|Shares Out. (in M):||42||P/E||0.0x||0.0x|
|Market Cap (in M):||1,137||P/FCF||0.0x||0.0x|
|Net Debt (in M):||425||EBIT||0||0|
I believe RESI offers investors a truly unique and compelling opportunity to invest in the housing cycle. I believe RESI has limited downside risk, substantial upside potential, and can pay a decent dividend in the interim while the company scales up and investors wait.
The single family rentals (SFR) industry offers several compelling investment opportunities – rosie918 recently highlighted one in ARPI and gary9 highlighted CLNY this summer. You can visit either of those ideas for the general opportunity in the homes for rental market, but to me there are several characteristics that make the industry attractive. It is a massive and highly fragmented market. We appear to be at the beginning of a secular change away from homeownership and towards rentals. Housing prices in many parts of the country have a long way to go to recover to prior peaks or even to replacement cost. Forward inflation risk favors real assets and even further home price appreciation. And there are no trusted brands yet in the single family market – unlike the apartment market where large REIT brands have established themselves over the last couple decades. And we are still in a period where institutions with capital have an edge in buying properties as many individuals either cannot buy (due to lost savings, lost equity value in their own homes, or ruined credit) or have chosen to sit out the market for the time being, still traumatized from the housing meltdown of 2007-2011.
There is a lot to like about the SFR industry over the long term for the reasons mentioned above, but to date, the public SFR players have struggled – at least their share prices have – for a few reasons. First and I believe most importantly, SFR REITs don’t yet pay meaningful dividends, and REIT investors don’t seem to appreciate REITs without any yield. The reason SFRs can’t pay much in the way of dividends yet is that they are growing rapidly. Rapid growth means low occupancy, as new vacant homes have been added to portfolios at rates that have exceeded lease-up rates. Until portfolios stabilize, occupancy levels, NOI, AFFO, and ultimately dividends cannot reach attractive levels. The lack of public investor appetite has caused SFR stocks to languish, causing another major problem, limited attractive capital for growth. Trading below book value, SFR stocks have been effectively shut out of the equity markets. Credit markets have been of limited benefit either as most industry participants have been averse to relying too much on credit and nascent SFR lending is only now gathering momentum (with recent progress in securitization a very promising development for the group). No capital equals slower growth, and less of an ability to scale. Which leads to another big problem for much of the group – external management fees that eat up book value at an unappealing level – especially when growth is limited. And lastly, though the rental market for homes is massive and in no way new, institutionalization of the market is new, and investors are still taking a cautious view of SFR players’ ability to effectively operate diverse properties spread across multiple cities.
What makes RESI unique is that it has developed the lowest acquisition cost model for SFR and solved many of the key issues to date with SFR business.
What is RESI’s approach?
RESI buys homes through the purchase of non-performing loan portfolios. It then works with Ocwen to either 1) get the borrower current or modify the loans to make them current or 2) take ownership of the property if the borrower cannot continue to make payments. RESI then determines whether a home can be rented at an attractive yield or not. If so, then the house is renovated and rented with the help of Altisource Portfolio Solutions (ASPS). If not, then the home is sold (possibly renovated first if a positive return is expected on incremental investment).
Why is RESI low-cost?
Others in the SFR industry buy homes through a few channels: MSR channel (regular listings of properties), auction (foreclosures), and bulk (portfolio purchases from other institutional holders of homes). All of these channels provide opportunity to get good deals on homes, but there are few barriers to entry in these channels, and much of the easy money has been made by those that bought most aggressively in 2009 to early 2012. RESI buys distressed properties pre-auction through the non-performing loan (NPL) market from banks or other financial institutions that hold loan portfolios in various stages of default. Whereas traditional channels for SFR offer slight discounts to fair value (adjusted for investment in renovation), the NPL market offers loans at greater than 30% discount to market. And where anyone can bid in the MSR market or in the auction market, only a limited number of sophisticated investors are in the NPL market. Not only is supply/demand better in the NPL market compared to the other channels, but substantial costs are eliminated by going through this channel. Sales commissions and other foreclosure costs can be avoided going through the NPL market instead of the MSR and auction markets. The typical NPL buyer is a hedge fund or other financial institution that buys a portfolio and works with an affiliated or partner specialty servicer to either modify the loans or sell the properties in the portfolio. RESI is no different, working with Ocwen to get a loan current or sell the property if the borrower cannot pay. But RESI has added the rental option to the mix through its relationship with ASPS.
