for residential new construction and the renovation of existing homes as well as demand for the capital needed to fund these projects.

The current housing shortfall can be traced back to the global financial crisis, as the pullback in consumer credit at the time prompted a sharp decline in housing starts from which the industry has yet to recover.2 Household formation (that is, growth in the number of families), meanwhile, has continued nearly unabated, and the resulting gap between housing supply and demand has widened further, as shown in Exhibit 1. The impact of new-housing underbuilding has been exacerbated by the limited supply of existing homes for sale, partially due to the “lock-in effect” that serves as a disincentive for homeowners to sell. To illustrate, 81% of outstanding mortgages carry an interest rate below 5%, 61% are below 4%, and 23% are below 3%;3 the 2023 high for the Freddie Mac 30-year fixed was 7.79%.4 And with a median age of owner-occupied homes at 40 years, the homes that do come to market likely will need remodeling to maximize their value.5

Exhibit 1. The US Housing Gap Has Worsened in Recent Years
Cumulative in Millions, 2008 through November 2023

exhibit 5

*Year to date through November 30, 2023.
Source: Source: Federal Reserve Bank of St. Louis; data as of November 30, 2023.

While housing supply has grown increasingly strained over the past 15 years, regulatory changes in the wake of the global financial crisis have hampered banks’ ability to finance certain types of real estate activities, including acquisition, development and construction lending. As shown in Exhibit 2, for example, construction loans as a percentage of bank total assets today are less than half of what they were in 2007. Effectively, the banks have been replaced by a highly fragmented set of lenders across the country that lack institutional capital, which has presented an opening for asset managers to become liquidity providers in the space at attractive terms.

Exhibit 2. Traditional Banks Have Pulled Back from Certain Types of Real Estate Lending
Construction Loans as a Percentage of Total Bank Assets, 2007 through March 2023

Exhibit 3

*Year to date through March 31, 2023.
Source: Federal Deposit Insurance Corporation; data as of March 31, 2023.

Despite the adverse impacts of inflation and tighter financial conditions, US consumers remain in good financial shape, suggesting near-term demand for housing should remain strong. At the end of the second quarter of 2023, the total value of the US single family housing market increased to an all-time high of $44.5 trillion, 84% above the 2006 peak.6 A large portion of this growth came from the increase of homeowners’ equity, which rose 123% over this period, while outstanding mortgage debt only increased 29% to $12.9 trillion.6 Given the dramatic increase in equity relative to mortgage debt, the rate of aggregate residential mortgage debt to value has declined to 29% today from more than 50% in second quarter 2013.6 Households with low-rate mortgages secured before the recent hikes, in particular, have benefitted from this deleveraging and maintain strong debt-service ratios even as other forms of credit have grown more expensive.

…Creating Durable Opportunities for Providers of Capital to the Real Estate Industry

The increase in benchmark rates since the Federal Reserve began its rate-hike cycle in early 2022 has pushed yields across public credit investments in general to levels not seen in decades, while yields on more complex private credit assets also rose, albeit at a slower pace. In light of our constructive view on US residential real estate, the yields available in market segments like residential transitional loans and land banking appear particularly compelling to us. In addition to offering complexity and illiquidity premia of 200–300 basis points over traditional market options like leveraged loans and high yield bonds, the short durations and robust cash flows typical of these assets enable frequent reinvestment of proceeds.7

Residential transitional loans. To many buyers, a refurbished home in an established neighborhood can be more desirable than a new home in a new area, allowing them to tap into proven infrastructure like schools, parks and retail, potentially at a better price. This demand combined with the aged US housing stock shown in Exhibit 3 has fueled a surge in “fix and flip” activity in which real estate developers buy single-family residences with the intent of renovating and reselling at a profit within a short period of time. There is a similar dynamic evident in the multifamily space, as real estate investors seek to upgrade existing rental properties to standards that can command higher rents.

