Note Investing: Predictions for 2022?

Question

Okay note investors, get out your crystal ball. I am curious to hear from experts and newbies alike what their predictions are for next year in the note space.

Will we see an increase in inventory? How will expiring eviction/foreclosure moratoria affect things? What role will inflation play? NPLs vs. performing pricing? Seller financing vs. institutional paper? Geographic/state-level shifts? How are you preparing for 2022?

I know this is a broad topic but feel free to weigh in from one or more angles. No one has access to the results so there are no wrong answers.

Chris Seveney · Answer

Will we see an increase in inventory? I believe we will. The 2nd and 3rd quarter this year were the first years that I have invested in notes where there was almost no inventory or whatever was out there was dramatically overpriced. How will expiring eviction/foreclosure moratoria affect things? Being at the bottom of the proverbial totem pole, I do not think this will have a major impact for many of us.What role will inflation play? I believe we will need to increase interest rates, which will have an impact on borrowers as well as others cost of capital which should drive the current note pricing down.NPLs vs. performing pricing? With inflation the price of performing should go down. You want your weighted risk return (current return - risk free rate of return) - which if rates go up, govt bond yields go up which means your returns should adjust accordingly. NPL's - If house prices start to fall, that can have an impact on NPL's as sellers are not concerned with NPL property values and holding costs, but if housing turns, then holding assets which have out of pocket costs AND are losing value will force them to sell much faster.Seller financing vs. institutional paper? I rarely tough newly originated seller financing because the loan is overpriced. What I mean by that is the house was a $50k house and did not sell conventionally but then sold $70k owner financed. Well the house really is not worth $70k, and if rates go up, and housing goes down and these borrowers stop paying. whoever holds these notes could be in for a world of hurt.Geographic/state-level shifts? Election year - no new state level shifts. How are you preparing for 2022? - Go big or go home. Big things in store for 2022. :)

Andy Mirza · Answer

I think we will see more NPNs come to the market place. I have no idea how much.My main concern now is inflation and I think the implications are unclear in how that'll affect us. On one hand, inflation is assisting with a rise in real estate prices. This helps when buying little equity to underwater NPNs as the underlying asset goes up in value and valuations look back at the last 90 days of sales comps. When you close on the sale of the NPN, the value of the RE is already higher and continuing to climb.You have to be quick to move if and when it goes the other way. I don't see any indications that RE will tank like it did in 2009. I think it will cool down and maybe flatten out.Inflation hurts when buying, in general, as there is a lot more money out there chasing assets and yield. Sellers want more for their notes. Our main strategy is still the same: find the assets that the sellers undervalue. The big funds stick to their BPOs and don't challenge the values. When you find a BPO that's poorly completed and shows a much lower value than it should be, that's one to pursue.

Don Konipol · Answer

@Jamie BatemanWhen I began investing in notes, it was residential second liens. In 1981 I was looking for a 20%+ yield to maturity. Now I invest in commercial firsts, and set a 12% floor. Obviously, interest rates in general have declines A LOT more than the decline in my target yield.In 1981 I had my choice of notes. Deal flow was probably five times what it is today.What about 2022? The truth is even our best guesses will probably mis in at least some areas. But playing the percentages I have to believe that inflation will lead to increase in interest rates. I’m less sure about note availability in the secondary market. The amount of inventory out there at prices that a,e no sense is astounding. Guess somebody is paying those prices. Even in the note origination side of our business we are seeing a lot of lower end commercial property with non credit borrowers and no tenants trying to cash out at high LTVs. Quite frankly, we had a great year in 2021. Between a couple of large notes purchased at huge discounts, with one now performing and the other paid off for a 60% gain ( with a 4 month hold time) and another big gain on a foreclosed property, we had our best year since we began our current fund (2013). I don’t expect 2022 to be as good. Transitional years seem to have mediocre results. Using mark to market valuation, rising interest rates can mean out portfolio valuation can take a hit. Those who also invested in out commercial property equity real estate fund should be able to offset any decrease in value of the note portfolio with increase in value with the equity portfolio. Although I don’t offer investment advice, in my own portfolio I hold an amount of real estate equities equal to twice the value of my notes at 50% leverage. So if I have $2 million ( mark to market value) in notes, I hold $4 million in real property, at 50% leverage meaning I have an additional $2 million invested in equity. That way (theoretically, my entire portfolio of notes and equities are protected from inflation, and I still get a great current yield, about 14% on the note portfolio, and 8% plus appreciation On the equity part.

