This article originally appeared in Servicing Management Magazine.
One of the more interesting phenomena we’ve witnessed over the past few years is the sudden entrance—and now, the equally sudden apparent exit—of REO investors in the market.
After the incredible volatility of the housing market boom and bust that left the industry with a mountain of delinquent and defaulted loans to process—and which ultimately led to almost seven million borrowers losing a home to foreclosure—investors swooped in, lured by the unusual confluence of events and resultant opportunities.
Home ownership rates plummeted from a high of about 70% to below 64%. Apartments and other multi-family rental units were at historically high occupancy levels of 96-97%. Millions of displaced former home owners were looking for somewhere to live. And millions of foreclosure properties were on their way through the process, adding to the already staggering shadow inventory of distressed homes about to come on the market. From an investor’s perspective, this looked like a once-in-a-generation opportunity: buy up this inventory at a discounted price; re-purpose the homes as rental units; and eventually sell them at a profit after home prices appreciated.
For lenders and servicers, this also looked like an unusually serendipitous moment in time, as it would now be possible to sell large numbers of distressed assets to a relatively small number of deep-pocketed, highly-motivated buyers rather than haggle over each property sale in the typical, tedious, time-consuming REO disposition process.
Some of the original assumptions proved to be incredibly wrong. For example, most early participants—both buyers and sellers—assumed that distressed properties would be sold off in bulk. Large portfolios of homes would be bundled together and sold off at deep discounts to the highest bidder. Then the investors would hold the properties for a short period of time, making nominal yields on rental cash flow before selling the homes at high profits when home prices appreciated after a few years.
Neither of these beliefs turned out to be quite correct.
First, other than one pool of 2,000 properties auctioned off by the FHFA—a process that took nearly a year to complete—there really weren’t any large bulk sales worth noting. Instead, investors wanted the opportunity to select the specific properties they wanted, in the geographies where they wanted to do business. If the investor’s model called for 3-bedroom, 2-bathroom, 1,500-square-foot homes built after 1990 in the suburbs of Phoenix, a portfolio of 1950-era row homes in metro Detroit wasn’t of any interest. Sellers weren’t as anxious to create “mini-bundles” of their more attractive properties, because they believed that these were the kinds of properties they could sell at the highest prices and lowest discounts. Not surprisingly, the sales model reverted to the traditional one-at-a-time approach—albeit with somewhat ravenous, well-capitalized buyers competing for many of the properties.
Not coincidentally, the buy-at-a-discount model also didn’t exactly work out as planned. Investors, whose business models all looked remarkably similar, tended to focus on many of the same markets—beginning in the Southwest, where states like California, Nevada and Arizona had been ravaged by the foreclosure crisis, and had a seemingly endless supply of relatively new, relatively inexpensive vacant properties available for purchase, along with demographic trends that suggested a robust rental market for the foreseeable future.
What happened next surprised virtually everyone who’d been following this situation. A relatively small number of institutional investors—notably Blackstone, American Homes for Rent and Colony—began aggressively competing for properties in a handful of markets, especially Phoenix and Southern California. In an unexpected twist, demand for REO homes suddenly overwhelmed supply. The ensuing feeding frenzy reduced the already-limited supply, drove prices up further—ultimately to the point where the “foreclosure discount” virtually disappeared. In fact, some analysts believe that median home sales reports published over the past two years have been skewed by the price inflation at the low end of the market. Investor activity in a handful of high profile markets was making the national numbers look like they were going up faster than they really were.
Prices went up so high, and so quickly, that the early participants’ business models became problematic—the price appreciation that was going to account for most of the profit had taken place prior to the purchase of the homes. A number of investors opted out, either to sell off their own rental properties while the market was still hot, or to find another trade, since this one had become too expensive. And this led to the beginning of the rumor that institutional investors had decided to exit the space.
The Rumors of My Death Have Been Greatly Exaggerated
Mark Twain’s quote seems entirely appropriate here. It’s true that two of the bigger players in the buy-to-rent space, Blackstone and Colony, have announced plans to slow down their single-family residential (SFR) home buying, but it’s also true that investor SFR purchases, as a percentage of existing home sales, are still at an all-time high.
It’s important to keep the purchase activity in perspective. According to data presented at the recent IMN Single Family Rental conference in Scottsdale, AZ, the largest 18 institutional SFR buyers account for roughly 1.2% of the current inventory of single family rental properties—about 172,000 of the 15 million homes being rented out today. That inventory, meanwhile, has continued to grow even as the largest of the investors have begun to slow down their purchase activity.
How is this possible? Two likely reasons.
First, a reversion to the mean. Prior to institutions getting involved, there was already an enormous market for single-family rental homes—some 12 million units rented just three years ago. And research published over the years had estimated that well over 90% of those homes were owned by investors whose portfolio of properties consisted of five or fewer homes. During the peak of the institutional buying, similar research suggested that this number dropped to 85-87%, but it still comprised the bulk of the market. It’s likely that some of the inventory no longer being gobbled up by the big hedge funds is now being purchased by the mom and pop investors who have been outbid over the past few years.
