A Very Optimistic Bet on Housing

A Case Study in Investing Objectivity
Keeping the emotional voices under control when assessing an investment takes discipline.
Bloomberg, October 26, 2016

Ever since the credit crisis, the housing market has been the subject of enormous skepticism. Given the psychological damage caused by a series of financial disasters — the dot-com collapse, the residential real estate boom and bust, the Great Recession, the stock-market collapse — this isn’t a surprise.

Investors, however, need to maintain some emotional distance from these events, lest their biases lead them to missing opportunities. Since I spend so much time discussing how investor behavior has such a negative impact on performance, I would be remiss if I failed to point out when some investors manage to bypass cognitive issues to make a good trade.

One person who hasn’t let his predisposition prevent him from seeing potential upside is Donald Mullen, former global head of credit at Goldman Sachs. He is best known as a leading architect of the bet against the subprime mortgage market, aka “The Big Short.”

Despite being on the right side of the ’00s bet against housing — or perhaps because of it — Mullen has spent the past four years on the other side of the trade. His firm Pretium Partners now has assets under management of about $6.5 billion after raising money for two funds. According to the Wall Street Journal, the firm is now on to its third:

Pretium, which rents and manages its homes under the name Progress Residential, owns the fourth-largest pool of U.S. homes. It is raising money for what would be its third fund dedicated to residential real estate. The first fund, which raised $1.2 billion in 2012, was used to buy more than 16,500 homes at big discounts. In 2014 Pretium raised another $900 million to purchase roughly 14,000 nonperforming home loans.

Because the crash was so traumatic for so many people, there still is a lot of gloom on housing. Despite signs of price and sales volume increases, then negativity lingers: millennials can’t come up with the money for down payments; lenders have adopted excessively tight credit standards; many homeowners still have little or no equity, limiting their ability to move up; too few houses come up for sale, creating an inventory shortage that drives sales prices too high. Although there are some signs of recovery, psychological damage persists.

What makes Pretium’s third fund so intriguing is that it seems to be less of a collection of distressed assets and more of a macro bet on the housing economy. According to CoreLogic, distressed sales were 8 percent of homes sold nationally in June 2016 — that’s near pre-crisis levels. The Case-Shiller index of national home prices is touching its 2006 peak, and is 38 percent higher than the 2012 lows.

Mullen’s firm, which the Journal said is pitching pensions, endowments and institutions, is making an essentially optimistic wager on the future of the U.S. real estate market. The expectation seems to be that the rental markets will continue to see robust gains as “Households that have been unable to obtain mortgages have become renters, thus driving high occupancy rates and robust rent growth.” In theory, that means increased home purchases once credit availability begins to ease.

Given how wary some people are of homeownership, why should we be thinking about demand strengthening? Here are a few possibilities:

1. Millennials seem to be moving out of their parents’ basements, and forming households;

2. Mortgage rates are starting to rise, and the potential for further rate increases could lead potential buyers to getting off the fence;

3. Low equity constrains inventory; that drives up rental demand as well as prices;

4. The economy continues to recover and even expand;

5. Unemployment has been about 5 percent for about a year, and wage increases are finally beginning.

All of these add up to an increase in the number of households, including renters — many of whom go on to become buyers.

Evaluating a potential trade is a fraught undertaking. The tug of gut feelings is compelling and always present. Keeping the emotional voices under control requires discipline. What Donald Mullen is doing seems like a case study in objectivity.

Originally:  A Case Study in Investing Objectivity