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2 December 2013
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2 December 2013, Comments: 0

Chris Smith recently interviews Terry Kaufmann about Mortgage-Backed Securities in an addition of “Word on the Street.”

Interview with Terry Kaufmann, President, Rockhouse Capital

Partners and Friends,
In the last several issues of Word On The Street, we wrote that we expect home prices to continue falling in the near-term. Many investors agree with our cautious outlook and have embraced alternative real estate investments to find new opportunities.ISCM believes that some alternative real estate vehicles can offer value, but that investors must perform adequate due diligence to select alternatives that fit their personal risk profile. I spoke with Terry Kaufmann, President at Rockhouse Capital, about the condition of the housing market and his favorite class of alternative real estate investments — Mortgage-Backed Securities (MBS).
Chris Smith | Managing Director

Is our assessment of the housing market too negative?
TK: Not at all. I agree that home prices will continue to decline as foreclosure sales and short sales – often at a deep discount – crowd other sales out of the market. We expect housing weakness to contribute to continued volatility across all capital markets for the next several years.When the real estate market was hot, flipping homes was extremely popular. Given the reality of weaker markets how can investors protect themselves from falling home prices and market volatility?

During the bubble years investors could easily buy low and sell high as constant home price appreciation created quick profits for home flippers. We call these “Market Value Investments” since their return was driven by a positive change in market value. But in a flat or falling economy these investments will struggle.At Rockhouse Capital we focus on “Cash Flow Investments”; alternative assets driven by a series of cash flows that can perform well when broader markets are falling. We believe that investors should allocate a larger percentage of their portfolio to such investments when prices are volatile.

What is a Cash Flow Investment and how can they prosper in a falling market?
TK: When market growth is low or non-existent, income producing investments can still create a positive return by virtue of their class flow. Cash Flow Investments are driven by these regular payments.

For example, a rental property can produce enough monthly cash flow for its owner to ignore soft home prices for as long as he is willing and able to own the property. The flipper on the other hand would have locked-in a loss over the same period.

Rental properties are growing in popularity as home prices fall. They seem to be an obvious alternative to flipping.
TK: We consider rental properties to be a hybrid between a Market Value Investment and a Cash Flow Investment since the eventual sale of the property is almost always required to create a positive return. Many investment properties have become rental properties by necessity because the owner is unwilling to sell the property at an immediate loss. Other investors are purchasing property with the goal of owning rentals. This strategy can be profitable and satisfying for investors who enjoy owning physical property.The downside to owning rental properties is that the investor remains exposed to falling real estate prices. Collected rent may pale in comparison to a property’s loss of market value.It also can be difficult to create a positive net cash flow when the expense of property management, mortgage payments, and maintenance costs are considered.

Your firm specializes in Mortgage-Backed Securities (MBS). What is a Mortgage-Backed Security and how do they qualify as Cash Flow Investments?
TK: MBS are portfolios of individual mortgage loans that have been combined for the convenience of investors. A Mortgage-Backed Security is like a jar filled with marbles, where each marble represents an individual loan with a borrower who is responsible for monthly payments. MBS gives the investor partial ownership of every loan in the portfolio. There are several advantages to buying real estate in such a structure: First, a carefully selected portfolio of MBS can diversify an investor’s risk across thousands of loans in a variety of cities and states. This provides valuable risk diversification – especially for investors with a limited wallet. Next, the loans are managed by a servicing company which collects monthly Principal and Interest payments from the homeowners. The cash is passed directly to investors each month. This is more efficient than hiring a management company to oversee an individual property or a small portfolio of properties.Finally, the borrower is making mortgage payments rather than rental payments. Because he will eventually own the home, the borrower has a stronger incentive to continue making payments.

Weren’t MBS at the center of the financial collapse?
TK: Yes, and it is easy to understand why. If all of the marbles in your MBS Jar are bad – say loans made in 2006 at the height of the real estate bubble – it is unlikely that borrowers will successfully pay back their loans. The MBS created with such loans have lost most of their value as the loans have failed. Financial institutions bought Billions of dollars of MBS stuffed with these toxic loans and their balance sheets continue to suffer as a result. But MBS structured with loans originated prior to 2005 have performed much better. Most of these borrowers continue to make regular payments. The majority hold positive equity in their homes. Despite their good performance, pre-2005 MBS continues to trade at a deep discount. This represents an excellent opportunity for investors with the ability to analyze the underlying loans, identify MBS holding “good marbles”, and buy them at the right price.

Are there risks to holding MBS?
TK: There are risks to all investments and MBS is no exception. Illiquidity (the lack of liquidity) is an important risk for all alternative asset investors to consider. The market has taken several memorable dips since 2008 and alternative asset prices tend to dip lower during such shocks. They also tend to take longer to recover. Investors with a short-term horizon should not expose themselves to the risk that prices are low when they need to sell. The second risk is that real estate prices continue to fall. Buying MBS allows us to diversify — but not completely remove — risk from the portfolio. If home prices continue to fall, pushing more homeowners underwater, loan performance could suffer – even for loans made prior to the housing bubble. Good analysis is important, but we must also have the humility to understand that markets are continually changing. We attempt to offset these risks by promoting diverse holdings and demanding a deep discount when we purchase investments.

Investors have already started to shift to alternative investments. How do MBS compare with other alternatives such as REITs?
TK: MBS and REITs are both structures that allow partial ownership of a portfolio of real estate assets. The biggest difference is the type of assets in each portfolio. REITs are often structured with income producing properties such as hotels or commercial real estate.As with MBS, individual REITs will only perform as well as their underlying assets, so REITs should be researched and selected carefully.

Briefly summarize your best advice for investors buying their first alternative investments?
TK: Do your homework, don’t be afraid to ask questions, and make decisions at your own pace.

Thank you for your time, Terry

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