REO to Rental

In the words of housing consultant John Burns, bulk sales of REOs could be a "game changer" for the U.S. housing market.

The Obama administration this summer floated the idea of selling foreclosed homes to investors, who would agree to rent them out.

The interest in a REO-to-rental program was so high that interested parties flooded the government with nearly 4,000 RFIs — or requests for information — in September when the topic hit fever pitch.

The pool weighing in on the matter is vast.

It includes the requisite professors, consultants and think tanks.

But it also encompasses investors big and small, lenders, mortgage insurers, property management firms, out-of-work homebuilders, mortgage and real estate trade groups, entrepreneurs of all stripes and nonprofits.

"There is significant interest, and there is interest up and down the spectrum," said Alon Cohen, a housing policy adviser for the Center for American Progress, a Washington think tank, on noting keen interest among small to large nonprofits.

What's not to like about a bulk REO rental initiative?

It could stabilize home prices and neighborhoods, improve REO asset recoveries, keep rental rates in check and reduce the shadow inventory, according to John Burns, chief executive of Irvine, Calif.-based John Burns Real Estate Consulting.

"I know that there were small mom-and-pops that submitted and there were billion-dollar hedge funds that submitted," he said.

But Burns and others admit it's not that simple. The challenges are many.

Will the government get an acceptable price by selling in bulk? Will investors make an acceptable return? Will managing a portfolio of single-family properties prove too difficult? Will investors reap a windfall and then leave neighborhoods in slum-like conditions? 

"(Home) prices are already very low so the opportunities, and demand are already there," notes Oliver Chang, U.S. housing strategist at Morgan Stanley.

"Even without government intervention, private capital is already beginning to flow in. With bulk REO sales, the industry moves from niche and cottaged to institutional," Chang said.


Housing has been in the doldrums for about five years now, and the Obama administration has struggled to give it a lift.

Home prices slumped again over the summer although sales gained traction in what is traditionally the busiest season for the industry.

The REO market continues to make life challenging for homebuilders as sales of new homes dropped another 2.3% in August for the fourth-straight monthly decline and the lowest level since February.

The inventory of new homes hit a new record low.

Growing in concern is the backlog of foreclosure cases and the glut of real estate owned properties held by major servicers and the GSEs.

The government currently owns about half of the REO inventory in the country. Fannie held more than 135,000 REO at the end of the second quarter, more than double the 61,000 owned by Freddie. The Federal Housing Administration had 43,856 REOs as of Sept. 15, with about 19,200 of those under contract.

About 4.25 million properties were at least 30-days delinquent but not yet in foreclosure in August, with 1.9 million of those at least 90 days past due, according to Lender Processing Services, suggesting the REO inventory is set to grow.

The home ownership rate, meanwhile, has fallen to its lowest level in 13 years to 65.9%, down from a peak of 69.2% in 2004. The overall decline, whether from foreclosures, short sales, an inability to get financing, or personal preference is pushing up the demand for rentals.

Illinois is just one example of this shift. One in four homeowners in the state is underwater on their mortgage, according to statistics from the Woodstock Institute, a housing group that advocates on behalf of minority neighborhoods in Chicago.

The rental market has gained steam over the last 12 months in the city as previous homeowners become renters, said Tom Feltner, vice president at Woodstock.

"We've seen rents rising in many neighborhoods. At the same time, we've seen an interest in homeownership decline. There is serious pressure on the affordable rent housing in Chicago. Renting REOs definitely is a step in the right direction to relieve some of the pressure on the affordable housing market."

In August, the Obama administration — via the Federal Housing Finance Agency — put out its RFI seeking input on new options for selling single-family REO held by Fannie Mae, Freddie Mac and the Federal Housing Administration.

REO sells at a steep discount. So reducing the overhang of distressed properties — and ultimately raising home prices and home sales — is a priority for many housing market participants, including two of the biggest trade groups in the nation, the Mortgage Bankers Association and the National Association of Realtors.

"Existing government programs should be modified to support financing and availability for local investment," the MBA wrote in a letter supporting bulk REO sales. "Providing affordable, responsible financing options to investors not only eliminates REO properties, but also empowers neighborhoods by giving local residents an increased stake in its success."

NAR wants any REO-to-rentals or a lease-to-own government program to be narrow in scope. The trade group, which has about 1.1 million members, is concerned properties might be expedited to foreclosure to enable a bulk sale.

"In any kid of lease-to-own joint venture program, it should be in small, specific geographical areas and not run by a large institution or administered by the government," said Charlie Dawson, associate policy representative at NAR.

Instead, NAR wants to see local investors and local nonprofits.

"Keep this as local as possible so you have people who really understand the market and are more hands-on," Dawson said.

