The FHFA’s Bulk REO Rental Plan Makes Sense

Posted by Joel pate in Mortgage Loans. Tagged: , , , , , , , , ,

Since late 2008, John Burns Real Estate Consulting has been pushing for a program that allows the owners of REO to sell the homes as rental units. Financially, we have nothing to gain other than the benefits that accrue to everyone from a stable housing market.

Two years ago, a Housing and Urban Development Department executive agreed with us, calling it a “no-brainer” and championing it through Washington.

But at last year’s REThink conference hosted by HousingWire, the consensus view of attendees seemed to be that it was a bad idea. It became clear to me over the course of the conference, however, that many of the attendees benefit from transactions that involve a sale and a mortgage. They were speaking from self-interest rather than a belief in doing what is right for the country.

At the risk of being castigated, let me lay out my thinking. Encouraging investors to buy REO homes and rent them out helps stabilize home prices and neighborhoods and improves REO asset recoveries. It also prevents rents from rising too quickly and removes a huge cloud hanging over the future of the housing market.

The most effective rental REO policy would involve a joint-venture structure that allows experienced professionals to manage the portfolio according to free market conditions, with the only significant stipulation being that they can sell no more than 20% of the homes in any given year.

The best economic recovery would include seller profit-and-loss participation, similar to the successful policies utilized by the Federal Deposit Insurance Corp. and, when feasible, a market-rate lease option to the foreclosed homeowner. That would eliminate the costs associated with vacancy and leasing while also providing relief to the former homeowner.

Finding Stability

We estimate that more than 8 million distressed home sales will occur over the next five years, representing approximately 30% of all transactions. This will put downward pressure on home prices, unless the government-sponsored enterprises, HUD and the major banks implement a massive rental REO policy. Regulatory and political hurdles need to be removed to allow the decision-makers at these institutions to make the right decisions. Home prices cannot stabilize until the volume and percentage of distressed transactions declines significantly.

Vacant homes contribute to neighborhood deterioration, and there were approximately 2.4 million more vacant homes than normal at the end of 2011, which we forecast will take until late 2014 to normalize. (Our forecasts vary significantly by market and neighborhood.) A rental REO policy will fill up the homes much more quickly than the current path, which keeps many homes vacant for months.

Investor Involvement

Investors already play an enormous role in determining home prices, as they are purchasing more than 19% of all homes, according to the National Association of Realtors. Some of these investors “flip” the homes for a quick profit, while others rent the homes for a marginal annual return with the potential upside of future price appreciation. Selling homes in bulk will and can recover more than selling individually because bulk buyers will be able to purchase homes without the expense of brokerage commissions and other selling expenses.

They also will have the ability to finance their portfolio with debt, allowing bulk buyers to pay more than individual investors who pay with all cash. Finally, the seller can reduce carrying costs, including overhead and transaction costs, including brokerage commissions.

Limited restrictions on the buyers, as well as access to quality due diligence, will help increase the price paid. An REO rental policy should not be mandated for all homes, as there are instances where the economics are more favorable for disposition.

We believe rents will rise as the economy recovers, unless there is plenty of rental supply. More rental supply will help moderate rental increases, which will hold down the cost of living for renters and allow renter households to save and to use more of their disposable income to help the economy recover. Also, since “owner equivalent rent” is 23% of the consumer price index, lower rental rate increases will have the additional benefit of limiting inflation, saving taxpayers huge dollars on entitlement increases tied to inflation.

The shadow inventory of future distressed sales is keeping investors and homebuyers on the sidelines. A rental policy that reduces future distressed sales will alleviate much of their concerns and contribute to growing confidence in a housing rebound.

Answering the Critics

Critics of the rental REO policy tend to fall into three camps: 1) transaction-based companies such as real estate agents and appraisers, 2) REO/servicing employees who want to preserve their jobs, and 3) armchair quarterbacks, some of whom are granted media airtime because they know a lot about a particular segment of the housing market, but have not studied this issue in depth.

One key criticism is that there is better asset recovery on individual sales than bulk sales. We estimate that there is a 10% cost savings associated with a bulk transaction, and that a significant rental REO effort will prevent further deterioration in home prices. The notion that bulk investment buyers will pay less for homes is most likely not true, given that 29% of all transactions are already to cash buyers/investors.

Critics contend that investment groups will bid low to cover the risk of unknown capital expenditures. The seller solves this problem by providing excellent information on the portfolio.

Some argue the government is giving up large future profits to investors, but the FDIC adopted a transaction structure that returns a portion of the profits to the FDIC after the investor has received a reasonable return, essentially guaranteeing a FDIC share in any windfall, if it occurs. This same policy could be adopted by the seller.

One hurdle is bank capital requirements. A new policy that allows banks to hold “investment in housing rental REO” with minimal capital set-aside required would help the banks make the right economic decisions.

We also don’t buy the argument renting REO is merely delaying the distressed sale to a future date. The entire addition to the single-family rental stock will be, at most, 9 million homes, and I can’t imagine a scenario where 15% or more of those owners decide to sell in the same year. If they did, that would still be fewer distressed transactions than in 2010 and 2011.

The properties should be sold to investors who work with professionally managed and experienced property management companies who have a great track record of property maintenance and fairness with tenants. We don’t believe it wise to have the federal government act as the property manager.

Some critics contend there are no large property management companies to handle the growth. There were 12.6 million single-family rentals in 2010, and we believe there will be 17.5 million in 2015, for a 7% annual growth rate. With this program, that growth could possibly go to 21 million, an annual growth rate of 11%, which we believe can be reasonably achieved.

Capital isn’t interested say some critics. Based on the phone calls we have received, and the more than 4,000 submissions the FHFA received, we are confident that this is not an issue. We agree with critics who say we need to let the free market take over. Current regulatory practices and political realities prevent the free market from occurring. Capital restrictions on REO investments prevent bank executives from renting significant REO. Also, repeated threats of shutting down Fannie Mae and Freddie Mac have caused the GSEs and their regulator to delay the resolution of REO. Banking and GSE leadership should do what is best for their shareholders/conservators, which also happens to be in the best interest of the U.S. economy and taxpayer.

Taking our pain via expedited foreclosures just won’t cut it. With 12.5% of mortgages currently delinquent, allowing an expedited foreclosure process could result in another collapse in home prices, resulting in rising bank failures and a recession. While we all want this crisis to be over, the pundits who call for laissez faire have not completely thought through the ramifications, or more likely want a better investment opportunity when home prices tumble.