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Short Duration Residential Mortgages Are a Good Place to “Hide Out,” According to 1Sharpe Co-Founder

The firm has been investing in residential mortgages for the past eight years. It’s seeing better opportunities now than it has for some time, its co-founder says.

The past year saw a myriad of new funds being launched with a focus on private credit, with investors eager to take advantage of the dislocation in the real estate capital markets. But for 1Sharpe Capital, a Piedmont, Calif.-based real estate investment firm, credit has been a focus since its founding in 2016. For the past eight years, the firm has been running an open-end credit fund that invests in short-duration residential mortgages in the U.S. and Europe. (The firm also has a fund focused on owning and operating single-family and multifamily housing and an early stage venture fund focused on new technologies).

The main investors in the credit fund have so far been institutional investors, including pensions funds and insurance companies, as well as some family offices. But though 1Sharpe’s strategy for the fund has been to focus on larger accounts, its minimum investment requirement is $1 million and it has been having conversations with RIAs and wealth advisors recently about bringing in more high-net-worth investors.

In a market with rising interest rates and general volatility, low-leveraged investment in residential mortgages is an attractive place to “hide out" and a good alternative to fixed-income products, according to Gregor Watson, who co-founded 1Sharpe with Rob Bloemker, the firm’s chief investment officer. And the relatively simple investment structure of 1Sharpe’s credit fund is appealing to investors, he noted.

Before founding 1Sharpe, Watson invested in distressed housing and in single-family rentals, while Bloemker ran fixed-income investments at Putnam Investments after stints at Solomon Brothers and Lehman Brothers. In the wake of the Great Financial Crisis, Watson and Bloemker also built a bridge lending business in Dwell Finance that the partners eventually sold to Blackstone.

WMRE recently spoke to Watson about 1Sharpe’s current credit investment strategy, its investor base and how it views the current moment in the market.

This Q&A has been edited for length, style and clarity.

WMRE: Can you tell us about your firm?

Gregor-Watson.jpgGregor Watson: We started 1Sharpe about eight years ago and we run three different strategies. We run a credit fund, where we invest in credit throughout the U.S. and Europe. We run a housing fund, where we are the owner/operator, vertically-integrated operator in single-family and multifamily housing. So, workforce, multifamily, single-family— we have a couple of thousand units in each category. And then we have an early stage venture fund, where we are focused on all things in the traditional larger markets—fintech, insurtech, real estate technologies. So, we incubate and invest in companies there.

WMRE: Can we get more detailed information on your credit fund? I understand you are focused on short-maturity residential mortgages?

Gregor Watson: We’ve always liked that business. We view it as a very safe asset class. Our average loan-to-value is 62%, the duration we average about nine months. Why we like that is we’ve been worried for a long time that things are over-valued and that interest rates would move up from the historical lows and that duration was important to us.

We’ve invested about $10 billion to date in that asset class. And that asset class is interesting because it’s highly fragmented and it’s not a place where the banks tend to play, both from a capital treatment standpoint, because it’s in between commercial and residential, and also they don’t like the short duration.

We’ve built a network of partners throughout the U.S. and Europe. They originate loans every months, we review them all and end up buying the very best loans. It’s very labor-intensive, we had to build lots of systems to do this at scale. But [it’s] paying about 10% interest to our investors, with super low debt. We don’t use leverage outside of cash management, so it’s a very low-levered and low volatility product. And so, what we found is a lot of institutional investors, a lot of private wealth managers, insurance companies like this as a high-yield fixed-income alternative.

The underlying business is kind of a simple business. There are professional investors in every market that are looking for opportunities to buy a home and renovate it, take the oldest home in the neighborhood that needs a new kitchen, a new floor, a new bathroom. They’ll buy those, they’ll renovate them, they’ll put in energy-efficient appliances and a roof, and then sell the home to a home owner and allow that home owner to buy that fully-renovated home and be able to finance all those improvements. And they make a spread there, the spreads are much better than your homebuilding spreads. These are essentially urban homebuilders and we are financing them to improve those houses and then the take-out is the homeowner.

WMRE: So, this is an open-end fund?

Gregor Watson: Yes. This is an open-end fund, we’ve been operating it for eight years and have done about $10 billion to-date.

WMRE: If you can tell me what kind of equity investors you are working with for this fund?

Gregor Watson: It’s the global consultants—it’s pension funds, endowments, large family offices, traditional institutional investors.

WMRE: Are you working with RIAs or wealth advisors on this in any way?

Gregor Watson: We’ve been recently approached by a number of RIAs and wealth advisors and we’ve been discussing potential partnerships and [them] becoming part of some of these different platforms, but early stages of that.

WMRE: It sounds like you are interested in tapping that capital channel?

Gregor Watson: Absolutely, this is a great product for high-net-worth investors that are looking for stable cash flow and don’t want to take a lot of risk. There are not many places where you can have the low volatility we have and get the kind of payout that we are able to provide on a quarterly basis.

Our biggest issue is it’s only so scalable. It’s not like buying securities or placing investments in the equities market. We have to go out and manufacture those returns, we have to find those loans, we have to underwrite those loans, we have to process those loans. So, we are more capacity-constrained than we are capital-constrained.