NAR wonders if bulk deals would be too large, in the $50 million to $1 billion range.


While the government may be interested in luring big national players, local and regional investors aren't waiting for a bulk deal from the GSEs.

They are building their portfolios of REOs one at a time to rent or resell.

Orange County, Calif.-based G8 Capital is already in the game.

The investment firm supports the idea of finding ways to clear government inventory using mechanisms common to the private sector.

"About half of the buyers that we deal with are investors that are buying properties. In a lot of cases, they are buying properties as rental properties," the company said.

Besides representing investor-clients, G8 also is investing on its own behalf.

"We have held onto about 350 properties — most of which are condos — in the past year and a half. We started building this rental portfolio, and we are seeing significant opportunity going forward."

Salt Lake City-based Green River Capital, an REO asset management firm, announced plans recently to operate a national program to rent out previously foreclosed homes.

In March, the REO asset management company became one of three firms handling REO sales and upkeep for Freddie Mac.

Green River's investment in a new rental program followed on the heels of the RFIs that flooded into the Obama administration on how to handle government-held REO properties.

The company said its rental program would be conducted on a regional basis and include single-family homes, duplexes, condominiums and town homes.

Green River plans to reach out to delinquent homeowners who might be able to stay in their homes as renters, as well as to new tenants.

"With the housing market's continuing challenges and President Obama's recent request for firms to propose alternative rental approaches, GRC’s enhanced, nontraditional servicing program allows our clients to conserve their properties and prevent losses," said Joe D’Urso, president of Green River Capital.

Homebuilders have also diversified into REO to find new revenue sources for the dried-up new home market.

The MacDonald Cos., a small homebuilder from Kerrville, Texas, began buying up REO a couple years ago and providing a lease-to-own program.

"I can't imagine why more people haven't done it, especially when there are whole streets available in some markets," said Granger MacDonald, president of the central Texas firm. (See more on homebuilders investing in REO in sidebar, page XX.)

Mom-and-pop shops are also at play.

Victor and Teresa Avramenko, a couple from Canada, bought their first American property two years ago. They now own five houses in the Phoenix area and they plan to buy another three to five.

One they use for their U.S. visits and the rest are rentals. Foreign investors pumped between $30 billion and $41 billion into the U.S. housing market for the 12 months that ended March 31.


Small investors see the value of investing in REO, but will big hedge funds and investment firms feel the same way?

Dain Ehring, founder of CoreLogic Dorado, said motivating private capital to buy REO makes the most sense of the various options being floated by the administration.

"That's one extremely viable way to get through all the shadow inventory that the market hasn't gone through," he said. Ehring is especially interested because he believes CoreLogic Dorado's cloud computing tools may be able to help make the transfer of those REOs to private investors more efficient.

"We're looking at ways we can automate the purchase of those houses and do it in a way that (investors) can understand and have a clean asset."

But money could be a hurdle, he noted.

"Right now it's onesies-twosies. You've got to do it in a big, big way and bring in some big money. So when you do that, then you've kind of got to institutionalize it."

The big-money players — hedge funds and private equity funds — still have too much fear and uncertainty to step in, Ehring believes.

Investor Ron D'Vari, co-founder and chief executive of NewOak Capital, sees challenges on the seller and buyer side.

"Most institutions are not in favor of bulk sales, but I am sure they are doing mini-bulk or asset-by-asset bid," he said.

"Bulk auctions are typically very challenging as the buyers are not going to be able to do their homework, which is super expensive, for a (bid) that they may lose. Many institutional buyers actually stay away or bid very low due to their light due diligence," D'Vari said.


"I don't see a problem moving the inventory right now," said Todd Mobraten, president and COO of Res.Net, an online real estate tracking system used by real estate agents, servicers and homebuyers.

"I don't see any issue liquidating REO. We are connected with every REO player in the industry. We have 160 companies that use our software on a daily basis to liquidate REO. None of them are having a problem moving that inventory."

It's not unusual for local investors to go to a delinquent borrower in a house that is listed for a foreclosure auction and offer to buy the house and lease it back. But Mobraten is skeptical about whether that could work on a mass scale.

Christopher Thornberg, founding partner with Los Angeles-based Beacon Economics, also questions the administration's proposal.

It's definitely a bad idea if you are a multifamily landlord, he notes.

"If you want a bunch of people buying up these REOs, it's going to cause a bunch of vacancies in the apartment stock.  I guess if you prefer to have the single family tight and the multifamily loose, maybe that's OK."

