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.
Other options for financing REOs include secured credit lines, lending syndicates, high-yield debt, and financing from government-sponsored enterprises.
Waypoint Real Estate Group, a private equity real estate fund that owned more than 2,200 homes in California, Phoenix, Chicago and Atlanta in 2012, plans to ramp up its purchases to 11,000 homes by the end of 2013. In September, Citigroup made a $65 million loan to Waypoint for investments in distressed single-family houses converted to rentals. By October, Citi had already topped off that loan with a $245 million revolving credit facility for the renovation, long-term ownership and management of Waypoint’s portfolio, according to a press release.
Beasley told ASR that, although this type of balance sheet lending serves as a precursor to executing securitization transactions, beyond the ongoing preliminary, exploratory conversations, the company is not actively working on any securitizations at present. “We are very happy with our bank facility with Citi and will be keenly observing how the securitization market develops over the upcoming year,” he said. “We are in good shape on debt for now and focused on exploring additional avenues for raising additional equity capital over the upcoming months.”
D’Vari also noted that at this point, investors don’t really “need a whole lot of leverage to generate relatively ‘juicy’ cash-on-cash returns, which by themselves are very attractive even without much home price appreciation on the investment exit.”
“After expenses and management fees, the generated cash-on-cash often range in high single digits but gets adjusted down by vacancies,” he explained. “Therefore, the flexibility of bank lines makes them more attractive versus somewhat rigid terms in securitization.”
Another financing trend developing for financing acquisitions of single-family home rentals is unsecured debt raised by specialized real estate investment trusts.
According to D’Vari, while portfolio lending to a well-sponsored lender is available, ultimately the discussion is moving toward a REIT structure—where the assets are alternating, and the vehicle is more dynamically managed than what you would find in bank fund or securitization vehicles.
D’Vari said that because REITs have audited financial reporting, research coverage, regular dividend and possibly rating, it makes them a natural exit for the REO-to-rental private equity funds over the four-to-five-year horizon. This matches the typical funds redemption period.
And within the REIT space, some players are looking to broaden their access to debt capital by going public. Silver Bay Realty Trust Corp., a REIT that buys single-family homes to be held for rental or resale, completed an initial public offering in December that raised $245 million. American Residential Properties is another REIT that has filed the initial paperwork to go public.
“Having the ability to go public is one of the exit strategies for these single-family rental operators and gives them a chance to monetize their assets,” said Ray Huang, an analyst with Green Street Advisors.
But this option of going public is only really for REITs that can achieve the right economies of scale; it still continues to be a challenge for players in the space to acquire a sizable portfolio large enough to go public. “In this space, the bigger you are, the more access to capital you typically have, so bigger is definitely better in the REIT space,” said Huang.