Sparking the Shadow Market #cre #multifamily

Credit: Jeff SingerDoug Brien, a former NFL place kicker, is now managing director of Waypoint Homes, which has converted more than 2,100 foreclosed single-family homes into rentals in the past five years.

Credit: Jeff Singer
Doug Brien, a former NFL place kicker, is now managing director of Waypoint Homes, which has converted more than 2,100 foreclosed single-family homes into rentals in the past five years.

The foreclosure crisis has sent scores of former homeowners—and their former homes—into the rental market. But is the burgeoning REO-to-rental business model a threat or an opportunity for multifamily players?

Rumors of the death of the American Dream have been greatly exaggerated. But for many, that dream now includes a lease instead of a mortgage.

Since January 2007, 4.5 million homes have been foreclosed on by lenders—lenders that never wanted to be property owners. The foreclosure crisis has had a crippling effect on the balance sheets of these institutions, not to mention the people and neighborhoods to which they lent.

Yet, one man’s trash is another man’s cash. Almost as quickly as these homes were emptied out, investors began taking a closer look at the inventory and saw the possibilities in pursuing a new type of asset class: REO-to-rental housing.

Given the number of former homeowners who want to stay in their communities, demand may soon outpace supply. In 2012, there was a 12 percent increase in the number of single-family rentals in the country. And the national supply has fallen to 2.6 months, meaning it would take only that long for inventory to dry up at the current leasing rate, according to Irvine, Calif.–based market research firm CoreLogic.

There are about 11 million single-family homes across the country occupied by renters. But that’s just the tip of the iceberg. Since autumn, Fannie Mae has been busy selling bulk portfolios of foreclosed houses to well-heeled investors, with a catch—they must remain rentals for a certain period of time before they can be sold.

How long the houses must remain rentals is a wild card. The Federal Housing Finance Agency (FHFA), which oversees this federal REO-to-Rental pilot program, changes that requirement from deal to deal, oddly enough.

Freddie Mac will follow Fannie in the pilot program, and the Federal Housing Administration (FHA) is still waiting for its number to be called. And these government agencies are desperate to unload their deadbeat mortgages on the private sector.

That’s where investors like Doug Brien step in. Brien is the co-founder and managing director of Oakland, Calif.–based Waypoint Homes, a firm dedicated solely to buying foreclosed homes and converting them to rentals. Since 2008, the company has acquired more than 2,100 houses.

Brien expects competition to heat up in 2013, but as a 12-year NFL veteran and two-time Pro Bowl kicker, he’s no stranger to competition.

“Other people have figured out that this is an interesting business, so there are some big buyers out there paying a lot of money and buying a lot of houses,” says Brien. “There’s a lot more competition now.”

As a former place kicker, Brien has precision written in his DNA. While many investors believe that the single-family rental game is all about going long—that the investment only pencils out when done on a massive scale—Brien has a different view of bulk deals.

“You kind of need critical mass to manage these houses efficiently, so buying in bulk is potentially a way to get there,” he says. “But it’s usually littered with ones you really don’t want, so we like the idea of one-off deals, because we can be very selective.”


For years, the shadow market of single-family rentals has been a nagging nemesis of the apartment industry. It’s notoriously difficult to quantify, in terms of both sheer numbers and its impact on the fundamentals; hence, the “shadow” moniker.

It is to the apartment industry what unlicensed cabs are to the taxi industry.

But maybe there’s nothing to fear. According to Jeff Hayward, head of Washington, D.C.–based Fannie Mae’s multifamily division, there’s plenty enough demand to go around, and it’s an apples-to-oranges comparison anyhow.

“We see REO-to-rental initiatives as a complement to the multifamily market,” says Hayward. “A stand-alone house attracts a different type of renter: They tend to be older, may have a family, and therefore need more space. They may have even been through a foreclosure or short sale, so they may be accustomed to living in a single-family home.”

Some early investors have seen their gamble pay off handsomely. Single-family rents rose by 2 percent in 2011 and nearly that much in 2012. That might not sound like much when you stack those numbers up against apartment rent growth. But consider this: ­Single-family rents have been growing steadily for a couple of years even though the sector’s growth typically lags home price growth by about 12 months.

