One of the big challenges is that using mortgage liens as collateral would be prohibitively costly in a deal backed by large numbers of low-value properties. So market players are looking instead to use equity pledges in the vehicle that owns the properties as collateral. This creates another set of problems, however. If the sponsor went bankrupt, investors in the securitization would have to compete with other creditors. Having an unsecured claim on the properties would also expose investors to the risk that the property owners could incur additional liens. And it would leave these investors unprotected in the event of an unauthorized sale of properties.
For all these reasons, Moody’s Investors Service said in a guidance issued in January that it would be difficult for a such a deal to achieve a rating above Baa unless it had a strong sponsor.
This hasn’t diminished enthusiasm for the market. Panelists at the American Securitization Forum conference said that there has been a surprising amount of progress since Fannie Mae announced plans in 2011 to unload a large portfolio of real estate owned homes.
“A year ago, the idea of lending against a large portfolio of leased homes was a foreign concept, whereas people have gotten their heads around the combination of the security and the assets and the cash flow generated,” said Gary Beasley, managing director of Waypoint Homes.
Beasley said that most money center banks have term sheets out or facilities in place to finance the warehousing of these properties.
On the other hand, yields on REO to rentals are not as attractive as they were a year ago, before there were so many investors bidding them up. Competition today is “ferocious,” Beasley said. “You have to be very disciplined about your buying-and-operating strategy.”
By a number of measures, there are still plenty of REOs for the taking. A Jan. 8 report from Keefe, Bruyette & Woods cites data from the Federal Reserve Bank of New York indicating that, to date, only 15% of the 443,000 unsold REOs have been purchased.
CoreLogic data show that only 20% of the 354,000 properties already in REO have been sold, and just 2% to 5% of the 1.8 million properties in foreclosure, according to data from Lender Processing Services.
KBW said that this amounts to less than 1% of the approximately 13.8 million attached and detached single-family rental properties, according to the U.S. Census Bureau.
Still, Beasley said, the potential returns on REOs are better because players have a superior view of how they could ultimately exit these investments.
Much of the panel’s discussion focused on the pros and cons of acquiring properties in bulk or one at a time, and whether property management should be outsourced or done in-house.
Frank Terzuoli, a director for credit data and analytics at KPMG, warned that property management is going to create challenges for the asset. The hidden costs of owning rentals “can really bite you,” he said. “They eat away at profits at the back end.”
Terzuoli cited Florida as an example; home prices are low there, but the cost of replacing a roof could exceed the cost of acquiring the property.
Another potential concern: The prospective tenants for REOs are a new class of renters. Many owned homes before the financial crisis, and they may want to become homeowners again. If they eventually leave, it could create issues for this product in several years, he said.
Michael Dryden, managing director of global asset finance at Credit Suisse, said that from a lender’s perspective, it is very advantageous to have someone “watching the kitchen.”
Also of concern to ratings agencies, and potential securitization investors, is the lack of historical data on single-family rents; this makes it difficult to predict future cash flows. Fitch Ratings warned in an August 2012 report that “the lack of historical data and ambitious growth strategies by regional operators will make high investment-grade ratings on these transactions difficult to attain.”
Morningstar Credit Ratings also cited its reservations about the lack of history with the newly emerging asset class in a report published the week of June 4.
And in a May report, S&P said “the property manager’s expertise in large-scale residential real estate management and ability to manage subservicing arrangements may also be a credit consideration.”
Ron D’Vari, cofounder and chief executive of NewOak Capital, said that the short-term nature of leases makes it challenging to predict the cash flows for a securitization deal that tends to be structured over longer maturities, due to predictability of vacancy and variability of rent.
“Banks look at these as lending on a portfolio of operating assets,” he said. “As a result, the financial and property management operational strengths become a factor that can be taken into account. It may be hard to define adequately flexible and dynamic management guidelines in a securitization framework.”
There are other potential structures that could be used to securitize REOs. KBW said in its report that the nonperforming loan securitization model could serve as a potential template. But here, too, issuers would have to consider providing greater subordination on those securitizations, because all returns for senior bondholders would come from the resolution of distressed loans and/or asset sales.
Moody’s said it has looked at the nonperforming loan securitization structure as a potential model for securitization of REOs. “Moody’s will consider how we look at those structures and how those structures relate to any structures we might be presented to securitize single-family rental properties,” said a spokesperson at the ratings agency.