But recently a lot of the levered players in this market have not been able to compete, they pulled back, so we’ve actually been able to increase some of our capacity, where we have historically been sold out. It’s a pretty interesting time to market and opportunity for us for future growth.

WMRE: What kinds of returns are you targeting and over what period of time?

Gregor Watson: We are currently paying out just under 10%. We are targeting risk-free plus 400 to 500 basis points net to our investors. That’s currently in the nine-and-a-halfish percent.

WMRE: How do you usually reach out to new investors? What are your outreach efforts?

Gregor Watson: We’ve been pretty targeted in our outreach. We are focusing mostly on institutional investors to start our platform. We feel like this is a great product for lots of different types of investors, both offshore and onshore. We’ve been relatively quiet—this is the first time we’ve hired a PR firm and this is the first time we are talking to reporters about this specific product. It’s kind of sold itself.

WMRE: Especially when you are working with family offices, how are your partnerships structured?

Gregor Watson: I’ve spent a lot of time working with family offices over the years and what we’ve learned is it’s really a relationship business. This isn’t just one product and one time we are going to partner with these groups. We look to grow those relationships over decades and across markets and products.

Structure-wise—we have a co-mingled find, we’ve set up separate accounts for very large clients. So, we are flexible, but at the end of the day, it’s a relationship business.

WMRE: Right now it’s a transition time in the market. How easy is it to find the kinds of loans you are looking for compared to a year ago?

Gregor Watson: We are seeing better credit opportunities today than we were seeing a couple of years ago. We’ve always been a very disciplined investor. Credit quality is our number one priority. Rate is number two. Part of that is why we raised an unlevered vehicle. We didn’t want to be chasing double-digit returns in a market that we didn’t think could sustain double-digit returns and you would have to take too much risk.

Now what we are seeing is better credit quality at a much higher rate, just given where rates have moved over the last year. We are pretty excited about what we are able to invest in. Also, our relationships are growing, every year we are adding new and new relationships, so we see the cream of the crop when we see these types of loans.

WMRE: When the firm is evaluating the loans it wants to take bets on, what specifically are you looking at? What are your criteria?

Gregor Watson: Number one we do a lot of bottom-up and top-down analysis. So, looking at the markets, looking at the neighborhoods, looking at the houses themselves

Liquidity is our number one focus. Is this home a liquid asset? Is this a $20 million condo somewhere that’s got a lot of pricing volatility and may or may not be that liquid? Or is this a $400,000 home in Phoenix where there are many of those homes, there’s lots of comparable sales and where we know that if were to lower that price by 5%, that home is going to sell very quickly? So, liquidity is our number one focus.

We then look at the experience of the borrower, we want to make sure that the borrower is very experienced, that they’ve done many of these projects in the past. We look at the cost analysis—what is it going to cost them to renovate? We don’t provide any capital until the renovations are completed. We want to make sure that their budget is in line with all the data that we have. From the 30,000 homes that we bought, renovated and rented to the $10 billion of loans that we did, we’ve got a tremendous data set of what it costs to actually improve these assets.

And then we look at the borrowers’ credit scores, their net worth, their liquidity. Given our attachment point of about 62% loan-to-value, we want to make sure that the volatility and the liquidity is in the tight range of that underlying asset.

We want to make sure we are in neighborhoods that are positive in terms of school scores, that are growing neighborhoods, with good population growth.

And then this may be a little counterintuitive—we are actually looking at how quickly the home prices are rising. We don’t want to be in a market that’s grown too quickly. We are looking for stability. As a lender, we only have downside, so we are not getting paid for that volatility on the upside or that extreme growth. We are looking for very stable markets, making sure we’ve got enough population growth and jobs in each market.

WMRE: When you are talking to investors these days, are they excited about the opportunity to invest in this type of fund, are they concerned about the larger market headwinds? What is their attitude about investing in real estate credit?

Gregor Watson: Look, I think our product is a great place to hide out in this crazy market. Why we started this to begin with is my partner and I wanted to invest our own money into something where we could have liquidity and we could wait for the big opportunities. And so we built a product that does that.

We are able to pay out about 10%, with good liquidity and very low volatility. It’s a product that when people understand the nuances of it, they get pretty excited about it. It’s a simple product, it’s not a product that requires really complicated structuring, it’s pretty straightforward.

WMRE: Is there anything else about this specific product you think is important to know?

Gregor Watson: I just think the housing market in general right now is interesting. You’ve got mortgage rates at 8%, you’ve got the lowest number of transactions that we’ve seen in decades. It seems like an odd time to be investing in housing.

But because of the way the U.S. mortgage market works for the majority of mortgages at 30-year fixed rate, you’ve got a lot of people who are trapped in their homes because they have such low interest rates. The people that are moving are the people that need to sell. There’s huge demand.

We are chronically undersupplied in housing in the U.S., and that’s from the GFC, being down almost a million homes a year. We still need to build our way out of it. We really have a supply side problem, but a lot of health in the housing market. And our product fits nicely into that business. Even though we are down a lot in terms of the number of transactions, it’s still a huge number. We are talking hundreds of billions of dollars of assets trading hands on an annual basis. We are a small fraction of that, but it’s a very big pool with very strong tailwinds.

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