Arixa Capital's own Kevin Zvargulis, CFA, wrote an article that was published in this month's CFA Society of Los Angeles’ newsletter. Read on for more:
In Search of Yield: Institutional Capital is Beginning to Discover Dark Corner of the Market By Kevin Zvargulis, CFA CFALA e-Newsletter: April 2014 (click here for original article)
In January of this year, Los Angeles based firm Oaktree Capital Group LLC (OAK) committed $100 million to Genesis Capital, LLC, a Calabasas based firm in the business of originating private loans to people who fix and flip houses. The money is to be deployed across the nation in private loans secured in the first position by houses being renovated for resale. The news of this investment was met by Arixa Capital Advisors, LLC, with both excitement and trepidation, as it gave Arixa’s own investment strategy institutional legitimacy, but at the same time marked Wall Street’s first foray into a dark corner of the market that the Westwood-based investment firm would prefer remain undiscovered. In its search for yield, institutional capital may finally be uncovering an area of the market that for the past five years has offered attractive risk adjusted yield but has been the exclusive purview of small investment companies that cater to private individuals.
Jan Brzeski, the founder of Arixa Capital, has noticed the market evolving over the past four years. In 2010 investment firms were commanding a 15% annual interest rate, lending on distressed homes or bank-owned properties. Traditional financing was unavailable even for well capitalized projects as banks were actively reducing their exposures to single family mortgages and were unwilling to lend on vacant homes which often had significant deferred maintenance. Mr. Brzeski notes, “At the time I started pursuing this strategy four years ago, I thought that the investment opportunity would be short lived, perhaps 24 months. Since that time I have become convinced that while the underlying economic factors that gave rise to this opportunity may have shifted, the market is deeper than I thought.”
Single family home fix-and-flippers make their money in three ways. The first is by finding a “deal” on a home - purchasing a home below its fair market retail value. In 2009 and 2010 there was an abundance of distressed homes in California in places like the Inland Empire and the San Fernando Valley, and well capitalized entrepreneurial developers were snatching up homes often for less than their replacement cost. Since that time, as the market has recovered, it has become increasingly difficult for developers to find these attractive deals. This occurred in part because of large capital flows from institutional investors amassing portfolios of single family rental homes. In 2011 and 2012, companies like Oakland-based Waypoint Homes and the New York-based Blackstone Group, LP, were very active in areas of the San Fernando Valley and the Inland Empire purchasing homes for their single family rental strategy.
The second way that single family home fix-and-flippers generate profits is by selling into a rising market. Over the past two years, as distressed deals have dried up, the market has rebounded strongly in Southern California. In the past 24 months home prices in the Inland Empire have risen 38%, in Los Angeles 33%, and in Orange County 28%. There are signs that the housing market recovery has begun to normalize and single family developers will likely no longer be able to rely on such a strong wind at their back.
The third manner in which single family home developers generate profits is by creating value through cost effective renovations. And it is this third factor that continues to make this market such an attractive area in which to generate yield. In California in particular, there is an abundance of homes in desirable neighborhoods that were built during the housing boom of the 1950’s and 1960’s. Many of these homes have never been remodeled and present home developers with a particularly attractive opportunity to renovate and resell these homes for 15% margins. Due to the short timelines for the purchase and resale of these projects, traditional bank financing does not meet the needs of home renovators. As a consequence, while yields have declined from the go-go days of 2010 and 2011, private lenders are still able to command between 12%-15% for short term financing at a 75%-80% loan to cost. It is these types of risk-adjusted yields that have attracted the likes of Oaktree into the space. Arixa Capital estimates that the size of the market for these types of fix-and-flip loans to be $4 billion in California alone, deep enough to absorb capital from institutional entrants. Asset-based private lending is continuing to grow in popularity and it is likely you will see more announcements like Oaktree's as investors increasingly seek out dark corners of the market in search of yield.