Secondary market interest in distressed single-family homes converted to rentals continues to attract a lot of interest. But figuring out how this up-and-coming asset class will best fit the capital markets is a problem.  

The overstock of housing is one of the biggest impediments to a sustained housing price recovery. Analysts at Barclays Capital said the housing bust that began in 2007 highlights the depth of the oversupply of single-family homes. BarCap projects 4 million in distressed liquidation over the next three years and 6.4 million over the next five years.

These projections mean that a considerable amount of people face eviction and will be looking for alternative housing accommodations, which is most likely to be some form of rental housing, over the next five years.

According to Keefe, Bruyette & Woods, real estate investment trusts alone raised $6 billion to $8 billion for REO-to-rentals. This suggests potential acquisitions of 40,000 to 80,000 properties. Still, without financial leverage, this still amounts to less than 15% of unsold real estate owned inventory. (See chart 1.)

As buyers look to ramp up portfolios of these assets in a significant way, secondary market players have started to consider what role they will play in this new and emerging asset class. At first look, the asset class is a perfect fit because REO-to-rentals have a much more tangible cash flow that can be underwritten than other distressed real estate products.

But for a secondary market to develop, the asset class first needs to prove its worth. For now, investors are concerned that there isn’t enough historical performance data or track records of property managers; these are just some of the hurdles that need to be crossed before a market develops in earnest. 

Suzanne Mistretta, a senior director at Fitch Ratings who spoke at the American Securitization Forum sunset seminar on REO-to-rental securitizations in October, said that the rate of decline in homeownership, which is currently at 65% from a pre-crisis level of 69%, means a change in living situation for about 4 million U.S. households.

Rick Sharga, executive vice president at Carrington Mortgage Holdings, estimated that in terms of supply, there are roughly 600,000 REO homes not yet sold, another 1.5 million homes in some stage of foreclosure and 3.5 million borrowers who are seriously delinquent on their loans but not yet in foreclosure.

According to Mistretta, in the private-label sector alone, more than 1 million borrowers are 60 days past due. On top of that, the government-sponsored enterprises reported about 1.3 million borrowers were distressed as of the first quarter of 2012.

“Even if half a million of these borrowers were successfully modified, almost 2 million units would need to be absorbed by liquidation, short sales or other means,” she said.

As the rate of homeownership declines and credit remains tight, there is a greater need for more rental properties. But, according to Sharga, rental units are already 97% occupied. “Millions of displaced former homeowners would probably rather live in a single-family home than an apartment,” said Sharga. “In fact, between 10% and 12% of all rentals today are already single-family homes, so what we’re talking about is essentially growing that rental category, rather than creating something entirely new.”

SECONDARY MARKET IS LISTENING

When the Federal Housing Finance Agency sought a request for proposals on REO rentals in 2011, it stirred substantial pockets of equity that moved beyond the typical mom-and-pop investors who have historically driven rentals of single-family homes in the U.S.

“Renting single-family properties is not a new phenomenon, in fact it’s been around for a long time and it’s been done in large numbers,” said Ryan Stark, director at Deutsche Bank who also spoke at the ASF event. “Now it’s being done on an institutional level.”

Dash Robinson, a managing director at Wells Fargo, said the amount of equity growth in the space since 2011 has been “dramatic.” “I would say that there are a few modest-to-large pockets of equity that have been investing in distressed purchases of single-family homes for the purpose of renting,” he said.

And while some private-equity firms have the equity in hand to make these initial purchases, Thomas Hiner, a partner at Hunton & Williams who leads the firm’s New York-based Structured Finance and Securitization practice; said that eventually even they will have to consider how to fund their purchases and boost their returns.

ACQUISITION FINANCING

Acquisition financing is critical to getting investment vehicles off the ground as they head toward a possible public market exit because that is how buyers of the REO are going to be able to grow beyond their initial investments. Investors will not be able to invest with any great degree without access to the capital markets to finance these REO investments. Right now there isn’t a huge need for acquisition financing for most of the interested parties. According to Carrington’s Sharga, there’s actually more capital available than desirable properties to buy.  Sharga calculated that even if all $8 billion of the funds already announced by various investors were spent buying distressed properties, that would purchase about 80,000 of these homes, so there should be more than enough inventory to meet investors’ appetites. 

“[But] if the category expands dramatically, it will be an indication that the participants are generating good financial returns; if that’s the case, financing will be readily available,” he said.

Hiner said that the biggest source of acquisition financing today is Fannie Mae with a program designed for an orderly disposition of its REO portfolio. Fannie offers two joint venture options, where the bidder bids jointly with the GSE. Fannie helps with financing and the qualified investor is responsible for the management and servicing of the assets. However, the investor remains an equity partner with Fannie Mae.

The third option for buyers is the all-cash bid which involves third-party financing. “That seems to be the route that investors are going to take, because they are looking to buy on their own terms,” said Hiner.

Bank structures for financing being kicked around fall into two types of categories that both draw on traditional financing like commercial real estate financing, mezzanine financing and aspects of residential mortgage financing and securitization techniques, according to Hiner.

