DEC 12, 2013 12:22pm ET

Risks Brewing for Next Wave of Single-Family Rental Securities

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The pricing of the inaugural single-family rental securitization indicates only initial obstacles to a rated securitization have been mitigated, not the potential risks likely to emerge in 2014, says Brian Grow of Morningstar Credit Ratings.

As the single-family rental market develops further, he warns in his “Single-Family Rental Securitizations: The next Wave” report, the future performance of SFR securities will be affected by multiple, untested factors that lead to new investor risk.

His investor beware short list starts with the borrower, or the property owner profile, which is changing to include more untraditional REO buyers willing to consider SFR securitization options.

The quality of conversion from owner occupied to rental unit, known as property stabilization, also is crucial because it depends on rehabilitation, leasing and marketing quality. Investors should know stabilized properties “are the best candidates for securitization,” he says.

In addition, vacancy management and data quality represent risk factors Morningstar will monitor closely in 2014, Grow says. As with any securitization “data quality is extremely important when assessing the risk in a SF rental transaction,” especially when third parties are used to verify data.

Many mortgage and non-mortgage companies have been watching the REO-to-rental securitization market for years long before it became clear that the issuance of a security on single-family rentals was inevitable, says Rick Sharga of Auction.com, who sees a few reasons why some investors still hesitate to jump in.

“Market prospects remain gloomy” most notably because past the initial assessments already made by the rating agencies “there’s no history to base the securities performance on because so far everyone has been managing or owning whole loan portfolios of single-family properties,” he says. It probably was “a little premature” to start securitizing these assets in 2013.

In his view, the closest comparable asset class would be securitized multifamily property rentals, which feature “two major differences.”

The first is that multifamily apartment buildings have multiple units in one location, whereas “in the single-family property scenario there are properties all over the place,” which makes it far more challenging to manage.

As importantly, “this type of property will attract a different type of dweller whose behavior needs to be studied,” he adds. “We don’t know whether the behavior of these renters will be different enough to have an economic impact on the investment,” which is why research studies and new data is necessary.

There appears to be a consensus about the overall market dynamics. The REO-to-rental market has firmly “established itself as a potential institutional asset class,” suggesting more companies will enter the market over time, Keefe, Bruyette & Woods analysts observed in a report earlier in 2013.

At first glance, “because REO-to-rentals offer more tangible cash flow than other distressed properties,” this asset class seems like a perfect fit with secondary market players, analysts wrote. The evolving REO-to-rental asset class appears attractive to large institutional investors such as private equity funds, mortgage REITS and hedge funds that are “new entrants to the distressed real estate owned market.”

KBW estimates cash returns on investments in REOs in the 5% to 7% range, with total returns hitting 15% to 20%, and forecast robust growth in 2014 and 2015.

Risks aside, the $479 million multitranche Invitation Homes issuance completed by Deutsche Bank “was received very well,” indicating the still emerging REO-to-rental securitization market will continue to grow, agrees Brent Taggart, SVP at Green River Capital. And since “other aggregators and lenders have inquired about doing their own securitizations,” one would expect the impact of this asset class will continue to grow and so will potential risk.

The issue tranches were priced 5 to 35 bps higher than initial expectations. The transaction had six sequential floating rate tranches. The classes were rated by Moody's Investors Service, Kroll Bond Ratings and Morningstar.

The size of the market “is not so small,” says Sharga. “When it’s all said and done,” even if it may not consist of millions of properties, it certainly will grow to include tens of thousands of REO properties under management.

At the same time rental units across the country are 96%-97% occupied and household formation continues to increase, so “the likelihood of more rental demand is high simply because there are not so many places left to rent,” he argues.

“Most people don’t realize that probably 20% of all rental units are already single-family units that have been managed pretty much one at a time, on a local market basis by individual local investors.”

Today the big difference is that “institutional investors are coming into the market with deeper pockets buying large portfolios of properties,” he notes, “making four-family rentals resemble more a commercial enterprise whose functions are very different” from those of an individual investor.

Blackstone Group LP is one such investor known for leading a group of institutional investors into a two-year buying spree and has reportedly spent about $17 billion on more than 100,000 homes, establishing B2R Finance LP, its buy-to-rent spin-off firm that offers loans starting at $10 million to lure other landlords into the seemingly lucrative marketplace. The move was described by insiders as an effort to legitimize this emerging marketplace by bringing in financing to investors who cannot get a “large enough credit facility.”

FeatherStone Investment Group is one of the first to report it had begun underwriting a rental income securitization in 2013. The real estate mortgage investment conduit specializes in structuring into pools single-family rental properties that generate annual rental distributions of 7% to 10% and has established itself as one of top REO-to-rental investors.

Another major reason why it could be premature for REO-to-rental securitizations to take off in the near future, according to Sharga, is because right now “there’s more capital than there’s inventory,” boosting investor competition and artificially increasing REO asset prices.

Billions of dollars have already been invested in the REO-to-rental market.

“Ultimately financing products will take off but it doesn’t seem to be a desperate need for it while there is a lot of property sales activity in many markets,” he says. “A few companies have been talking about establishing specialized REITs. Whether it’s an experiment or just investors with a tolerance for a certain amount of risk, that’s what it takes initially to jumpstart it.”

The REO-to-rental securitization market may be hard to jumpstart “but will get easier” after a few deals get done, says Barclays’ Sandeep Bordia, even then, however, it cannot be fully clear how the market will develop in the future.

Securitization was built on innovation, so the single-family rental market will continue to evolve, agrees Grow. Despite steps taken to launch the single-family rental securitization market and assess investor risk its future “is still unknown.”

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