How has RESI solved the dividend problem?
Getting loans current or modifying a loan pays immediate dividends for RESI. NPL purchases have to date come between 65-70% of market value (broker price opinion based market assessment). These portfolios have to date had unpaid principal balances (UPB) of 120-150% of market value. If an average loan in the portfolio is made current without a modification, this is a homerun for the NPL buyer and yields an almost 100% return on total capital (pay 67% of market and a loan with UPB of 130% of market goes current). The servicer is unlikely to get many loans current without modification, and typical modifications come in at 95% of market value. This is still very attractive, returning over 80% on equity assuming funding at 50% debt to capital (pay 67% of market for the loan, fund ½ of purchase with debt, modify to 95% of market). RESI has estimated 10-15% of its NPL portfolios can be made current or modified which at the low end yields 6-7% on the entire NPL portfolio in the first year (10% * 84% return on equity as above less carrying cost for 6-9 months). In Q3, RESI had 118 loans resolved, of which 14 (12%) were effectively made current (refinance, paid in full, reinstated) and another 30 (25%) were modified. In Q2, of the 104 loans resolved, 18 (17%) were made current and 18 were modified (17%). RESI had boarded 1,410 loans before the end of Q2 so within 6 months, they had already modified or made current almost 6% of these loans, making the 10% objective for modification look attainable. As a result, RESI paid a $0.10/share dividend one quarter (Q2 2013) after boarding its first portfolios and had $0.18-0.20/share dividend capacity (assuming 90-100% dividend of taxable income) in its second full quarter (Q3 2013). RESI can also recycle capital from any loan made current or modified by selling the performing loan at par.
How has RESI solved the scaling problem?
RESI leverages two large related entities to give it immediate scale. Ocwen, as described above, is critical to loan servicing. This gives RESI immediate scale in the process of getting loans current or making modifications. As described above, this covers 10-15% of the portfolio. The remainder of the portfolio leverages ASPS for either the rental or disposition of the property. For rentals, ASPS will manage renovation, leasing, and maintenance. ASPS already has a national vendor network that it uses to maintain and renovate homes before disposition. ASPS is managing over 300k delinquent loans for Ocwen as of Q3 2013 and has been selling about 6k homes per quarter through its Hubzu website. While the ability to successfully execute on the growth and management of a large rental business is an issue for the entire industry, RESI at least is starting with a partner with operating experience, national scale, and a known vendor and contractor base.
RESI also has addressed the external management issue with a sliding fee scale. AAMC (written up in VIC previously – but as a short because of valuation) is the external manager for RESI and gets paid 2% of all cash available up to $0.161/share quarterly dividend, 15% of cash available from $0.161-0.193/share quarterly dividend, 25% of cash available from $0.193-0.257/share quarterly dividend, and 50% of dividend above $0.257/share. All told, until RESI pays out greater than $1.03/share in annualized dividend, AAMC gets paid out $0.098/share in total. And above $1.03/share in annualized dividend, AAMC splits cash flows 50/50 with RESI. While this limits the potential upside in RESI somewhat, it avoids the problem of management fee bleed in a scenario where the model is not working. Also, the incentive of the manager in this structure is aligned with the RESI shareholder, as both are looking to maximize dividend potential (as opposed to other structures where managers are incentivized solely to maximize AUM).