Second, we’re seeing the creation of a new, middle tier investor. Let’s call them the “super regionals.” These are legitimate businesses, many either public or planning to go public, who are implementing some of the purchase and operating lessons learned by the institutional investors, and running portfolios of several hundred to several thousand homes within precisely defined geographies. They’re not as big as the biggest institutions, and don’t have access to their virtually unlimited capital; but they’re also not as small or under-capitalized as the typical mom and pop investor, and have processes and operations in place to manage a group of properties more professionally and across a broader territory.
We’ve also seen that, rather than exiting the space entirely, many of the larger investors have simply shifted their business models to work more optimally within the new market reality. These changes have manifested themselves in several ways:
First, as REO inventory has dried up and as what’s left has become increasingly more expensive, investors have begun to buy other types of properties. Investors are buying short sales, participating at foreclosure auctions, and even buying traditional, non-distressed properties listed on the MLS.
Second, buying more expensive properties has caused a fundamental shift in profit structures. While the early entrants to the market were largely dependent upon home price appreciation, today’s investors are much more reliant on monthly rental cash flow for their ROI.
This rental income focus forces investors to look for properties that they can pay market price for and still rent out at a monthly rate which is both affordable and profitable. So the geography has shifted significantly as well. What began as a 21st century West Coast gold rush is now more of a Southeastern U.S. treasure hunt—Florida, Georgia, and the Carolinas—and increasingly moving into the Midwest as well, with rental home purchases on the rise in Michigan, Illinois, Indiana and Ohio.
Financing has changed as well. Issuances of securities and the formation of public REITs has added leverage, and also at least suggests that investors will hold properties longer than originally anticipated, since REITs have specific rules for this, and securities are highly regulated, and under intense scrutiny from the rating agencies as well. The biggest players—Cerberus, in addition to the previously-mentioned Blackstone and Colony—have introduced financing products aimed at the SFR buyer. The companies which had been the biggest buyers haven’t, in fact, exited the space; they’ve simply shifted their focus from managing properties to managing money.
The New World Order
So what does all this mean for lenders and servicers still processing the backlog of delinquent and defaulted loans in the foreclosure pipeline?
First, it means that there’s still probably slightly more demand for distressed properties than there is readily-available inventory, just from less well-known investors. Demand for rental properties, in fact, is likely to go up over the next few years as household formation finally appears to be trending up, but a higher percentage than usual of these new households are renters. And with 96% occupancy rates of rental units, even with the multi-family construction in the works, supply isn’t likely to exceed demand. And investors in most parts of the country are still leaning very much towards a “buy-and-hold” strategy (verified, anecdotally, by a recent survey of thousands of investors who have registered to participate in our Auction.com sales).
From a marketing perspective, things are going to get a bit more challenging. Local investors abound, but are often under-capitalized. Foreign investors have ample capital, but are harder to reach than local folks. So sellers will need to forge strong local relationships with investors and investor groups, but also find cost-effective ways to introduce their properties to foreign buyers, or their US-based agents.
Similarly, the level of repair of properties for sale will depend on the type of buyer being targeted, which is at least partly influenced by geography. For example, Auction.com research suggests that most California investors are interested in flipping properties, while most Texas and Georgia investors are more interested in buying and renting properties. Flippers generally want the lowest possible price; buy and hold investors may be willing to pay more to get a property in better condition in order to get a tenant in place faster. That’s especially true for public companies, which get dinged by the ratings agencies for having vacant properties in their portfolios.
As the market recovers, we’re seeing fewer short sales, and a lower percentage of homes being repossessed by lenders; not surprisingly then, we’re seeing more properties sold at foreclosure auctions. One of the more interesting recent trends we’ve seen is the propensity for lenders to take properties that weren’t successfully sold at auction and put them on the market immediately (often by auction) and sell them, occupied, to investors. This saves the lender thousands of dollars in holding costs, and generally allows the investor to buy a property at a significant discount.
We’re also seeing completely different approaches to asset disposition. Many lenders are opting to move non-performing loans rather than holding on to them and taking the properties through the foreclosure process. Others are working with local community groups to move REO assets to owner/occupants within underserved communities. Still others are simply donating un-sellable homes to local governments or charities that can re-purpose the homes or the land.
The lenders and servicers who will be the most successful at getting through the final few years of the foreclosure crisis will all have one thing in common: they’ll be flexible enough to shift their sales and marketing efforts to adapt to changing market conditions.
For these companies, it’s important to understand that the investor is not abandoning the REO market, but that the rules of the game—from engagement, to presentation, to the ultimate transaction—have all changed dramatically over the past few years. And the only thing we can be sure of at this point, is that there’s probably more change yet to come.