Chad U. · Answer

There are a number of people much smarter than I and who run large funds that predict a surge in inventory after q1 next year. This may be true, but the inventory released is pent up due to expiries from covid forbearance, most likely all of these loans will be heavily scrutinized by the numerous regulators, and will be difficult to navigate. There was a large swath of inventory out for sale this quarter from several funds in meeting their year end obligations. However the pricing expectations was so ridiculously high it was not even worth while bidding much of it. I suspect that will continue on into next year despite the so-called 'surge' n inventory from forbearance expiries.

Dave Van Horn · Answer

A lot of interesting takes above, with much I agree with so I guess I'll just try to keep my prediction simple by sticking to what I'm optimistic about. I'm optimistic when it comes to the growing supply of NPLs within the note space, as the Fed tapers the quantitative easing it should provide more paper in the marketplace. The question then becomes: well what about pricing?There is likelihood especially in the short term with interest rates increases impacting the cost of capital (especially institutional capital) when we're already in a market with relatively thin margins, so until prices are adjusted by NPL sellers it'll probably stay that way. Also optimistic with moratoriums lifting and being able to move forward with foreclosure/evictions but court houses could definitely be backlogged in certain areas for some time.As for REO renovations, supply chain disruptions will have to cause some friction as emerging markets around the world become more vaccinated and can start to rebound from the virus, thus creating more competition for a limited amount of goods.So short term in my opinion: it's a bit more of the same. Long term: cautiously optimistic but think we'll ultimately see real positive movement and change.That said, we've bought more product this year than we ever have in the past 14 years combined so I think there's potential in just about any market!

Marco Bario · Answer

Great quote. I also like how Warren Buffett said it years ago: "Only when the tide goes out do you discover who's been swimming naked."

Liz Brumer-Smith · Answer

I agree with the sentiments here about rise in inventory. Clark Street Capital has an AWESOME report they put out bi-weekly, and it gives super great insight into the commercial and residential debt markets. My favorite line "excessive stimulus has a way of covering up problems." They believe the distressed picture is really just starting to come into play. 2022 could be the year this starts to unfold, but it could be well after when we start to see an uptick in inventory of NPLs. If anyone else is interested in learning where the market could be headed in 2022 and beyond, the Diversified Mortgage Expo (DME) will be a great 2 day event (March 10 - 11, 2022) that will have the VP of Analytics from the Mortgage Bankers Association, Marina Walsh, as the keynote addressing this EXACT topic.

Joe Daigle · Answer

Thanks Jamie and all for this timely question and feedback. As a newbie trying to find my way in this investment space, this is some very enlightening information. I hope you guys keep it up for those like myself to hear some truth before we "jump in the water." Happy Holidays and please be safe.

Mitchell Goldstein · Answer

Notes can be a worthy investment - when the marketplace is predictable! Today, the marketplace is not predictable and, IMHO, notes are a significant risk. Creating wealth has been defined as making 15% over inflation. If inflation is accepted at the current 7% level, adding 15% means we must earn 22% after tax. I am sure most of us understand the government habitually understates inflation, which is probably at least 15% and adding 15% means we must earn 30% after tax. This is almost impossible for regular notes, excepting some types of non-performing paper, which has its own issues.I feel that, currently and continuing until things become predictable, that the safest way to do notes is to buy a property at fire sale pricing, raise the price to market or 10% above and create a seller financed note, which, after some seasoning, can currently be sold at a small discount. I no longer see value in holding real estate, excepting those specific situations which are government supported, e.g. subsidized housing, adult living facilities and the like or if getting the real estate at fire sale prices, e.g. 25% of current fair market value. I agree with Chris Seveney that seller financed notes will be a dangerous note to own because they are overpriced.Government policy is quickly showing that it wants to eliminate small real estate investing, e.g. the law in Illinois that requires a realtor to be part of ANY transaction, thus curtailing creativity and raising costs. Government has already allowed our manufacturing base to deteriorate or move to China and in the coming recession the service industries could be decimated.I expect the Democrats to want to have good economic times for the coming election. They will continue big spending, witch will further inflate the economy. Usually low inflation is good for stability but wages never keep pace with higher inflation and costs are rising quickly, e.g. gas and food, so, with household income remaining steady, late payments will rise, putting notes in jeopardy.In these times, cash and junk silver are safe, all else are speculative, including gold and real estate. Therefore, I only concentrate on distressed property situations, use $1 to option a property at a nice discount and flip ASAP without a fix up. My long term exposure is $0 as any potential loss is limited to $1. Best of luck to all.CoachMitch.com

Wesley I. · Answer

@Jamie BatemanJust from the websites that I check, looks like there are quite a few NPNs trickling in but the prices are insane and do not make sense. I predict we will still see no shortage of these in 2022. As for me, im still going to network, keep the powder dry, and pull the trigger when something comes my way that makes sense. Even notes on vacant land!