RESI to date has had better success in the capital markets
Because RESI is buying assets at substantial discounts, is paying dividends from the outset, and has avoided destructive management fee drains on capital while it scales, RESI has had more success than peers in accessing the capital markets. In the credit markets, RESI has gotten credit facilities with advance rates of 63% at blended cost of L+300bps. This is attractive and supports continued accretive growth of the model through additional NPL acquisitions. More importantly, RESI trades at a healthy premium to book value. Book value after the most recent secondary is $18.30/share ($425m of equity on 9/30 + $349m of net proceeds from offering on 10/1 divided by 42.3m shares). The shares most recently traded at $27/share or approximately 1.5x book value (which I believe is cheap as I will discuss in more detail below). Any additional offerings of equity to support further portfolio additions will be accretive to book value – for example, another $300m equity deal at the current price would be about 10% accretive to reported book value.
To illustrate the potential accretion from growth, let’s work through an example. Suppose we assume NPL portfolios are still selling at 70% of market value (higher than actual to date), and debt to capital is sustainable at 50% (even though advance rates are already above 60%). At the current equity base for RESI of $774m (after the most recent offering), RESI would have a total capital base of $1.55b, which at 70% price to market value would give ~$34/share of NAV potential. If RESI were to raise an additional $300m of equity at the current share price and keep debt/equity at 1/1, then it would have $2.15b of total capital available and $37/share of NAV potential (still assuming 70% price to value). So NAV/share would grow 10%. The same exercise could be done at $1b of additional equity at current price, and the NAV potential grows to $42/share. This requires RESI to find another $2b of attractive portfolios to buy, which still seems small relative to the magnitude of portfolios being transacted today (approximately $5b in Q4 alone). I believe this is why the market has responded to capital raises by RESI so positively and may continue to do so on a forward basis.
RESI economic model
As described above, there are three basic things that can happen once RESI acquires an NPL – the borrower can be made current or RESI can take ownership of the property and then either rent or sell the home. RESI anticipates 10-15% of loans will be made current (though more recent commentary has suggested the high end is more likely – see ASPS Q3 earnings call for example), 50% of homes will be rented, and 35% of homes will be sold. The economics of each of these outcomes is different and has important implications for the overall value of RESI.
Modifications were described above. RESI assumes that modifications will on average be made at 95% of market value (though experience to date suggests that this assumption may be low). It is assumed that modifications will take 6-9 months on average. If we assume purchases at 70% of market (more expensive than experience to date), mods at 95% of market value (appears below experience to date), 9 months of carry cost, and 50% debt to capital (below current advance rates) at 3.5% cost of debt, then RESI generates about 70% return on equity on modifications. If 10% of the portfolio generates this return, then this generates about 7% return on the entire portfolio, and if RESI hits the high end of its modification target, modifications alone will contribute over 10% return on the entire portfolio.
Dispositions are next easiest component to assess. RESI assumes homes can ultimately be sold at 90% of market value (though experience in the last 2 quarters is 95%). However, there is carry cost and expenses of running through the disposition process that conceptually either adds to the cost basis or effectively cuts into the gross proceeds on sale. If we assume 10-15% cost to manage NPLs (this is property tax, maintenance, etc), 1-2 years to dispose of assets, 3.5% cost of debt, and NPLs sell for 90% of market value (again, below recent experience), then RESI earns ~12-15% return on equity for dispositions before home price appreciation. At 95% of market value, then RESI can earn mid 20s% return on equity before any home appreciation. But in the disposition model, home price appreciation matters, since there is 1-2 years between acquisition and disposition. Every 1% of home price appreciation can add 300-400bps to the equity returns from disposition. Overall, it seems reasonable to assume 15-20% returns on equity from disposition, and with 35% of the portfolio in disposition, that is 5-7% return on the entire portfolio from dispositions.
