Any long-term REO-to-rental strategy will need to adopt extensive refurbishment plans in order to resell the assets.  Further, much of the foreclosed property that financial institutions would look to bulk-sell is currently in need of repair.

Morgan Stanley (MG) analysts say that nearly 95% of distressed homes are in no shape to rent out, in some key markets. Only a tiny fraction of these properties are less than a decade old, they add.

"The importance of getting construction — or specifically, re-construction or rehabilitation — right cannot be overstated," according to a report from lead author Oliver Chang, sent to Morgan Stanley clients. "The quality and cost of rehabilitation can continue to benefit or haunt the asset far past the initial completion of work. For example, shoddy plumbing or other infrastructure work can result in significantly higher maintenance costs over time, and can also affect eventual exit pricing."

Chang and his team point out that these complexities predicate that REO-to-rental investors should not look for a quick buck and place bets that housing prices will recover so that the property can be sold for a much higher price.

"Therefore, we believe it is critical that the rehabilitation work be done such that the workers are incentivized to minimize long-term costs, not just short-term expenses," the report states.

Chris Clothier, a partner in Memphis Invest, said his turn-key real estate investment firm follows a renovate strategy.

The firm acquires, renovates, sells and manages REO rental properties for private investors in the Memphis and Dallas markets. It spends an average of $78,000 to acquire each REO and puts an average of $16,300 into renovations.

The company works with about 400 investors, generally smaller investors with portfolios of several homes, not hundreds.

Clothier declined to seek bid approval on the Federal Housing Finance Agency's upcoming pilot bulk REO-to-rental program because he prefers to keep a tight control on the location and condition of the REOs he buys, investing only in well-known established neighborhoods. Buying properties one-off allows that control, he said, whereas the FHFA pilot likely will require bulk investors to accept some undesirable properties.

Morgan Stanley estimates that renovations will cost about 25% of the purchase price and provide an internal rate of return of about 8.2%. See cashflow model assumption below.

Chang and his team sent the report just as sources said the FHFA pushed the vetting process back to May for prospective bidders on Fannie Mae REO. For Morgan Stanley, bidders will not be qualified unless they can prove scalability of their operations.

"Our premise is simple: if an operator can handle the acquisition of 20 homes per week (about 1,000 per year) right now, what would happen if they were delivered 400 empty, distressed homes in one week?" they ask.

Moody's Investors Service believes rental markets are generally balanced. Further, market fundamental may tend toward working out on their own.

"It is unclear how many additional purchases the federal program can generate," said Celia Chen, a senior director at Moody's Analytics. "On their own, investors are already purchasing foreclosed and distressed properties in large and growing numbers. Tax incentives may be a more effective way of driving additional investor purchases."

Kerry Curry contributed to this report.

jgaffney@housingwire.com

kcurry@housingwire.com