Take Santa Monica, Calif.–based Colony Capital. Colony has become a dominant player in the sector, scooping up more than 19,000 distressed single-family properties or loans since 1991 to the tune of $48 billion.

In November, the firm purchased a 970-property portfolio from Fannie Mae—with homes spread out across California, Nevada, and Arizona—for approximately $176 million. And Colony CEO Tom Barrack has signaled that he will be placing a $1.5 billion bet on the asset class moving forward. Currently, Colony’s investments are yielding 7 percent to 8 percent returns after ­expenses.

And then there’s New York–based Blackstone, which is buying $100 million in houses each week and is up to about $1 billion in its current portfolio.

“This is the kind of thing that happens once, or ­every once in a while, where you see something that’s a market-turning trend,” said Stephen Schwarzman, Blackstone’s chairman, in a conference call in October. “And we are loading the boat.”

One of the sector’s pioneers is Scottsdale, Ariz.–based American Residential Properties (ARP), which is in the process of filing for an initial public offering in 2013. According to Laurie Hawkes, president of ARP, the company looks at individual family circumstances and regional considerations to ensure its portfolio is filled with profitable assets across the board.

“Our expectations in these investments really do vary regionally,” says Hawkes. “We are generally seeing 20 to 25 percent turnover, but we’re still in the early stages of this investment class.”

ARP usually looks for investments in the $100,000 to $200,000 range and has been seeing 5 percent to 7 percent net returns so far.


New investors are embracing this trend too, and competition continues to grow more heated, with all-cash institutional investors and smaller, local firms forming joint ventures left and right.

Among those willing to put all his chips on the table is Oliver Chang. Until May of 2012, Chang was the head of U.S. housing strategy at Morgan Stanley. But then he decided to put his experience and analytical skills to the test and put his money where his mouth is. He quit the Wall Street life to found Atlanta-based Sylvan Road Capital to invest in the single-family rental market.

In the short time since its inception, Sylvan Road has already partnered with Atlanta-based Delmar ­Realty Advisors and has acquired 200 foreclosed homes, renovating each for $30,000 to $50,000 per house. According to Chang, Sylvan plans to spend more than $1 billion on REO-to-rentals in the next two years.

Given the interest of such well-heeled behemoths as Colony, Blackstone, and Starwood, it’s surprising that many of the winning bidders of Fannie Mae’s portfolio have been relatively smaller firms.

The first pool of Fannie Mae REO assets, consisting of 699 properties in Florida, sold to San Diego–based Pacifica Cos. for more than $12.3 million. As part of the deal, a new limited liability company was formed wherein Pacifica shares controlling interest with Fannie Mae. Fannie receives 90 percent of the rental revenue, up to the point it reaches $49 million, after which Fannie’s slice drops to 50 percent.

The second winning bidder was the New York–based Cogsville Group, which bought 94 Fannie Mae properties in Chicago. And in early December, ­Boston-­based nonprofit developer Community Builders bought a 19-property portfolio in Cincinnati from Fannie Mae for $10.6 million.


Why buy the whole tree when you can just pick the low-hanging fruit?

Not all investors believe the GSE bulk portfolio sales are the wisest strategy. Many cite the scattered nature of these portfolios as a deterrent to buying in bulk. So the majority of investors are taking a more cautious approach, cherry-picking properties instead of getting stuck with unwanted assets in a bulk pool.

A great example of this reluctance recently ­occurred in Atlanta, where investors have been snatching up deeply discounted homes for years. On the first Tuesday of each month in Georgia, foreclosure auctions are held in counties across the state, and this past September, two investment companies spent $9 million in just two of the metro’s 13 counties.

But when the FHFA tried to auction off a portfolio of 572 homes there in the autumn, it failed to produce a single winning bid.

The most common complaint from investors like Waypoint is that having a portfolio so geographically diverse creates logistical problems, first when doing the rehabs, and then, of course, in the ongoing management of each rental.

