June 29, 2023
For over 25 years, Trez Capital has taken a rigorous approach to risk management; it is a foundation that continues to serve investors today.
When it comes to protecting and growing investor capital in the face of inflation, rising interest rates and market risks, Trez Capital excels through its active risk management. Three important elements of this approach include stress testing, setting loan-to-value limits and market selection.
By harnessing the power of stress testing, Trez Capital dynamically invests and adjusts during market uncertainty to protect investor capital.
Stress testing provides valuable insights into the performance of investments and entire portfolios resulting from challenging circumstances or unexpected events. By subjecting portfolios to rigorous stress tests, investment managers can comprehensively understand potential vulnerabilities and risks that may affect returns, further enhancing the strategy’s overall resilience.
At Trez Capital, stress testing forms a key pillar of our risk management framework. It enables us to evaluate the strengths and weaknesses of our portfolio, empowering us to plan and make course corrections amidst uncertainty. To calibrate scenarios, we use projections from leading industry experts including CoStar, Oxford Economics, and John Burns Research & Consulting.
Our stress testing analysis drills down to individual loans, tracking city-level product-specific benchmarks for each investment. This granular approach allows us to closely monitor key factors such as value, rent, vacancy, cap rates and whether market trends align with underwriting.
Case study: Q1 2023 Stress Test
Residential real estate assets in the US experienced a sharp rise in value emerging from the covid pandemic as people adjusted their living spaces to manage comfort during lockdowns, capitalize on the work-from-home phenomenon and lock in record low interest rates. The rise in real estate values underscored economy-wide inflationary trends that since March 2022, the Federal Reserve has strived to unwind through progressive interest rate increases and quantitative tightening. As inflation proved non-transitory and Fed rate increases accelerated beyond initial expectations, real estate values peaked and began to decline as the economy adjusts to interest rates that are higher for longer. Forecasters are calling for growth to slow to 1% and unemployment to rise 140 basis points (bps) resulting in year-over-year declines in real estate values during 2023 and 2024, before a modest rebound in 2025.
Based on this narrative, the Q1 2023 stress tests revealed significant shifts since the average Trez Capital loan closed in September 2021 as demonstrated in Exhibit 1. Notably, lot development exhibited robust growth with a 15.7% increase in new home values, influenced by the Federal Reserve’s zero interest rate policy and changing living arrangements. Condominiums also experienced a softer 6.2% value growth, moderated by the urban locations and higher luxury prices. Class-A rental apartments demonstrated strong price growth of 11.5%, supported by 17.1 bps cap rate compression and 5.1% rent growth. Class-B rental bridge financing projects appreciated by 5.0%, reflecting their position as price-sensitive workforce housing.
This bird’s-eye view of our portfolio highlights market movements and illustrates how current collateral values are supported by the market lift. Consequently, our LTV ratios have been de-risked in a mark-to-market (MTM) sense as can be seen in Exhibit 2. Lot development LTV substantially de-risks to 58% as values peak but returns towards appraisal LTV of 68% as the economy re-adjusts in 2024. Similarly, multifamily for-rent goes from 68% LTV at closing down to 61% at the 2022 year end before stabilizing near 64% LTV. As lenders, we find comfort in these mark-to-market value adjustments while remaining vigilant for downside risks and adversity, given continued interest rate volatility.
The stress tests validate the efficacy of strategic risk measures to safeguard investor capital against negative market trends. By utilizing loan “vintage” analysis, we segment loans based on the year of their closing.
In response to increasing risk signals surfacing from the macroeconomic environment, Exhibit 3 shows how Trez Capital prudently reduced leverage in new loans by lowering LTV ratios at origination from 74% in 2020 to 65% in 2021 and further to 64% in 2022. These risk-mitigating measures have helped maintain the security of our portfolio, even amidst anticipated declines in asset values and adjustments from peak-market valuations.
Based on forecast asset prices over the coming three years, loans initiated in 2020 and 2021 demonstrate lower MTM LTVs while loans issued during market highs in 2022 exhibit slight softness, more so in lot development. Lot development entails the construction of finished vacant developed lots (VDL) for sale to homebuilders, who eventually construct homes for sale to consumers. Typically, lot development is pro-cyclical and influenced by interest rates, which feed homebuyer affordability and purchasing behavior. During prior economic downswings, home building and buying and prices have typically experienced downturns.
However, these risks were anticipated and mitigated by Trez Capital by reducing leverage at the origination of these loans. Lot development loans issued in 2022 were at 65% LTV on average and are projected for a potential 11% MTM increase up to 76% LTV overall, returning in line with leverage for loans issued in 2019. Consequently, the mitigation measures demonstrate that even the segment forecasted to have the greatest mark-to-market movement within Trez Capital’s portfolio remains within our historical risk tolerance parameters.
As the market adapts to new economic factors, Trez Capital has consistently taken steps to insulate our investors from downward market movements. Stress testing serves as a reaffirmation of our risk management approach and reinforces confidence in the robustness of our practices.
Trez Capital understands the importance of continuing to re-invest and grow capital, even amidst potential market fluctuations. Our investment thesis remains compelling and is backed by quantitative market surveillance to support strategic investment decisions.
While we anticipate a degree of price volatility in response to increases in interest rates, we are witnessing a resilient housing market. New home sales now account for over 30% of overall home sales, more than double their traditional share of 13% and signify a shift in the market (away from resale). We believe this trend will persist, yielding positive stimulus for new residential construction.
Existing homeowners who locked in fixed mortgage rates prior to the recent rise in interest rates are choosing to remain in place. This naturally curtails supply and delivers a favorable impetus for new housing development.
Recent data from renowned John Burns Research & Consulting reaffirms our strategy, forecasting a significant undersupply in the United States housing market, with an estimated shortfall of 1.7 million homes over the next decade. This represents a persuasive long-term opportunity for growth and value creation.
Trez Capital’s primary markets—Texas, Florida, Arizona, and Canada—have demonstrated impressive resilience and consistent economic growth in the post-pandemic era. Sunbelt growth states in particular, are benefiting from a surge in migration, leading to a robust demand for real estate. The business-friendly climates and comparatively lower cost of living in these regions will, we believe, continue to stimulate economic growth and attract both corporations and individuals alike. Exhibit 5 illustrates how our primary markets have outperformed secondary markets and are expected to retain more value growth.
As we continue to bolster our presence in Dallas, Florida and the West Coast, we are confident that our local deal origination teams and extensive borrower networks will adeptly navigate market ebbs and flows.
Remaining proactive and prepared
Even as inflation and elevated interest rates pose challenges, Trez Capital is well-positioned and prepared. We have judiciously curtailed leverage to guard against downside risk, and our asset management stands ready to respond to unforeseen events. We continue to deploy capital for investment and our focus remains on the most dynamic growth markets and on partnering with high-quality developers.
By continuing our comprehensive risk management, Trez Capital is confident that it will continue to safeguard and grow capital for the benefit of investors.
Information presented in this material is information purposes only and does not constitute an offer to buy or sell in any jurisdiction. This information must not be relied upon in making any investment decision. Trez Capital cannot be held responsible for any type of loss incurred by applying any of the information presented. Past performance is not indicative of future performance and cannot be solely relied upon. Trez Capital does not assume responsibility to update any of the information. Trez Capital cannot guarantee the completeness and accuracy of third party information it may use. This material cannot be distributed, altered or communicated without the prior written consent of Trez Capital.