The REO-to-rental market is expected to grow robustly over the next two years, firmly establishing itself as a potential institutional asset class. At least that’s what Keefe, Bruyette & Woods [stock KBW][/stock] is saying, and the market is showing.

Traditionally, the single-family rental market receives its funding from retail or smaller institutional investors. However, as the inventory of bank owned properties increases, so does the interest of investors towards a larger-scale investment in this space.

KBW estimates cash returns on investments in REOs are in the 5% to 7% range, with total returns hitting 15% to 20%. The asset class seems like a perfect fit with secondary market players at first glance because REO-to-rentals offer more tangible cash flow than other distressed properties.

Apartment rentals are on the rise, increasing 4.5% since the end of 2009. In November, Trulia [stock TRLA][/stock] reported that rents are up 5.5% since the previous November.

Reports from CoreLogic revealed that prices of single-family distressed properties are down 27% from the peak, while traditional properties only dropped 21%. Therefore, REO-to-rental conversions are more and more appealing.

According to KBW, real estate investment trusts alone raised $6 billion to $9 billion for REO-to-rentals. This suggests potential acquisitions of 40,000 to 90,000 properties.

With that being said, without financial leverage, this still amounts to less than 15% of the 443,000 properties of unsold REO properties.

Right now, investors are skeptical about the amount of historical performance data and track records of property managers, according to a recent in-depth article in the December issue of HousingWire magazine

Currently, at least three public REITs, Colony Financial [stock CLNY][/stock], Silver Bay Realty Trust [stock SBY][/stock] and Altisource Residential [stock RESI][/stock] are actively investing in the sector.

Mortgage REIT Two Harbors [stock TWO][/stock] also recently contributed its single-family residential properties portfolio to Silver Bay. Silver Bay Realty Trust and Altisource Residential are the first publicly traded REITs focused on this market. 

KBW expects more public companies to enter the space over time, and so all signs point to REO-to-rentals coming into their own as an asset class.