Finally, there is the rental component of the business. This is the trickiest to model, but at least there are several public and a handful of large private industry players who have discussed their models and performance for the business. In general, the models have 10-12% gross yields on portfolios and 5-6% net yields on properties after renovation, all operating costs, and ongoing capital reserves. There is still a lot of debate about what net yields operators will ultimately achieve, but Colony, Silver Bay, American Homes 4 Rent, Invitation Homes, and others all maintain they are still seeing 5-6+% net yields on their portfolios before leverage. Since RESI has a lower basis than competitors from its acquisition model, it should achieve yields above the high end of its competitors. This ultimately needs to be proven out through execution though. If we assume RESI continues to buy homes with market value of $200k for 70% of market, spends 10% to take ownership of homes, invests $20k per home in renovation, maintains 50% debt to capital, and achieves competitor 6% net yields, then this generates approximately 10% return on equity, before home price appreciation (this assumption is much lower than management’s targets, but I prefer to take a more conservative approach until they can show success in execution). This equals 5% on the entire portfolio, again before home price appreciation.
The mix above of modification, disposition, and rental yields high teens return on equity assuming no home price appreciation. I believe there is a fair amount of conservatism in each of the components above, such that much better returns are possible. For RESI shareholders, how much of the return gets shared with AAMC is a function of when cash flows and dividends are paid. Under the worst case assumptions, this still translates to low to mid teens ROE for RESI shareholders before any home price appreciation. At current book value, this means that shareholders are getting a net ~$2/share of ROE (dividend), which is 7-8% yield. This is an attractive yield, with ability to grow organically through home price appreciation, rental inflation, or increased leverage. Dividends and yield should grow as RESI closes more deals also.
What is RESI worth?
An asset based approach shows what I think is significant value already embedded in RESI shares. As of Q3 and the subsequent equity raise, RESI had acquired 6,650 properties with underlying value of $1.35b. This was financed with $425m of debt. This yields $21.50/share of NAV. However, RESI is undercapitalized relative to its target level of 50% debt to capital and can fund another $350m of acquisition with all debt to reach its target level (still below its capacity for debt of >60% advance rates). At 70% purchase price to market value, this would add $11.80/share of additional NAV to hit its target level. This would put total NAV just above $33/share before any further deals.
There are several sources of upside to the current NAV. Additional deals as described above should provide NAV growth. Management seems to have aggressive plans for more deals, so NAV can grow quite meaningfully if they are successful. Home price appreciation in the rental portfolio or for the next couple years for the disposition properties yields upside to the NAV. As an example, 10% home price appreciation over the next 2 years (5% inflation per year), yields >$4/share of NAV growth on the existing portfolio. And consolidation can also drive upside. Given the relative trading multiples of book value, RESI is in a good position to accretively add bulk portfolios or operations to its portfolio to enhance its scale, though this doesn’t seem like a likely strategy in the near term.
We can take a yield approach to valuing RESI also, using the numbers above. The problem is that it is hard to determine what yield the market will give to this asset. I tend to think it should be relatively low – given the potential for upside in dividend and book value and given the yield afforded to apartment REITs (3-4% yields). A 5% yield on the current portfolio would get to $40/share (assuming the $2/share from above). At 8%, the current portfolio is worth $25/share. These seem like reasonable ranges for valuation and imply a positive skew to shares given the current share price.
BPO are materially off – There is a risk that the market values assumed are too high. Obviously this has strong implications for NAV calculations and ROEs from above. To date though, dispositions have come in at 95%+ of BPO, which indicates they are reasonable. Also, BPOs tend to lag the market. As home prices have appreciated, BPOs are more likely to be conservative in this environment.
Deal pipeline for NPL dries up or becomes unattractive – Additional deals are key to driving incremental growth in this model. The pipeline of deals appears to be there in the near term, but it is unclear how long it will last in size. Management notes that NPL sales are not a byproduct of the financial crisis but a normal part of business in all cycles. They highlight that NPL sales have been slowed down by banks unwillingness to take large portfolio marks, and that as bank balance sheets heal, NPL pipelines can expand.
