Souring Mortgage Debt May Be the Next Big Thing

Hedge funds were among the first to institutionalize the single-family housing space by buying up swaths of distressed properties. Now that good deals are harder to find, they've switched to buying soured mortgage debt. Some single-family real estate investment trusts (REITs) are doing the same thing, offering you a chance to follow the high-risk path being blazed by hedge funds.

Paradise lost
When the housing bubble burst, institutional investors quickly rushed in to buy up homes at fire-sale prices. The foundation for REITs like American Homes 4 Rent (AMH 0.36%), Silver Bay Realty (NYSE: SBY), and American Residential Properties (NYSE: ARPI) were built during that period. Put together, these companies now own around 30,000 properties in key markets throughout the United States.

However, in the third quarter all three noted that they were slowing their purchase pace or shifting purchasing tactics in response to changing market dynamics. In other words, the opportunity that brought these REITs into existence is going away. This brings with it big questions about how these companies will continue growing.

Risk versus reward
But that doesn't mean there isn't opportunity in the housing market. Hedge funds have started to buy soured mortgage debt as a way to continue making money off of the housing bust.

Silver Bay, American Homes 4 Rent, and American Residential all have a pretty simple business model. Buying homes and renting them out is easy to get your head around and works well within the REIT structure. And as long as they don't get overburdened with debt, they'll be running fairly low risk operations backed by hard assets. You, as an investor, should get a steady stream of dividend payments along the way.

The hedge fund push into buying bad mortgage debt is far more aggressive. There are all sorts of problems with the model of acquiring homes by foreclosing on delinquent homeowners. For example, according to RealtyTrac, it took an average of 564 days to complete a foreclosure in 2013. That's a lot of time and legal headache. And don't forget that foreclosed homes often need extensive repairs and updating before they can be rented out.

Still, with home prices heading higher, the best way to build a portfolio of cheap homes may be taking on the extra risk of buying delinquent debt. For all of their tax benefits, REITs have to pass on most of their revenues as dividends, so acquisitions are incredibly important for growth. While Silver Bay, American Residential, and American Homes talking about slowing home purchases shows the industry is quickly maturing, it also means growth could be harder to come by in the highly fragmented single family home market.

You can play the hedge game, too
It's also why Altisource Residential (RESI) and newly minted single-family REIT Starwood Waypoint Residential (NYSE: SWAY) may be of interest to you. This pair is following along the path of the hedge funds, purchasing delinquent mortgage debt. To be fair, Altisource has been employing this tactic since day one. But that's meant it has always looked a lot more like a mortgage REIT than a homeowner.

Starwood Waypoint, meanwhile, was only just pushed into the public sphere by Barry Sternlicht's Starwood Property Trust (NYSE: STWD). Unlike Altisource, which pretty much doesn't own any homes, Waypoint already owns thousands (around 6,800), so it has a stable base from which to expand. Its nearly $1 billion in non-performing loans (representing about a quarter of its portfolio) will, ostensibly, fuel its growth. Altisource's loan portfolio is around $1 billion, too.

Options across the spectrum
If you want to invest like a hedge fund in the housing market, Altisource offers you just that opportunity. While that may sound enticing, it isn't without risk, so only aggressive investors should jump aboard. More conservative investors should probably stick with Silver Bay, American Homes, and American Residential. There's nothing wrong with slow growth if you are looking for safety. Starwood Waypoint, meanwhile, is an interesting entrant. Not only is it new to the sector, but it's a mixture of the safe and risky approaches. That could make it a nice compromise for those seeking a little more excitement, but not too much.