Coastline Capital Fund Management

5 Reasons Why our Note Funds Have Been Stable (During the Pandemic)

As a result of the fear of uncertainty surrounding the coronavirus pandemic and its effects, investments around the world faced incredible volatility like they did just 12 years ago when we experienced the Financial Crisis of 2008. In the past few months, stocks got hammered, U.S. treasuries hit all time lows, and oil went negative.

How did non performing notes fare? Very stable, no losses, little anxiety or worry.

Let’s take a look why that was….

A Quick Look at the Other Markets First

U.S. Stock Market

Let’s look at the other asset classes first to see what happened to them:

According to Yahoo! Finance, the Dow Jones hit its peak on February 12, 2020, at 29,568.57. On March 23, 2020, 40 days later, the Dow Jones reached a low of 18,213.65. That’s a drop in value of 11,364.92 points or 38%!

As of the end of last week, May 8, 2020, the Dow Jones closed at 23,875.89. The difference from the February 12 peak was 5,692.68 or 19%.

The stock market had huge swings up and down, enough to make any investor sick to his or her stomach, on top of the fears any of us might have had regarding the coronavirus itself. If you had to sell at the wrong time, you had to face the prospect of selling at a huge loss.

U.S. Treasuries

Let’s look at the same time period for ten year Treasuries. High of 1.639% on February 11, 2020, a low of 0.571% on April 20, 2020, and 0.682% as of last week, May 8, 2020.

Not very exciting to earn less than 2% on your money but that’s better than losing money like you would in the stock market if you had to sell.

Oil Futures

 

Crude Oil went as high as $54.09 a barrel on February 20, 2020, dropped to as low as $11.88 on April 26, 2020, and closed at $24.63 per barrel last week May 8, 2020. The 78% drop from February 20 to April 26 was far steeper than that of the stock market.

Now Let’s Look at Non Performing Notes

There’s no easy way to value non performing loans and measure their performance like we can with stocks, bonds, and oil. We can’t make an apples to apples comparison. The best we can do is look at the closest substitutes, show what’s happened to our investments and to our investors’ bottom lines, and the reasons for those occurrences.

 

The Residential Real Estate Market

One of the best proxies or the non performing note market is to look at the real estate market. These mortgage notes are backed by real estate. When the note is “underwater,” in which the amount owed exceeds the property value, the main factor that goes into a note investor’s bid for that distressed asset is what the property is worth. (See this post for more details on bidding underwater properties.)The real estate market is much, much slower to react to market news than stocks, bonds, and oil. Real estate is far less liquid than those other classes and transaction times are measured in weeks and months instead of milliseconds. It usually takes a good six to twelve months to see the effects in the market.

Trends in Real Estate

According to Realtor.com’s March Housing Market Trends Report, national inventory declined 15.7% year over year, the median listing price was $320,000, up 3.8% from year-over-year, and homes sold in 60 days, 4 days quicker on average than the prior year.New analysis indicates that home sales could fall 35% for spring, 2020. Falling home sales don’t automatically equate to lower housing prices. During the lockdowns, sellers that didn’t have to sell and buyers that didn’t have to buy did not participate in the market.This behavior mirrors what most loan traders, including ourselves, did: we stopped buying and selling loans. Why sell at a loss when you don’t have to? Same thing with homeowners and real estate. Most decided either to not list until things recovered and opened back up or to stand firm on their listing prices.

New Residential Listings and Sales Down but not Necessarily Prices

Once more data comes out, I anticipate that we’ll see that new listings, sales and transactions slowed significantly.Another article I read pointed out that we’re experiencing a sudden drop in demand with an even bigger drop in supply of residential housing. From what I’ve mentioned above and everything else I’m seeing this makes sense. Econ 101 tells you that when demand (even weak demand) outstrips supply, prices will go up.

Weak Demand coupled with even Lower Supply Equals Higher Prices

Indicators are that residential real estate values will go up on a lower volume of sales in the next year.

Non Performing Note Performance

So, why have non performing notes been stable during this time? Two categories of answers:

1.       Not Dependent on Cash Flow

2.       Value Add via Forced Appreciation

3.       Leverage is less likely

4.       Use of Leverage

5.       Payouts upon liquidations

 

1. Not Dependent on Cash Flow

The borrowers for non performing notes weren’t paying on their mortgages before the pandemic. They didn’t miraculously start paying again when the crisis hit. We wouldn’t expect anything different.Cash flow isn’t a requirement for a successful investment in non performing notes like it is for performing and re-performing notes.I make a comparison below to “fix and flip” real estate investors. On fix and flip investment projects, it’s obvious that the investor is expecting zero rental income since they renovate vacant homes. The same expectation holds true for the non performing note investor. When income does come in, it’s treated as a bonus and not included in projections.