Operational problems prevent successful execution in rental model – RESI is still unproven operating a portfolio. They have the luxury of more time than competitors to get the model right as they earn money immediately from modifications and dispositions. Also, leveraging partners with known vendor networks, contractors, and property managers reduces risk relative to some of their competitors.
Dispositions take materially longer than expected – The biggest risk to the model is having a lot more dispositions than expected and dispositions taking materially longer to resolve – as there is a lot of carrying costs to non-performing loans. However, Ocwen is very experienced with loan resolution, so RESI should be advantaged relative to others in this aspect of the business. Also, the easing foreclosure pipelines should begin to accelerate time to resolve non performing loans.
Housing market declines – Problems in the housing market certainly create problems for the existing portfolio at RESI. There may be some offset as this would increase future prospects for NPLs and building a portfolio.
Counterparty risk with Ocwen, ASPS – RESI is highly reliant on its partners.
Note: I know that AAMC has been written up as a short earlier this year and discussed off and on in the message boards. The short thesis on AAMC is based on lack of valuation support. I do not have a view on AAMC valuation, other than to note that the success of RESI and its growth will drive AAMC ultimate valuation. However, as I think I covered above, whatever your thoughts on AAMC and its valuation, RESI has some value support already in its portfolio, whether it successfully grows or not.
More portfolio deals
Dividends increase as portfolio matures
Progress on rentals
Analyst day in December
|Subject||Modifications / Rentals|
|Entry||11/19/2013 09:15 AM|
Couple questions: Given the compelling economics from loan modifications why haven’t the banks themselves modified the loans? My understanding is that most of the selling banks here have strong servicing capabilities and bank regulators view modifications favorably.
Why do you think RESI will actually be able to rent 50% of the homes they buy at reasonable vacancy rates? People I’ve spoken to in the industry seem to think that a much smaller % will actually make suitable rentals.
|Entry||11/19/2013 12:17 PM|
In addition to the comments about their ability to purchase 30% below FMV, I think another problem here is that AAMC has an incentive to continue issuing secondaries even if the marginal deals are much less attractive. It is instructive to consider the combined AAMC/RESI mkt cap. It certainly implies a lot of secondary issuance that would seem to cap the price of RESI at a certain percentage above FMV.
And even if there are limited secondaries and we accept that AAMC is terribly overpriced, the mlp-like payoff structure caps the upside here. In terms of capturing the upside of housing prices (as opposed to their ability to purchase homes cheap), this is a very inefficient play due to the AAMC fees.
I have started shorting RESI recently as I am quite bearish on the SFR industry, and I think that upside is limited here.
However, if AAMC/RESI has a sustainable and scalable way to buy houses at a 30% discount (or even a 15% discount) versus a normal SFR player like SBY, then even with my caveats, the shorts will lose.
One other slight point: SFR's are having trouble paying a dividend not solely because of vacancies on new properties (although this is part of answer). Maintenance and other costs have proven more expensive than planned. And rents have not been as high as planned (this is related to vacancies as it has taken longer to get tenants at hoped for prices).
So one of the earliest plays here (the Provident Private Fund --> SBY) predicted 5-6% cash flow starting 6 months after purchase of house. The time to cash flow has taken longer. And once it begins, it has been 2-3%, not 5-6%. And the numbers are even worse than presented because I am using purchase price, but the FMV has appreciated 30+% so the yield over FMV is even lower.
SFR home ownership is simply inefficient. It is very different from the efficiency of a large apartment building. Further, home rental is not yet a "natural" consumer behavior. This might change, but if I did not own my home, I would not want to live in it. It seems odd to rent a home. The point is that you can get a lot more house for your rental money than apt for your rental money.
|Entry||11/30/2013 07:21 PM|
Great write-up - thank you for sharing. Anyone investing in this space would be behouved to read George Soros' 1970 white paper titled 'The Case for Mortgage Trusts". I believe that William Erbey is highly in tune to the reflexive feedback loop he has created and will take advantage of this market dynamic. Question is what will be the events (risks) that ultimately derail a feedback loop once it gains traction?