Of course, all of this requires capital. As commercial banks have pulled back from providing this type of financing, a fragmented group of specialty lenders has stepped in to fund these short-duration value-add renovation loans. The majority of these lenders lack the capital to underwrite and hold these loans at meaningful scale, however, and asset managers have been able to provide necessary liquidity to the real estate industry by purchasing individual loans to construct diversified portfolios with attractive risk-adjusted return potential.

Exhibit 3. Aging US Housing Supply May Drive Demand for Renovation Capital
Estimates of Median Age in Years of US Owner-Occupied Housing, 2005 through 2021

exhibit 4

Source: US Census Bureau, American Housing Survey; data as of December 31, 2021.

Land banking. Another byproduct of post-crisis US housing market dynamics is a shortage of permitted, build-ready lots for single-family construction, as the ownership of such lots can substantially tie up capital on a homebuilder’s balance sheet. The top homebuilders are increasingly moving toward a “land light” business model, and off-balance-sheet financing solutions like land banking have become a staple of their land inventory-management strategies.

In an example land-banking deal, a lender may acquire an entitled, permitted and improved property while simultaneously entering into an agreement with a homebuilder giving it the option to acquire lots over time in exchange for a nonrefundable fee. The two parties commonly enter into a construction agreement whereby the builder is paid by the land banker to develop the land, and a “takedown schedule” governs the pace at which the homebuilder must acquire individual lots on that property. Homebuilders typically are willing to pay a significant spread over benchmark interest rates for the optionality and off-balance-sheet treatment a land-banking arrangement affords. Given their financial strength and long operating histories, large public homebuilders have the capacity to furnish significant upfront deposits and completion guarantees that smaller private homebuilders are unable to offer.

Public securities. The opportunity we see in US real estate debt is not limited to private deals, however; real-estate-linked publicly traded structured credit, for example, may also provide attractive potential yields and serve as a complement to private deals. In fact, investors able to opportunistically manage their exposures to both public and private real estate debt markets may be well-positioned to capture not only the benefits of each but also the relative-value discrepancies that periodically emerge between them.

Agency mortgage-backed securities (MBS)—issued and guaranteed by US government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac—are one of the largest and most active of the structured credit asset classes.8 The largest holders of high-quality MBS risk, GSEs have the implicit backing of the US government; as a result, agency MBS present very limited credit risk to investors and pay relatively low yield spreads as compensation for interest rate risk. GSEs mitigate their own credit risk exposure through the issuance of non-guaranteed credit-risk transfer (CRT) securities referencing pools of mortgages they own; as CRTs bear both credit risk and interest rate risk, they offer wider spreads than agency MBS. CRTs are issued in tranches of different seniorities and risk/return profiles, enabling investors to tailor their exposure across junior, more credit-intensive segments of these securitizations. Similar high-yielding opportunities also can potentially be found outside the agencies, such as through instruments linked to mortgage insurance and non-qualifying mortgages.

Since GSEs issue these securities primarily to mitigate risk, they tend to do so programmatically rather than strategically based on market conditions. This sometimes gives rise to pricing inefficiencies that can be exploited, especially as programmatic buyers like the Fed have pulled back from the market. Moreover, the reduced capital flows that accompany periodic market dislocations—such as the outbreak of Covid-19 in 2020 or the regional bank crisis in early 2023—can drive spreads significantly wider even if the underlying fundamentals of the mortgages backing the securities are little changed.

Getting the House in Order
While the US housing market today presents both challenges and opportunities, we believe its technical and fundamental dynamics reflect a persistent structural trend that will be supportive of mortgage credit in the near term. The fragmented specialty-lending segments discussed above tend to have high barriers to entry, however, highlighting the importance of sourcing, underwriting and structuring experience for those looking to leverage the ample opportunities we believe exist in residential real estate credit.