Still, Thornberg questions whether the administration "should be favoring one part of the market and not the other. In any case, I don't understand what the purpose of this is. If investors want to go out and buy and rent, they'll go out and buy and rent. Are we supposed to subsidize people to do that? I don't think we need to subsidize people to do that. Just let prices fall further."

Plenty of bright entrepreneurs have seen opportunities with REO and have already bought them up, he contends.


Tom Eggleston is one of those entrepreneurs who figured out how to make an REO rental program work.

A former homebuilder now with real estate firm called RENU Management, he has some ideas for both big and small players.

The Indianapolis-based entrepreneur envisions a national pool auction in about 40 markets with 400 REOs in each portfolio for large institutional investors and hedge funds, and local pool auctions in about 10 markets with 100 properties in each portfolio for local and regional investors.

All would be subject to a five-year hold and rent, with limited exceptions.

"The savings are that you don't have institutional or branded marketing like multifamily does, so the marketing is limited to asset-specific marketing. Our method of marketing is to utilize about 50 websites — high-traffic sites where renters are looking for single-family properties, including duplexes and quads."

As a management firm, the company receives favorable rates for the ads, which generate a tremendous response. The firm pays on commission for showings and as leases are signed, which is similar to how multifamily works.

The savings come from not having to do upfront brand marketing, such as maintaining a website or advertising locally to draw traffic.

The firm pays licensed real estate agents on a commission basis to lease the REO it manages. On the capital expenditure side of things, single-family residences will likely be more expensive in terms of repair costs, Eggleston said.

"With the volume of repairs that our units generate, we do achieve very favorable cost arrangements with our contractors." RENU offers 24/7 repair to its tenants, similar to multifamily properties.

"I think we have some upfront savings on the marketing side and some higher repair and maintenance costs under the scattered-site model, but generally similar in terms of financial performance, which I think would surprise people," Eggleston said.

"I think they assume there is a huge premium in the expense structure to manage single-family (properties). We find with the right processes, it is very comparable."

Richard Green, professor at the University of Southern California's Lusk Center for Real Estate, compares bulk REO sales to “essentially what we did with the Resolution Trust Corp. after the savings and loans blew up in the late '80s and early '90s."

Going that route "imposes lot of pain in the short run but it gets it over with. I think there are places in the country where it probably would be helpful just to clear the decks."


Greenlining Institute's constituents are concerned about whether absentee investors will adequately maintain properties, so bulk sales raise the specter of neighborhood disinvestment and decay.

"The folks we're working with are dealing with homes that are left abandoned, or not properly maintained, or not even brought up to the appropriate standards that then make tenants suffer from health and other issues,” said Orson Aguilar, executive director of the Berkeley, Calif.-based public policy research firm. "There need to be rigid standards when it comes to the rehab and maintenance of the properties that are sold to investors." 

Any effort to dispose of these REOs should further Fannie Mae and Freddie Mac's mission to preserve affordable housing and help first time homebuyers, he said.

"We think it would be really unfair to help enrich a group of investors who are lucky to have enough cash to buy these bulk (properties) but don’t invest in the communities where these properties are located," Aguilar said.

Any national plan to facilitate mass sales of foreclosed homes should require the investors purchasing those properties to partner with local nonprofit groups, according to the Greenlining Institute.

"We're talking about a huge transfer of wealth to a group of investors in the name of stabilizing the market," according to Aguilar.

Cohen of the Center for American Progress said there could be some monetary benefit for the GSEs to work with nonprofits.

That might be more viable then selling to investors, who may have a hard time making competitive returns on REO and may demand a significant discount on the front end to make it work.

"A mission-driven nonprofit doesn't need to make the numbers work and should, as a result, be able to offer a higher price. A nonprofit also is likely to spend more money on the rehab. What if mission-driven organizations can offer more money, thereby giving the GSEs the short-term maximum value they are seeking?"

If the GSEs and the FHA provide cash-strapped nonprofits access to capital to buy up REO, then they could, in return, achieve short-term high returns on their REO combined with long-term neighborhood stabilization.

"We know there is a track record of investors coming in from outside and just flipping properties. You buy it for 20 cents on the dollar and you flip it for 30 cents on the dollar and you make out like a bandit. That's not helpful if you are trying for housing stabilization," Cohen said.

"Look, we don't need to vilify anybody. If you are an investor and you say my investment term is five years, then you'll do a five-year investment."

Nonprofits, however, are interested in holding the properties longer and thus will invest more in rehab on the front end, he said.

For John Burns, it all boils down to two key issues.

"We need to keep the distressed transactions off the market," he said, "and we need to make sure people don't go homeless. Rental REO solves the problem."

— Liz Enochs, Jacob Gaffney, Kerri Panchuk, Jon Prior and Jason Philyaw contributed to this report.

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