Jonathan Spinetto, president of Blackhawk Consulting, said market players are ready. “Whether or not they are publicly disclosing the financing of these transactions, they are (already) out there and available. Depending on size, we know exactly who needs to be called for lining up this type of financing.”

In September, Waypoint Real Estate Group said Citigroup would extend to Waypoint a $65 million loan for investments in distressed single-family houses converted to rentals. Then in October, Citi boosted its financing to Waypoint with a $245 million revolving credit facility for the renovation, long-term ownership and management of Waypoint’s growing national portfolio of single-family rentals. 

SECONDARY MARKET CONCERNS

But before a securitization market can develop for this asset class, investors remain concerned about several issues. On the one hand, buyers want reassurance over how big and how deep the market could get.

Youriy Koudinov, director at the massive teachers’ pension fund TIAA-CREF, said one concern is assessing how big the market is without the GSE presence and will it be scalable on its own? TIAA-CREF is an active investor in the securitization space and holds to a $75 billion securitization portfolio.

Koudinov said that the size of the REO securitization market depends on certain critical aspects such as liquidity availability, secondary commitments, creating an index benchmark for the new asset class and tranche sizes. Another bond investor concern is what the business model of potential issuers is, because it defines how sustainable that business will be. “Hopefully there is a limited number of distressed properties; and if that is so, does it cap the growth for the business model?” asked Koudinov.

Jonathan Spinetto, president at Blackhawk Consulting, which acquires REO properties on behalf of hedge funds and institutional investors; believes that the market is longer-term.

“Until properties started to come down in value this class did not make sense,” said Spinetto. “Now that the market has taken significant hits in both terms of price and supply, it makes sense.”

Although in the past the single-family asset class has been looked on as not having enough volumetric efficiencies to make sense to larger investors; the fact that many rental markets have always had strong numbers and show a potential for market appreciation means that large investors who have recently entered the space are more likely to proceed with a long-term business model, Spinetto explained.

Sharga said that at Carrington the model is a hybrid, which is based partly on rental yields and partly on anticipated home price appreciation over time. “We have some concerns that some of the investors entering the market may have underestimated the difficulty involved in managing multiple properties in multiple markets, and others may have over-estimated potential yields, possibly resulting in the investors being under-capitalized, which could be a problem in terms of adequately maintaining the properties in their portfolios,” he said.

Stark at Deutsche Bank said that some buyers have turned their purchases into a REIT, to really run the model more like a business where cash flows are collected long term. On the other hand, some buyers run their models like a modified nonperforming loan strategy, where the goal is more of a “fix and flip” one.

But Robinson is confident that either strategy could work for securitization. “The ABS market is very short, good-risk assets right now and REO-to-rental assets are very under-writable, one could argue that they are even more tangible than an NPL portfolio,” he said.

Spinetto believes that the yield strategy is the one that is best aligned with securitization. Texas, for example, does not offer the same appreciation potential of California, but the yields in Texas work and property is available in good quantities. “In several markets we are still purchasing even though the property is not being acquired on a 30% to 50% discount since the market is so competitive,” he said. “To maintain the purchase volume that the funds are looking for we are already in various secondary markets across the country.”

For Sharga, what determines which business model is a better fit with securitization, depends on assessing what the operating costs are, what the delinquency rates will be and what the occupancy rates will look like. “All of these variables will have an effect on yields and cash flow, which should be key factors in any securitization,” he said. “While we believe that at some point there will be securitization, at the moment, until there’s a track record of performance in the category, we think the conversation is a bit premature.”

RATABLE  ASSET?

Ratings remain an important decision-driver for secondary market investments. Koudinov said that the level of ratings a bond receives determines its liquidity — especially in the case of a new and emerging asset class. “In a post-crisis world, ratings signify a degree of confidence in cash flow and structure and also gauge a ratings agency’s comfort with the origination practice, compliance and servicing aspects of the deal,” he said.

Fitch’s Mistretta said that Fitch has received inquiries on how it would rate a (secondary market) transaction. But the single-family rental market, because it has been historically driven by the mom-and-pop formula, lacks the historical data to support the development of a secondary market, right now.

In October, Fitch published a commentary where it noted that a key challenge in structuring a potential securitization deal backed by this asset class is the investor’s security interest in the collateral. The collateral can consist of mortgages on the property or equity pledges.

With the latter, a property is deeded to a special purpose entity and a 100% equity pledge in the SPE is transferred to the trust. The key risk associated with this structure, said Mistretta, is the potential for the issuer or sponsor to pursue bankruptcy of the SPE if the deal underperforms and investors seek to enforce their rights.

Without a recorded mortgage, there is a potential for the issuer/sponsor to obtain post-petition debt secured by the underlying properties. Fitch is concerned that under a stress scenario, the noteholders would become unsecured creditors of the SPE.

The lack of performance history and track records of the managers also presents risks. “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,” said Mistretta.  <