The "equity" structure favored by bankers for deals in which real-estate investors create securities backed by the rental payments of single-family homes poses significant risks to investors, Moody’s Investors Service noted in its research report.
Such a structure would expose investors to risks that are not typically present in residential mortgage-backed securitizations and commercial mortgage-backed securitizations.
More risk also means more potential legal challenges. Moody’s analysts Yehudah Forster and Kruti Muni noted a mortgage structure, by way of comparision, is a stronger deterrent to legal challenges.
"Even after a substantive consolidation, a mortgage structure would give the securitization investors and not the sponsor’s creditors the first rights to the value of the properties because the consolidation would not extinguish the first priority lien on the assets," the analysts noted.
They added, "On the other hand, in an equity structure a sponsor’s creditors would share in the value of the entire asset pool if they could successfully cause a substantive consolidation."
Click here to view the equity structure layout.
The risks would include securitization not having senior rights to the properties following a sponsor’s bankruptcy, the unauthorized sale of the properties and other liens trumping the securitization’s claim on the properties.
"As a result, although these structures are more economical for the issuer owing to the lack of mortgage origination and registration costs, the credit quality of these structures is unlikely to be strong enough to support bonds with a rating higher than Baa absent strong mitigating factors such as a highly rated sponsor," the report said.
Thus, such a low investment rating could shrink the pools of possible buyers.
The equity structure would also expose investors to other property-level risks because having no mortgages on the properties leads to risk of unauthorized sales of properties and addition of liens eroding the issuer’s value in the properties.
These types of risks are less significant than bankruptcy risk because typically in the normal course, the whole pool is unlikely to suffer these issues, only a portion of the pool.
Ultimately, the choice of structure depends on the economics – whether sponsors believe that investors’ willingness to pay for the additional protection that having mortgages afford will outweigh the costs of originating and register the mortgages.
Click here to view the mortgage structure layout.
However, mortgages that may be quite expensive to originate are not necessary to make single-family rental property securitization work, the report said.
"Even without mortgages, an equity structure allows the securitization to foreclose on the equity interest of the issuer and sell the properties if the income from renters is insufficient to pay off bondholders, albeit with substantial additional risk borne by the investors," the analysts said.