By Howard Liggett and Tom McOsker of GFI Group Inc -- With yields low and outsized returns shrinking for hedge funds these days, practitioners are wondering what the next popular source of alpha will be. The answer might be found in an instrument that is a century and a half old in the US (and much older in Europe) that is currently developing a healthy secondary market: tax lien receivables. Tax liens provide competitive yield for investors and typically fit well into the investment mandates for credit-focused, real estate-focused, distressed asset, or multi-strategy hedge funds.
What is a Tax Lien Receivable?
A tax lien receivable is a fairly simple debt instrument: the right to collect taxes owed on a particular property. When property taxes become delinquent, many counties or municipalities sell tax liens at public auction. According to the National Tax Lien Association, most local governments fund roughly seventy-five percent of their budgets through the collection of ad-valorem real estate taxes. Without this crucial revenue, municipalities face difficulties funding their day-to-day operations, schools and public safety services. When property owners do not pay their obligations to their communities, local governments are forced to cut services, raise taxes on those who do pay, or borrow. As an alternative to these measures, selling this well-collateralized debt to investors willing to take the risk makes fiscal sense to many officials, and is indeed what takes place in 29 states and the District of Columbia.
If and when delinquent payers do settle their debts with the lien holder, the lien holder receives interest and penalties on top, with states often setting maximum interest rates set by state statue that range from 10-50% . Should the taxpayer remain delinquent, the lien holder often has the right to initiate foreclosure on the property and remain high in the creditor scale.
The Need for a Secondary Market
Using the analogy of publicly traded corporations, a company issues equity and debt securities to investors once through an initial offering, and then these same securities are resold again and again in secondary markets. These markets provide the necessary liquidity for investors in the assets, while allowing the company to keep the debt and equity outstanding to finance operations. This concept applies to assets of all types, and within various marketplaces. Until recently, however, tax liens have not been an asset class that enjoys the same liquidity from a formalized, institutional secondary market .
In the past, tax liens were typically advertised locally and sold only once to speculators who would then assume the recovery process. But there was never an organized mechanism to resell that lien, or to price it in an open market. Considering the current dynamics of tradable markets and recent developments in technology this doesn’t make much sense.
With the decline in the real estate market over the last few years, the supply of liens has increased dramatically (30% in 2008, 20% in 2009, according one survey) due to increased delinquencies by property owners. At the same time, there has been increase on the demand side, fueled by banks and hedge funds seeking better yields than are available in other liquid debt markets. In the last year, anecdotal evidence suggests that investors showing up at auctions are buying less paper than they had intended, or none at all. Thus the need for organized, efficient distribution of tax liens, just like any other security, is now evident.
Tax lien investors repeatedly describe them as short term, lower risk, moderate to high yield, well-collateralized debt receivables. Typical lien-to-value ratios run 10% or less across the nation, and have an average repayment rate above 50% percent in the first year (depending on the state and taxing authority). Normal returns for a tax lien portfolio range anywhere from 8 to 20 percent, depending on the region and the particular lien or group of liens. Relative to other asset classes, the risk/reward prospects for tax liens are currently very favorable.
But just like anything else, tax liens are hardly risk-free. For one, there is the issue of maturity risk. Unlike bonds, there is no definite maturity, as that is determined by either when a lien redeems, or when a property that a lien encumbers is foreclosed upon. With banks now taking longer to foreclose, this process can be longer than expected. In addition, while a secondary market is developing, there is always the chance a certain lien might not be able to be sold on demand.
Types of Players and Strategies
Types of funds that have actively targeted the market include global financial institutions, hedge funds, private equity firms, regional lien pools, venture capital investors, corporations, and family offices.
For credit or distressed funds, full recovery remains the main objective just as it would with any investment they make. For investors and funds with fewer liquidity needs and a healthy legal infrastructure, investing in tax liens can be an indirect way to get real estate exposure.
One of the main concerns with asset managers of any kind is their willingness, or lack thereof, to close a fund to new investors once capacity has been reached. Tax liens are no different in this regard. While there are a lot of funds currently operating with assets in the $5-$15 million range, and a few with assets over $100 million, we foresee that a tax lien-devoted fund could manage about $500 million and still be fully invested.
Howard Liggett and Tom McOsker are co-heads of the Tax Receivables Group at GFI Group Inc. GFI Group Inc. is a leading provider of wholesale brokerage, electronic execution and trading support products for global financial markets.