When the first flood of foreclosures swamped housing markets at the dawn of the Foreclosure Era in 2007, a new generation of investors saw the opportunity and discovered they could make much more money by holding and renting the properties they acquired than by flipping them.  Rental income from tenants—often families displaced by the housing crisis—created the cash flows necessary to fund additional foreclosure purchases and the REO-to-rental business was born.  

Investors found out they could net 8 percent a year, and the return on their investment could rise even higher when they held their purchases until values improved.[1]  By 2010 hundreds of thousands of investors were buying as much as 37 percent[2] of all homes sold in America, creating a new source of desperately needed demand to stabilize local housing markets and set the real estate economy on the path to recovery.  Today more than 13 million households are renting single-family homes[3] and single family rentals outnumber apartments.[4]

Today the business of buying, renting and selling foreclosures and short sales is on the threshold of even more dramatic changes that will have important consequences for the residential real estate economy as a whole.

Residential Investing Goes Big Time

In business, it’s hard to keep a good thing to yourself.  This year several dozen investment firms backed by $ 6 to $ 8 billion in private equity hedge funds announced plans to purchase between 40,000 and 80,000 previously foreclosed homes. The Wall Street invasion of what is certainly the most Main Street of all business sent shock waves through the ranks of individual investors.  Yet the new entrants may be just the first wave.  In September, investment bankers at Keefe Bruyette and Woods estimated the dollars raised so far may only trim 15 percent of the foreclosure supply, and there is room for even more growth that could last for years.  KBW analysts believe total potential returns could reach as high as 20 percent on some investments depending on leverage and how much home prices can appreciate in the months or years ahead.[5] 

It wasn’t long before the little guys felt the pressure.  This past year small investors found themselves losing auctions on courthouse steps where they had done business for years, and missing out on bulk deals that they never saw negotiated by lenders and the new private equity funds with deep pockets.  The new demand is driving up foreclosure prices and shrinking already-tight REO and short sale inventories. Some small investors have found a ready market for their properties in the new players, who pay top dollar.  Some have set themselves up as wholly owned real estate factories, with acquisition, financing, marketing and property management services under one roof.

Uncle Sam Blesses Bulk Sales

The Federal Housing Finance Administration, better known as the conservator of Fannie Mae and Freddie Mac, ignited even more interest on Wall Street in the REO-to-rental business when it selected five well-financed investors to buy or to manage foreclosures owned by Freddie and Fannie, paying a 20 percent management fee, twice the industry norm. When it was conceived, the pilot program had two goals: to get a lot of foreclosures off Fannie’s and Freddie’s books, and to keep them from threatening local home values by turning them into rentals.  By the time the deals were announced in October, however, while more than a million foreclosures remained backlogged in processing, inventories of foreclosures for sale were so thin that the government could have sold the foreclosures at a good price and local markets would have welcomed the new inventory.  The California Association of Realtors was so upset over the federal government’s decision to sell thousands of California foreclosures that it mounted an aggressive but unsuccessful campaign to block the bulk sales, which included a call for the resignation of the FHFA’s administrator.[6]

Self-Storage Facilities, Casinos and Cell Towers

There’s a certain irony in the vast amounts of Wall Street money that is pouring into foreclosures when just five years ago so many institutional investors were burned badly by subprime mortgage-backed securities.  Mortgage-backed securities are bonds backed by the value of mortgages held by major lenders.  Today virtually all mortgages are securitized by Freddie Mac and Fannie Mae, who bring the added benefit to investors of an implicit guarantee that the federal government will stand behind them.  For more than 70 years this system worked well until, in September 2008, the subprime mortgage crash threatened to take down the mortgage-backed securities market and Fannie and Freddie as well.  Only the takeover of the two government-owned companies by the Treasury Department kept that from happening. With government backing, the secondary mortgage market is still in business, but efforts to restart a market in nongovernment-held mortgage-backed, or “private label,” securities have yet to succeed.

Secondary markets have developed for other real estate-related securities, including medical offices, senior housing projects, self-storage facilities, casinos, student housing and even cell towers.  Securities based on these asset classes are bought and sold by institutional investors, their value based on the cash they generate supported by the value of the underlying real estate.

These real estate “asset classes” may soon be joined by a new one:  REO-to-rental.  Certainly the prospect of an REO-to-rental secondary market is the pot of gold at the end of the rainbow for many, if not most, of the new Wall Street private equity investors, who have been joined in the effort to create a new market by ratings agencies, investment banks and other services that would profit from fees generated by the new securities transactions.  For private equity firms putting the deals together, a secondary market would create a huge new source of cash, and by selling securities based on packages of single family rentals, they could transfer the risk to investors as they continued to make money from managing the properties.

Plans for a secondary market were on a fast track until the three major services that research and rate the quality of securities offerings weighed in with reports on how they would rate single-family rental securities.  Ratings agencies are the reality check for investors.  They are critically important because they govern how securities are priced based on independent research and hard data on which they base their decisions.  For a market based on an entirely new asset class in residential real estate, the views of the big three ratings agencies will impact not only the prices at which securities will be sold, but the viability of the asset class as a whole.

The Ratings Agencies Weigh In

S&P, Moody’s and Fitch Ratings all issued cautionary reports outlining what they would look for in making ratings, but Fitch was the most negative. Fitch said securities seeking a better rating are going to have to meet stringent requirements that look beyond price and yield.  The promise of a good or exceptional return will not be enough to win a higher rating.  It outlined the factors that it will use to rate offerings. The major issues the ratings agencies raised were:

• Location of the properties. Fitch will look first at the location of properties in rental markets, the local economy and employment base, and the desirability and quality of neighborhoods where rentals are located, since these will determine demand. 
• Quality of management. Management is critical to all three ratings agencies, reflecting their experience with other real estate asset classes.  Offerings will be rated based on the quality of their property management, and that quality will be determined by multi-year track records.
• Underlying assets.  The sales value of the properties as sources of cash flow.