“We’ve got a system where we can underwrite a lot of houses but only buy the ones that work for us,” says Brien. “We’re only buying roughly 3 percent of what we underwrite, in one-off deals.”

Among the biggest challenges in buying bulk ­scattered-property portfolios is coming up with a comprehensive property management infrastructure. It’s not exactly child’s play trying to keep track of numerous individual homes spread out across a wide geographical area. That’s where technology plays a major role.

Most of these investment firms were created for the sole purpose of buying distressed single-family homes to convert them into rentals. Few, if any, of these companies have experience in managing rental properties.

But Waypoint is well aware of the challenges inherent in managing a dispersed portfolio, and Brien uses all available tools to his advantage.

“You really need to leverage technology to pull off acquisitions one by one across the country; without that, it wouldn’t be possible to do it in such large quantities,” says Brien. “We’re highly focused on the rent-to-price ratio. We’re looking at discount to peak, discount to replacement costs.”


Not every housing professional is keen on the idea of converting vacant single-family homes into rental properties. In fact, some believe it will severely bring down existing home prices.

One of the more outspoken opponents of the REO-to-rental business model is the California Association of Realtors (CAR), which thinks REO bulk sales in California could be devastating to many of the state’s most fragile markets. According to CAR, bulk auctions like the ones the FHFA is conducting in California can only hurt, not help, the housing sector’s recovery. The reason for its disapproval is that these portfolios cost tens of millions of dollars and will therefore introduce unwanted new landlords to communities.

“At that price, only large Wall Street investment syndicates, hedge funds, and institutional investors—who have little to no interest in communities—are ­likely participants,” says LeFrancis Arnold, CAR’s president. “Additionally, the winning bidder must agree to convert these homes into rental properties for an unspecified period of time, potentially further delaying a housing recovery.”

Arnold has gone so far as to call for a change in FHFA leadership due to the mishandling of the foreclosed inventory.

Of course, things can seem worse than they really are from the outside looking in. But Och-Ziff Capital Management Group has been on the inside looking out. And it doesn’t like the looks of the single-family rental market.

When the New York City–based hedge fund got wind of a housing rebound a year ago, it decided to gamble on the growing inventory of distressed houses on the market with a rental business model in mind. Fast forward to late 2012, and the $31 billion group is looking to make a prompt disposition of its 300 or so single-family rental homes. It just couldn’t reach those 8 percent returns it was targeting.

Or take New York City–based Fitch Rating’s view on the market. The firm sees multiple challenges for investors entering this sector. First, there really is no historical data for investors to draw upon when evaluating a deal in this market. Second, there are issues with the investor’s security interests in the new collateral. The problem is the potential for the issuer or sponsor to pursue bankruptcy if the deal underperforms.

Another tough task for investors when renting out single-family homes is screening potential tenants. According to Hawkes, conducting credit reviews for potential residents is a crucial step to ensure stability and profitability. American Residential Properties looks at about 19 percent to 21 percent of gross income to rental payment for their tenants.

But all of this risk aversion may be a little less prevalent if the latest product from San Diego–based DataQuick and Westminster, Colo.–based RentRange is able to deliver what the partnership promises. By combining rental data analytics and market intelligence, the companies believe its RiskFinder suite can make managing scattered REO portfolios easier by providing fair market value for all owned properties.

No matter which side of the debate investors sit on, more money is flooding into the sector and competition for prime assets will only increase in the coming months and years. In fact, 22 of the country’s top 30 markets saw an increase in the number of single-­family leases year over year in 2012.

Only time will tell whether the bets being placed pay off. But the blossoming of this asset class contains a bit of irony. The single-family meltdown is the gift that keeps giving to the apartment industry. First, it helped by sending former homeowners into the rental pool, and now it’s sending their former homes into the rental pool too.

When the recession began, many multifamily investors were licking their chops, hoping to capitalize on distress fire sales in the same way that fortunes were made during the Resolution Trust Corp. days of the early 1990s.

While the multifamily fire sales were few and far between, investors are now finally getting the opportunity to buy up scores of rental units. It’s just that these units are all separated by white picket fences.

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