For rent: On the money trail of the burgeoning NPL and REO markets

The nation is slowly filling with rentals. And each property being put anew on the market comes from somewhere. However, how investors are bringing these properties to the scores of new American renters is not as easy as apple pie.

Large institutional investor purchases of distressed single-family homes converted to rentals are likely to grow but the key to that success is being able to expertly expand into new markets. And, afterward, to deftly handle the eventual outcome of each property purchased.

RealtyTrac said there is evidence in its data that indicates larger institutional players are searching for new markets to invest in, which is largely driven by falling gross yields in some areas due to rising housing prices and increasing competition.

“We can see a pattern where some of the markets that were hot last year, we are actually seeing the purchases either flatten out and in some cases like in places like Phoenix and California, actually decrease,” said Daren Blomquist, vice president at RealtyTrac.

According to the June 2013 report from Michael Orr of the W.P. Carey School of Business, institutional investor demand in Phoenix peaked in July 2012 at approximately 800 homes and is currently running at a rate of approximately 500 homes per month. The investor share of purchases decreased to 26.5% in June from 27.3% in May and 34.7% during the same period last year.

Blomquist said that in some of these markets, where home prices rose so dramatically over the last year, investors actually started to sell off their inventory. RealtyTrac does not yet have numbers at what rate this is happening, but is working to put together charts to follow this trend.

Anecdotally, the hot markets this year are Atlanta and Charlotte, N.C. in terms of percentage of big institutional investments, according to RealtyTrac. Many of the Florida markets have also seen increases in purchase from these buyers. These are markets that RealtyTrac defines as second tier.

Blomquist said there is already indication that big institutional investors or looking at third-tier markets.

And so, Realty Trac and RentRange published a list of “hidden gem” markets in September. These markets are smaller, less known, mostly Midwestern counties and cities that are considered third tier markets. 

“But the numbers still make sense here,” said Blomquist. “What you don’t have in these markets that you have in the Phoneix and Florida markets is strong home price appreciation, which in theory these investors aren’t as much concerned with.” 

Expanding into geographically diverse markets has challenges, in particular for large institutional players. 

Large institutional players have mainly looked at distressed real estate purchase opportunities. “They look for areas that have a high concentration of foreclosures because they can get a distressed purchase price with the addition of having distressed homeowners with a need to rent them,” said Wally Charnoff, CEO of RentRange. 

Reading between the lines

One way to determine where the activity in the market is heading is to approach the data in a new way. Dramatic shifts in REO saturation rates, for example, indicate where institutional investor activity is headed. Considering that an uptick in first-time homebuyers would show that the local economy is strong, or at least strengthening. This is a gradually lifting trend, and it takes time. 

On the other hand, REO saturation will sway hugely when institutional investors are buying up properties in bulk. A great source of this information comes from Clear Capital data. In a recent email to HousingWire, the valuation solution provider compared two markets according to REO saturation; San Francisco and Detroit.

In San Francisco, REO saturation remains low, at 6.3%. In Detroit REO saturation remains relatively high at 31.7%. Despite the high saturation in Detroit, Clear Capital called the number “much improved.” More than 30% REO saturation is much improved? Yes, actually.

Detroit’s REO saturation is half of what it was four years ago. And in the last six months from the date of the report, REO saturation fell by 11.5 percentage points

“Detroit’s struggle with relatively high REO saturation over the last several years delayed recovery,” explained the email. “Now, low price points and recent improvements in REO saturation, a key precursor to recovery, are driving gains. On the other hand, San Francisco’s median home price at $600,000 suggests noninvestor homebuyer demand is materializing, supported by its relatively strong local economy.”

Since 2010, investors have accounted for an average of approximately 19% of home sales, according to data from the National Association of Realtors. “It’s been a major factor in pushing home priced up on single family homes, you have this whole new source of demand that was never in the market before,” said Blomquist. 

A September Keefe, Bruyette & Woods report breaks down the numbers to include cash purchases as well, which suggest investor participation of 15% to 20%. Deutsche Bank calculated in a September report that the six largest institutional investors have purchased 84,000 houses in less than two years.

“As more markets continue to recover with lower foreclosure rates and higher prices, fewer investment opportunities at distressed prices will be available and market prices will climb, reducing potential gross yields,” explained Douglas Bendt, research analyst at Deutsche Bank and author of the report. 

Smaller players have more flexibility when it comes to expanding into these new markets. These players, explains Charnoff, typically use outside property management companies that give more flexibility in terms of where they can look for new purchases. 

The larger institutional players, on the other hand, tend to set up shop in the geographic area they are interested in so when they start looking at different areas “they have to target setting up operations in those areas also and not just buy properties in those areas.”

Allegheny County in Southwestern Pennsylvania is one of the top 25 “hidden gem” markets in the RealtyTrac/RentRange list. Ron Croushore, CEO of Prudential Preferred Realty, which covers real estate in Southwestern Pennsylvania, said that while purchase are up in the area, there hasn’t been an increase in large investor activity. “This is likely because our region has not been recognized as a ‘distressed market,’” he said. “In fact, Southwestern Pennsylvania has enjoyed an increase in sales of 12.5% and property values have had a steady appreciation of roughly 2 to 4% annually.” 