Fitch said it will assess management company experience and operating capacity, market analysis, lease terms, tenant underwriting and property marketing, operative efficiency, and management continuity.  Finally, and most important, Fitch will require years of data to assess the quality of property management. The ratings agencies made it clear there would be no exceptions.  Moody’s even warned that debt issuers may not always be able to overcome limited information by structuring deals with more investor protection.

Two months after its report was issued, Fitch stood by its guns despite industry pressure. “While we have had conversations with some of the market-level data providers, one of which we found to have a robust data warehouse, the history only dates back to 2008-2009. For these reasons, Fitch is unlikely to assign a high investment-grade rating to such transactions,” the firm said in late October. [7] 

The ratings agencies destroyed any expectation that any REO-to-rental security will get rated in 2013.  In light of the fact that the REO-to-rental business is only four or five years old, clearly it will take several additional years to develop the multi-year track record that Fitch will require for a high rating.  High ratings are critical for REO-to-rental securities because they will be a new investment product against a wide variety of established investment vehicles for the attention institutional investors.

However, delay could be costly or even fatal.  Billions were raised on the promise of potential yields in the 8 percent to 12 percent range based on prices 30 percent under their peak values.[8]  Business plans did not anticipate a multi-year delay.

Moreover, current market conditions are ideal.  Even though REO inventories are thin, some 1.3 million foreclosures are backlogged in the processing inventory and will be available soon for acquisition.  Demand for single family rentals is at an all-time high, and some housing markets that have been hit hardest by the foreclosure crisis have seen rental demand jump by more than 25 percent in the past year.[9]   Rising home values in most markets are being accompanied by rising rents.

The longer-term view is dimmer.  The days of the Foreclosure Era are numbered.  Default rates have been failing for two years and new foreclosures are nearly 30 percent lower than last year.[10]  A wave of new multifamily rental properties is coming on line to compete with single-family homes.  Some 44 metro areas will double their multifamily construction this year; there is now more multifamily construction than single-family construction in 36 of the top 183 MSAs.[11] A battery of surveys by Fannie Mae and others suggest that the next generation of homeowners is only awaiting an improved economy to leave the rental life for ownership, and certainly a large number of the foreclosure victims who largely populate single-family rentals will try to buy again once their credit is restored.

Investment Banks Weigh In

For the investment partnerships that have raised millions from private equity sources expecting to cash in with securitization, the delay must be excruciating.  Some are finding new sources of cash to tide them over until securitization is possible.  At least seven investment-bank lenders are getting set to roll out the first round of balance-sheet term financing to a handful of private equity and real estate firms looking to buy foreclosed U.S. single-family homes and convert them to rentals.

The banks, including Deutsche Bank, Barclays, Citigroup and Wells Fargo, will hold the loans on-balance sheet and by year-end are likely to refinance them with unrated securitizations backed by the rental cash flows.  Once completed, the unrated transactions will be presented to the rating agencies early next year as concrete proposals. Agency analysts will be able to vet them to determine proper credit enhancement for eventual rated asset-backed securities (ABS) transactions, which industry experts predict will appear in about 6 to 12 months.[12]

At least one major player may have a better idea.  Carrington Property Services recently established an exclusive national network of leading residential real estate brokerage firms focused on REO and short sales. This network provides an opportunity for successful brokerages to participate in institutional business, as well as property management, valuations, and purchasing assets for institutional investors. Carrington hopes to become a single source for institutional investment firms seeking bulk sales of foreclosures to securitize, which they will then manage as rentals.  Carrington has been managing single-family rentals since 2004 and a spokesman says it is positioned to do well in the REO-to-rental business whether a secondary market develops or not.

The Outlook

An industry source close to the action estimates that as many as half of the new private-equity-financed REO ventures will fold should securitization not pan out. However, the REO-to-rental business itself should have a long future. Firms like Carrington, with deep roots in real estate and strong property management capabilities, could thrive.

On the other hand, if the secondary market in single-family rentals takes off, it has the potential to change the real estate marketplace in ways that reflect the needs of investors rather than consumers.  Through the criteria they establish, ratings agencies like Fitch and Moody will have the power to dictate changes in the way foreclosures are bought, remodeled, rented and managed.  Well-run, quality properties will always have value based on rental and resale potential, but single-family rentals that comply with the ratings’ agencies standards will be more even more valuable because they can be securitized.  In other words, the tail will wag the dog.  A single-family rental industry driven by the needs of institutional investors may look significantly different from one driven only by the needs of tenants.

For example, properties located in communities with a favorable rental economy will be more valuable than those located elsewhere.  Single-family homes managed by property management firms with the data to demonstrate quality management practices also will be more valuable.  A single-family rental managed by its owner will be less valuable than the identical home under the management of an established management company.   Wonderful properties with great management and occupancy that happen to be in a less desirable economy will get a lower rating, as will excellent properties in excellent neighborhoods managed by a young, innovative property management company that has been in business only three or four years. Indeed, most of the property management companies handling single-family rentals today are small, local and young.  Local economies, management companies and neighborhoods can change quickly, and sometimes in ways even locals don’t notice.  Unless ratings companies stay on top of the properties on which securities are based, property values based on ratings could fail to reflect change.

Steve Cook is a communications consultant and journalist covering residential real estate. He writes and edits Real Estate Economy Watch and writes for UPI, BiggerPockets.com, Equifax and other outlets. He also helps leading real estate companies get news coverage. Previously he was VP for Public Affairs for the National Association of Realtors.

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