The market for residential nonperforming loans (NPLs), stagnant after the 2008-2009 financial crisis, is now growing apace. More than $30 billion in nonperforming and sub-performing residential mortgage loans were sold in the first half of 2014, compared with $25 billion in all of 2013.

This growth is likely to continue over the next few years, presenting opportunities for hedge fund and private equity fund managers with the skills and capital necessary to take advantage of the specialized market for these highly complex investments. The potential rewards for taking on critical analytical and management rigors can be substantial—with expected returns in the high single digits (unlevered) to the low double-digits (levered)—putting NPLs in the target zone of investment managers seeking yield not currently afforded by traditional asset classes.   
Today’s NPL market is a far cry from what many associate with the mortgage debacle. In 2008 and the preceding decade, the market was fueled by deficient or, in some cases, nonexistent underwriting standards, spawning hundreds of billions of dollars in mortgage loans with little income and scant asset verification.
Today, loans in most NPL portfolios—those offered by the U.S. Department of Housing and Urban Development (HUD) and various banks—have legitimate asset documentation and higher underlying market values, driven by rising national real estate values. Thus, these loans are easier for investment managers to modify over time to bring them into performance, increasing their value.
Current yields vary depending on a loan’s accrual, delinquency, lien and modification status. In general, yields for U.S. residential NPLs range from the high single digits to the low teens.
Investors typically purchase bundles of these loans, basing prices on estimates of property values and then buying at a discount to that value. Many buy NPLs expressly to modify them and bring them into performance. The most common modifications are to reduce interest rates and/or forgive missed payments up to a point. After two or three years of on-time payment history, reflecting rejuvenated credit, these modified loans can usually become marketable as performers and, depending on the investor’s total costs, salable at a profit.  
This type of strategy is an alternative to the more obvious tack of buying NPLs simply to foreclose and then sell the collateral properties as soon as possible, or to lease them until prices rise to levels delivering returns that satisfy expectations. Though more labor-intensive and longer-term, the modification strategy may offer higher potential yields for managers who develop the wherewithal to buy NPLs in bulk at advantageous prices and manage portfolios proficiently. 
Both strategies rely on accurate appraisals based on extensive knowledge of local real estate markets. As many borrowers may owe significantly more than their homes are worth, NPL purchasers are often more concerned with the value of the underlying properties than with the notional amount of the loans. 
NPL investors who execute the modification strategy typically hire servicing companies to manage the properties and collect payments. It’s critical to find servicers who intimately know relevant local markets. The ideal servicing firm is one that not only takes instructions from the investment manager, but also provides insights that enable informed bids on NPL portfolios. Servicers naturally perform better if their compensation includes tiered incentives for producing returns beyond set thresholds.
Trading data on NPL portfolios is usually private and seldom distributed broadly, but HUD’s periodic auctions show a steady rise in values. During the height of the financial crisis, these values were as low as 30 percent of the unpaid balance. Since then, NPL values have more than doubled in some cases. In June, for example, Lone Star Funds purchased 16 NPL pools with a weighted average price of about 66 percent of the unpaid balance.  
To navigate the NPL market terrain, it’s critical to understand key valuation methods, value drivers and market dynamics. These include:   
• Valuation methods based on both income- and market-based approaches. NPL portfolios are typically valued using the income approach. Discounted cash flow (DCF) analysis, commonly used in this approach, estimates the present value of the projected cash flow of an NPL portfolio, which typically includes revenue and expense items. The bulk of NPL portfolio revenue typically comes from the proceeds of property sales (for loans that can’t be modified). A smaller portion may come from principal and interest payments received from accrual mortgages and rental income, if any.
• In the market-based approach, valuations are derived from previous market transactions of similar assets. As many transactions are seldom truly comparable due to the heterogeneous nature of NPL pools, this approach has drawbacks. For example, a Florida pool of NPL mortgages largely in foreclosure may not be comparable to a Northeastern pool of NPL mortgages that have been heavily modified. 

• As the residential NPL market has become more established and prices have risen, with smaller portions of the portfolios’ mortgages underwater, modeling of recoverable cash flows becomes more important. More attention is being paid to previously incurred expenses, forborne or forgiven balances and other factors; this increased focus is used to justify the rising prices paid at recent auctions. 
• Leverage has become vital to hitting yield targets. NPL purchasers have begun to add securitization to newly acquired NPL portfolios to get financing— typically, 70 to 80 percent of a pool’s purchase price. 
• Home price appreciation (HPA) forecasts are perhaps the most noteworthy value driver, as many NPLs may be resolved by liquidating the underlying property within set time frames. Liquidations are performed either by taking the loan through the foreclosure process to sale or via short sale. In a short sale, the property is liquidated before foreclosure, though the proceeds don’t cover the outstanding balance of the mortgage. Strong HPA, now a reality in most domestic real estate markets, can increase incentives for borrowers to start making payments if their homes’ values have surfaced above water.
National HPA has been a major catalyst for the increased market pricing of NPL pools. Because of sustained low mortgage interest rates and the strengthening economy, HPA has rebounded over the last few years. According to the S&P Case-Shiller Home Price index, national HPA increased 10.8 percent in 2013 and has risen more than 5 percent in 2014 through September.

However, regional HPA isn’t geographically uniform. Some states have experienced considerably lower HPA increases in recent years than some of the markets hardest hit in the financial crisis, such as Florida and California, where a lower trough has resulted in more room for rebound in HPA.   
• Liquidation time lines—the time it takes to bring a loan through the foreclosure process for sale, assuming the loan isn’t modified. Location can make a big difference because this can determine whether loans are “judicial” and others are “non-judicial” in terms of how foreclosure is handled. In judicial states, the lender or servicer must file a complaint in court to foreclose, which leads to considerable delays as the validity of the debt must be proven; action by the homeowner can stall the process. In non-judicial states, intervention by the courts isn’t required, so the house can be sent to auction sooner.
• A loan’s current delinquency status relative to the property’s location must be considered in calculating liquidation time lines. For example, a property with a loan that is only 60 days delinquent in a non-judicial state can be liquidated sooner than a loan that is more than 120 days delinquent in a judicial state. 
NPLs are esoteric investments that require mastery of these market-specific principles and dedicating considerable time to ramping up. This preparation is by no means easy, and should be undertaken with the expectation of sufficient volume. Yet those willing to make this commitment can position for the yield available in the current brisk market.     
Gunes Kulaligil, a senior vice president in Financial Advisory Services at Houlihan Lokey, is an expert in nonperforming loans as an asset class. He is based in the firm’s New York office.   

The views expressed herein are the author’s views and do not represent the views of Houlihan Lokey.