Still the median market value for a single-family home in Allegheny County is $126,000 and the rent value is $1,034 with a potential rental yield of 9.8%, according to RealtyTrac/RentRange data.

Smaller players have the advantage of knowing their markets better. “They know their markets by streets, so they can make better long-term decisions than the institutional players that are looking for a certain formula to follow.”

Follow the money

Blomquist draws a parallel between investors in single-family home rentals and investors in pre-crisis mortgage backed securities. “It’s a case of the mortgage lenders originating and keeping mortgages on balance sheet vs. the mortgage brokers just originating their mortgages and selling them into securitizations; that is the difference with the local smaller investor vs. the large institutional investor – smaller investors have a vested interest in making good decisions for the long term when they buy properties.”

But smaller institutional players looking to access this market on a long-term basis face the essential problem of mortgage availability constraints. These investors can’t get conforming mortgages on more than 10 investor properties through government-sponsored enterprises. Commentary by market players points to a cumbersome process where that 10 limit is more often than not reduced to only five properties being financed at one time. 

“If you are planning on buying more than that number of properties it’s going to be financed with equity, which make the returns lower, the ability to access leverage would help to build up returns, ” said Jade Rahmani, the analysts at Keefe, Bruyette & Woods who authored the September report.

There are several companies forming that are looking to provide financing to the small-investor part of the market and hope to use securitization in the future as a way to provide financing. According to RealtyTrac’s Blomquist, securitization will continue to grow with the industry, but not in the ways originally expected. 

“I think that it may not take off as dramatically as the trend in purchases takes off because some of these players will decide that it is not necessarily a long-term strategy for them and they will back out of this market,” he said.

Some of the available credit facility and the private lending that is happening in the space includes Blackstone’s recently launched B2R Finance, which offers loans starting at $10 million. 

In September, Colony American Homes (CAH) announced it closed a $500 million credit facility with JP Morgan that will be used to acquire single-family homes across the U.S. The facility has a $500 million accordion feature that allows CAH to increase the credit to $1 billion. Colony’s Colony American Homes offers loans to investors with portfolios of single-family rental properties.

Progress Residential said its new revolving credit facility of $400 million it entered into with Deutsche Bank will be used to bulk up its portfolio of single-family home-rental assets. Progress Residential currently leases nearly 6,000 homes in 20 markets across nine states.

FirstKey Mortgage, through private equity firm Cerberus Capital Management, also offers finance solution to investors with portfolios of single-family rental properties. FirstKey offers structured financing loans to investors that own stabilized portfolios of single-family homes with market values of $5 million to $20 million.

The Dominion Group, which operates in the Baltimore region, also offers lending services to residential real estate investors. The Dominion Group targets loans of $40,000 to $1 million for both acquisition and renovation with terms of six to 13 months.

No end in sight

The recent market shift of specialty servicers to prime servicing is indicative of an improving mortgage market in terms of performance. Or, to put it another way, it shows that specialty servicing is no longer cost effective on a large scale simply on its own merits. In the accompanying HousingWire feature “Energizing Real Estate,” Wingspan Portfolio Advisers is named as a specialty servicer intersted in mineral rights. Others, such as BSI Financial and SLS are also expaning into other areas. Anecdotally, the former is expanding its management of prime RMBS pools, for example. In nonjudicial states, an undeniable option is to acquire nonperforming loans and move them into REO using a bespoke vender. 

In March, Rialto Capital, a subsidiary of homebuilder Lennar, issued a nonperforming loan securitization of 1,472 REO properties. There are also a number of performing loans in the mix, but REO outnumbered these two-to-one. Rialto acquired the assets between December 2010 and December 2012, purchasing 28 separate non-performing loan portfolios from eight regional banks and financial institutions for an aggregate unpaid principal balance of $843.6 million.

The deal, while not intended for the rental market, showed the potential of esoteric financing for the non-performing to REO market. The lenders from whom Rialto acquired the properties were well aware of just how risky and expensive it is to service large amounts of nonperforming loans. According to a white paper co-written by Mark Zandi of Moody’s Analytics and Jim Parrott of the Urban Institute, a lender spends on average eight times more money servicing a nonperforming loan than one that is performing.

“As a result of the experience, lenders now anticipate greater servicing cost and legal and reputational risk should those loans go into default,” they wrote. “The larger projected costs in turn make these loans less attractive to offer, because lenders are reluctant to charge higher fees to make up the difference, given the legal and optical risks of charging significantly different rates to this group of borrowers.”

Taking this quote at face value at first makes it seem that lenders will be reluctant to offers NPLs. However, what Zandi and Parrott mean by “these” loans are, in fact, purchase mortgages for borrowers. The quote actually indicates that lenders will look to offload NPLs onto the market as holding on to them will increase the cost of doing business for the very attractive purchase market. 

The logical conclusion is a surge of NPL offerings into the market. And this is what the industry is expecting. The next step from there will be the inevitable REO for a significant portion of these. In some certain markets the only option will be to rent those out. The financing may come in several forms, but it’s this chain of logic that leaves the big money banking on REO-to-Rental. 

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