1. Source: Congressional Research Service; data as of July 10, 2023.
2. Source: US Census Bureau; data as of October 31, 2023.
3. Source: John Burns Research and Consulting; data as of August 2023.
4. Source: Freddie Mac; data as of October 26, 2023.
5. Source: US Census Bureau; data as of October 31, 2023.
6. Source: Urban Institute; data as of November 30, 2023.
7. Source: Citi Research, Napier Park; data as of December 4, 2023.
8. Source: Securities Industry and Financial Markets Association; data as of December 7, 2023.

The opinions expressed are not necessarily those of the firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation to buy, hold or sell or the solicitation or an offer to buy or sell any fund or security.

Past performance is not indicative of future results.

Risk Disclosures

All investments involve the risk of loss of principal.

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Alternative Investment Risks
Alternative investments can be speculative and are not suitable for all investors. Investing in alternative investments is only intended for experienced and sophisticated investors who are willing and able to bear the high economic risks associated with such an investment. Investors should carefully review and consider potential risks before investing. Certain of these risks include:

  • Loss of all or a substantial portion of the investment;
  • Lack of liquidity in that there may be no secondary market or interest in the strategy and none is expected to develop;
  • Volatility of returns;
  • Interest rate risk;
  • Restrictions on transferring interests in a private investment strategy;
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  • Below investment grade loans, which may default and adversely affect returns.

Asset-based lending (ABL) is corporate borrowing supported by specific assets of the borrower.

The Conference Board Leading Economic Index (LEI) is a composite index of economic and market variables that aims to identify potential turning points in the business cycle.

Credit-risk transfers (CRTs) are transactions that transfer the credit risk of all or a tranche of a portfolio of financial assets.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

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Government-sponsored enterprises (GSEs) were established and chartered by the US federal government for public policy purposes. They are private companies, and their securities are not backed by the full faith and credit of the federal government.

Mortgage-backed securities (MBS) are financial instruments collateralized by pools of mortgages.

Personal consumption expenditures (PCE) price index is a measure of consumer spending on goods and services among households in the US.

Indexes are unmanaged and one cannot invest directly in an index.

ICE BofA MOVE Index is a measure of US interest rate volatility. It is a yield curve-weighted index of the normalized implied volatility on one-month Treasury options.

MSCI China Index (Net) measures the performance of large and midcap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings. A net-return index tracks price changes and reinvestment of distribution income net of withholding taxes.

MSCI EAFE Index (Net) measures the performance of large and midcap securities across 21 developed markets countries around the world, excluding the US and Canada. A net-return index tracks price changes and reinvestment of distribution income net of withholding taxes.

MSCI World Index (Net) measures the performance of large and midcap securities across 23 developed markets countries around the world. A net-return index tracks price changes and reinvestment of distribution income net of withholding taxes.

Russell 1000® Growth Index (Gross/Total) measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values. A total-return index tracks price changes and reinvestment of distribution income.

Russell 1000® Value Index (Gross/Total) measures the performance of large-cap value segment of the US equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. A total-return index tracks price changes and reinvestment of distribution income.

Russell 2000® Index (Gross/Total) measures the performance of the small-cap segment of the US equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. A total-return index tracks price changes and reinvestment of distribution income.

S&P 500 Index (Gross/Total) is a widely recognized unmanaged index including a representative sample of 500 leading companies in leading sectors of the US economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 80% coverage of US equities, it is also considered a proxy for the total market. The S&P 500 includes dividends reinvested. A total return index tracks price changes and reinvestment of distribution income.

Large Blend Morningstar Category: Large blend portfolios are fairly representative of the overall US stock market in size, growth rates and price. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate. These portfolios tend to invest across the spectrum of US industries and, owing to their broad exposure, the portfolios’ returns are often similar to those of the S&P 500 Index.

Large Growth Morningstar Category: Large growth portfolios invest primarily in big US companies that are projected to grow faster than other large cap stocks. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value and cash flow) and high valuations (high price ratios and low dividend yields). Most of these portfolios focus on companies in rapidly expanding industries.

Large Value Morningstar Category: Large value portfolios invest primarily in big US companies that are less expensive or growing more slowly than other large cap stocks. Stocks in the top 70% of the capitalization of the US equity market are defined as large cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value and cash flow).