2. Value Add via Forced Appreciation not Speculation

Investors make a profit investing in non performing notes the same way that “fix and flip” investors make money with real estate; they add value by forcing appreciation.The “fix and flip” real estate investor uses capital to repair and renovate a property to make it more appealing to the retail buyer who will pay far more for it than the combined cost of the acquisition and repair costs resulting in the investor’s margin or profit.

Note Investor Adds Value by Fixing Problems

The non performing note investor adds value by first trying to get the borrower to re-perform and resume paying the note. If this happens, the notes becomes more valuable to re-performing note buyers who will pay a premium.If the borrower doesn’t resume paying, the note investor uses capital to foreclose on the property or take other loss mitigation action to collect on what’s owed. The note investor adds value to the note with every step he completes to get it closer to liquidation. (See this post for another story on the subject.)Investors in these notes for sale aren’t speculating and hoping that the value of their asset goes up because of what the market’s doing. They’re forcing the value to increase through their actions.

3. Leverage is Less Likely

It’s very common to use leverage in the “fix and flip” and “buy and hold” real estate world. In fact, without debt financing, a lot of numbers wouldn’t even pencil out for them.In the non performing note world, it’s the opposite. Note investors and smaller funds typically buy with 100% equity.A typical “fix and flip” investor might have a 10-12% interest only payment on 80% of the purchase price of a flip. I’m sure a lot of investors are feeling the pain right now of having to make those payments while their flips are stalled because of the effects of the coronavirus lockdowns.

No Interest Payments Equal No Pressure

Non performing note investors with no interest payments don’t have the same pressure on their investments as those investors that use leverage.

4. Use of Leverage

Although it’s not common for smaller investors to use leverage to buy notes, I assume that larger institutions with good banking connections will have access to lending facilities to leverage their purchases of notes.These larger funds will have different exposure to leverage related risk and the ones that manage it well will be ok. The ones that run into problems will be the ones that have to sell real estate notes to increase liquidity and/or unwind their leverage.

Limited Leverage and High Reserves Equals Stability

We use very limited leverage at the back end. This means we’re not borrowing money to purchase non performing notes but, instead, we’ll get low interest, low LTV loans for some of our REOs to provide capital for rehabs and operating expenses.We maintain high enough reserves or get loans with no monthly payments. This keeps the pressure off and makes to our Funds and its investments especially stable.

5. Payout Structure

Each note fund is structured differently with different distributions to its investors.I know that some funds out there offer their investors consistent monthly income. Those funds may invest in notes that are solely non performing or in a combination of performing, re-performing, and non performing notes.I expect that some of those funds may experience pressure as their reserves get lower while cash flow decreases because more and more borrowers are facing increasing financial difficulties due to the pandemic induced lockdowns.

Distributions Only Upon Liquidations

Our funds are structured to provide distributions only when we have liquidations. When we liquidate an asset, we set aside any net proceeds that we need to keep in reserve for operating expenses or future rehabs for REOs. Anything left over gets sent out as distributions.Yes, this arrangement results in irregular cash flows to investors. However, it’s proven to be an extremely stable factor in the operation of our Funds. We don’t have to worry about making monthly payments to our investors during this time. We don’t have to incur losses by selling assets at fire sale prices.

Longer Timelines Result in Higher Preferred Returns for Investors

The worst thing that has happened as a result of the pandemic so far has been that the timelines to liquidations for some of our assets have been pushed out by a few months. In actuality, this has worked out in our investors’ favor by allowing them to accrue additional preferred return during the delay.

Final Thoughts

While the world has watched incredible volatility over the last few months in classic investments such as stocks, bonds, and oil, our alternative investing in non performing notes has been incredibly stable. We’ve achieved this because of the nature of investing in this distressed asset class and in the structuring of our Funds to use limited leverage and making distributions upon liquidations instead of on a regular schedule.

Coastline Capital Fund Management LLC

5861 Pine Avenue, Suite B, Chino Hills, CA, 91709, United States

P: (949) 371-6749

andy@coastlinecapgrp.com