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Large institutional investors bank on emerging asset classes

REO-to-rental securitization offers profitability

Historically, smaller institutional investors have funded the single-family rental market, but that's about to change.

Large investors are increasingly eying the nation's foreclosure inventory, coupled with a secular shift toward renting, which has created the possibility of larger-scale investments in the market, analysts with Keefe, Bruyette & Woods said in a new report.

To put it into perspective, $20 billion has been invested or raised by institutional investors for allocation into the single-family rental market.

"We see access to financial leverage as a future long-term catalyst for the industry, which would allow participants to boost returns," explained KBW analysts Jade Rahmani, Bose George and Ryan O’Steen.

They added, "We believe that securitization could eventually offer an attractive source of leverage and we would view single-family REO securitization as a potential catalyst for the second."

The six largest private equity firms, partnerships and REITs participating in the sector have purchased more than 81,000 houses in the last twelve months alone.

While projected returns on these investments seem appealing in today's interest rate environment, fund-raising efforts by these institutions, from investors and lenders, have prompted new interest in the factors likely to drive success in the single-family rental business, according to Deutsche Bank (DB) research analyst Doug Bendt.

Key factors that will contribute to profitability and sustainability in the market range from gross yield to operating expenses and vacancy reserves.

Consequently, as more markets continue to recover with lower foreclosure rates and higher prices, fewer investment opportunities at distressed prices will be available, reducing potential gross yields.

Thus, investors will have to find other markets to maintain gross yields.

Although large institutional investors have taken a slice of the single-family rental pie, these companies are still competing with a myriad of smaller investors.

"While larger institutional investors have gotten most of the attention in the press, purchases by smaller investors have dominated the activity," Bendt pointed out.

He added, "Moreover, investor sales were only about one-third of the total purchase market, so investors faced competition from owner-occupants, too."

Several ratings agencies have released comments regarding potential challenges and risks to rental securitizations.

For instance, Kroll Bond Ratings pointed out that REO-to-rental securitization presents aspects of both residential mortgage-backed securities and commercial mortgage-backed securities together with risks that are unique to single-family home rentals.

"Like CMBS, adequacy of rental cash flows, operating expenses and vacancy rates are some of the key stress variables to be analyzed," said Kroll Bond Ratings senior managing director Glenn Costello.

He added, "From an RMBS perspective, we bring our analysis of property values and potential loss on property liquidation. Specific to REO-to-rental is analysis of the property managers’ ability to manage and maintain a diverse and dispersed group of homes."

FeatherStone Investment Group was the latest issuer to set the stage in the REO-to-rental securitization market.

The company has designed a new program to provide liquidity to the sector, which will allows investors to participate in both the immediate rental cash flow as well as the potential gains from the sales of distressed properties.

Going forward, the REO-to-securitization market will depend on expanding into new geographic markets since prices in many of the current housing markets initially favored by institutional investors have risen, putting downward pressure on gross yields.

"We do think it will be an attractive option for leverage and our view that this has the potential to be a long-term institutional asset class," Rahmandi stated.

He continued, "It doesn’t necessarily mean it’s a permanent class forever, but the institutional plays could bring significant value to what was once solely a ‘mom and pop’ industry."

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