Small Blend Morningstar Category: Small blend portfolios favor US firms at the smaller end of the market-capitalization range. Some aim to own an array of value and growth stocks, while others employ a discipline that leads to holdings with valuations and growth rates close to the small cap averages. Stocks in the bottom 10% of the capitalization of the US equity market are defined as small cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.

Small Growth Morningstar Category: Small growth portfolios focus on faster-growing companies whose shares are at the lower end of the market-capitalization range. These portfolios tend to favor companies in up-and-coming industries or young firms in their early-growth stages. Because these businesses are fast-growing and often richly valued, their stocks tend to be volatile. Stocks in the bottom 10% of the capitalization of the US equity market are defined as small cap. Growth is defined based on fast growth (high growth rates for earnings, sales, book value and cash flow) and high valuations (high price ratios and low dividend yields).

Small Value Morningstar Category: Small value portfolios invest in small US companies with valuations and growth rates below other small-cap peers. Stocks in the bottom 10% of the capitalization of the US equity market are defined as small cap. Value is defined based on low valuations (low price ratios and high dividend yields) and slow growth (low growth rates for earnings, sales, book value and cash flow).

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The offering of the products and/or services described herein have not been approved or licensed by the UAE Central Bank, the UAE Securities and Commodities Authority (SCA), the Dubai Financial Services Authority (DFSA) or any other relevant licensing authorities in the UAE, and accordingly does not constitute a public offer in the UAE in accordance with the commercial companies law, Federal Law No. 2 of 2015 (as amended), SCA Board of Directors’ Decision No. (13/Chairman) of 2021 on the Regulations Manual of the Financial Activities and Status Regularization Mechanisms or otherwise. Accordingly, the presentation is not offered to the public in the UAE (including the Dubai International Financial Centre (DIFC)).

This presentation is strictly private and confidential and is being issued to a limited number of institutional and individual clients:

  1. who meet the criteria of a Professional Investor as defined in SCA Board of Directors’ Decision No. (13/Chairman) of 2021 on the Regulations Manual of the Financial Activities and Status Regularization Mechanisms or who otherwise qualify as sophisticated clients;
  2. upon their request and confirmation that they understand that the products and/or services described in this presentation have not been approved or licensed by or registered with the UAE Central Bank, the SCA, DFSA or any other relevant licensing authorities or governmental agencies in the UAE;
  3. must not be provided to any person other than the original recipient, and may not be reproduced or used for any other purpose.

Important Information for Residents of United Kingdom
This document is issued by First Eagle Investment Management, LLC and is lawfully distributed in the United Kingdom by First Eagle Investment Management, Ltd. First Eagle Investment Management, Ltd is authorised and regulated by the Financial Conduct Authority (FRN: 798029) in the United Kingdom. This document is directed only at persons in the United Kingdom who qualify as “professional investors". This document is not directed at any persons in the United Kingdom who would qualify as “retail investors” within the meaning of the UK Alternative Investment Fund Managers Regulations 2013 (S.I. 2013/1773) or the EU Packaged Retail and Insurance-based Investment Products Regulation (No 1286/2014), the UK PRIIPs Regulation, and such persons may not act or rely on the information in this document.

FEF Distributors, LLC (“FEFD”) (SIPC), a limited purpose broker-dealer, distributes certain First Eagle products. FEFD does not provide services to any investor, but rather provides services to its First Eagle affiliates. As such, when FEFD presents a fund, strategy or other product to a prospective investor, FEFD and its representatives do not determine whether an investment in the fund, strategy or other product is in the best interests of, or is otherwise beneficial or suitable for, the investor. No statement by FEFD should be construed as a recommendation. Investors should exercise their own judgment and/or consult with a financial professional to determine whether it is advisable for the investor to invest in any First Eagle fund, strategy or product.

First Eagle Investments is the brand name for First Eagle Investment Management, LLC and its subsidiary investment advisers.

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