With consumers more inclined towards renting rather than buying properties today, it is important for investors to know which markets make the most economic sense when converting bank-owned homes into rental units.
At the end of 2011, CoreLogic data revealed that rental closings increased 11.5%, while home sale closings declined 9.8% from the prior year. Rental closings made up 29% of all home closings through December 2011, up from 24.8% the year before and substantially higher than the 11.3% in early 2006.
Rental demand is currently so strong that the supply for rentals was 4.5 months through December 2011, the lowest year-end level experienced since 2006, CoreLogic said.
Last summer, the Federal Housing Finance Agency announced an initiative to sell REO assets controlled by the government-sponsored enterprises to investors in bulk who would then be responsible to offer these properties to buyers as rental units. The investors would also be in charge of maintaining and preserving the units for the duration that they own these assets, which could be approximately a three to five year window.
“I don’t think it’s a question of whether this is a good idea or whether this will or will not happen, but when and how,” said Rick Sharga, executive vice president at Carrington Mortgage Holdings, at SourceMedia’s National Mortgage Servicing Conference in April.
In February, Fannie Mae put up for auction the first package of 2,500 REO properties that are single-family units. The package is top-heavy in homes located in Atlanta, Arizona, Los Angeles/Riverside and different parts of Florida. However, at the beginning of June, the FHFA was still evaluating applications by investors who placed bids on the Fannie REO package.
There are approximately 4.6 million borrowers who used to be homeowners in the market today, Sharga added. He said that another three to four million homeowners are projected to go through the foreclosure process at some time, therefore needing a place to live in the near future.
“With the number of people that are eligible renters and the massive amount of available inventory that could and probably be purchased, there are multiple reasons why this makes sense,” Sharga continued. “From the economic standpoint, the ability to go in and buy up these assets in markets that are being decimated by shadow inventory and properties will help stabilize homeownership and home prices. It will also serve to stabilize rental properties, which are soaring astronomically on the markets because vacancy rates are at historic levels. We are at occupancy rates north of 95%, so it is clearly a renters market opposed to a buyers market.”
But the big question for investors interested in this initiative is where can they gain the most return for their investment of buying these REO assets and then renting them out to prospective tenants?
At CoreLogic’s symposium earlier this year in New York, Michael Bradley, head of analytics and modeling for the Santa Ana, Calif.-based firm, said a good way to gauge the profitability of renting a particular property is to calculate its capitalization rate—the expected expense-adjusted annual cash flows from renting a property relative to the acquisition price.
For example, if the monthly expense-adjusted rent is $1,000, in which the annual rent is $12,000, and the acquisition price is $120,000, the cap rate is 10%. Bradley said cap rates for the single-family rental market are 8.6% as of January 2012, down slightly from 8.8% last year.
But if bulk sales do come to market as expected, cap rates would increase to between 10% and 12%.
CoreLogic studied 26 markets that accounted for about 20% of national sales transactions as well as over 30% of all delinquencies that are 90 or more days and found a significant variation in cap rates for these cities.
Cities with the largest price declines had the highest cap rates, such as West Palm Beach at 12.4%, followed by Cleveland (12.3%), Fort Lauderdale (12%), Chicago (11.6%) and Las Vegas (11.4%).
Meanwhile, the lowest cap rates were found in Honolulu (5.4%), Raleigh (7.3%) and Austin (7.7%).
“Among the largest markets, Chicago is particularly attractive because it has a high cap rate and also a large inventory of REOs—132,000 housing units—available in the market,” Bradley said. “The single-family rental market is a $3 trillion industry and investors have to understand the risks and costs associated with participating in this initiative.”
Don Nikols, principal and president of The Nikols Co., a private money lender based in Newport Beach, Calif., that provides financing for borrowers to invest in the real estate industry, said the REO-to-rental initiative can be a productive investment model as long as investors buy homes in markets that will heal.
“As long as you’ve got houses within commutable employment basis and buying houses in markets below replacement cost of just the house, then this will be a profitable enterprise,” Nikols told this publication.
Nikols agreed with Bradley that investors are going to have a challenge managing these rental units because they will be located in various cities nationwide.
“Real estate is still a local business and with this REO-to-rental program, it’s not like you have a 100-unit apartment building where you can get the efficiency of a maintenance guy to fix the problems there,” Nikols said. “An investor will be responsible to maintain these properties that will be scattered throughout the country and will need to have teams in place that can run around and keep these houses in good shape. If an investor is going to do this strategy, it should be done in a large fashion where you can have staff that can handle whatever problems that might occur.”
Dan Magder, founder and managing director of Rock Creek Capital Group based in Washington, said the rapport between an investor and renter will impact how a property is maintained.
“If an investor treats a renter well, the likelihood of them trashing the house will be lower,” Magder said. “Additionally, if an investor offers the renter an option to buy the house at the end of the lease, the renter has skin in the game and will likely maintain the property better. It also has the benefit of providing the investor with a potential exit.”
