Bubble Bubble Here Comes Trouble? REO to Rental Securitization

Three WitchesBubble: The real estate experts in Las Vegas, NV were happy to report the Shadow Inventory of foreclosed homes in the region wasn’t as high as expected as of January 20, 2013. [LVRJ]  Nevada’s anti-robo-signing law (AB 284) is part of the reason, and some homes are still on the market because they aren’t in salable condition.  Before we get entirely too pleased with ourselves…

There are homes that will be included in the Shadow Inventory in the next two years; homes which will be in default and Nevada may be able to circumvent the foreclosure statistics  increases by using short sales.

Bubble:  There are several motivations for purchasing real estate, one of which is to transform unsold residences into rental properties, as in the following example from last December:

“Home prices fell 62 percent from 2006 to early 2012—the steepest drop in any U.S. metropolitan area—yet Vegas is again enticing buyers. The number of homes listed for sale has dropped to a 1.5-month supply, down from the four-month stock that’s typical in the area, says Jeremy Aguero, principal at Applied Analysis, a Las Vegas research and advisory firm. One reason for the inventory squeeze: Investors such as Blackstone Group (BX), GTIS Partners, and Haven Realty Capital are buying deeply discounted homes in bulk to rent out at a profit.”  [BusinessWeek]

The good news is that (a) more rental properties are available, (b) some of the excess inventory is off the market, so that (c) home prices could rebound and those “under-water” on their mortgages might see a bit of relief.   Again, before we become too cheerful, there’s another reason to invest in foreclosed properties which if not carefully monitored could lead to another Bubble.

Toil: There’s more to the story than Blackstone’s interest in getting into the rental business in Nevada.    Blackstone’s also been active in southern California:

“In all, major investors have raised between $6 billion and $9 billion to buy single-family homes, according to a recent analysis by investment bank Keefe, Bruyette & Woods. The goal is to bring corporate scale and efficiency to what has historically been a mom-and-pop, single-family-home rental business.” [LATimes]

What we have here is Wall Street moving in on Main Street.  Renting residences used to be primarily a Mom & Pop operation.  But, Mom & Pop don’t have between $6 and $9 billion to buy up residential real estate.  Now we tread into “market efficiency” territory.  There are some variant perspectives on what “efficiency” really means.

When we speak of efficiency as a component of Economies of Scale, the Black Rock venture looks like the application of operational efficiency to the old Main Street individual homeowner model of residential rental markets.  There are Internal economies of scale (the company is so big that it can buy in bulk usually at a discount not available to smaller concerns) and External economies in which the company is so big it can get preferential treatment from governments or outside sources to reduce taxation, get roads and utilities provided, etc. in an environment in which a small business or individual cannot successfully compete.

The initial view is that Blackstone is taking advantage of its capacity to be operationally efficient — it can buy up residential real estate in Nevada and southern California at prices heavily discounted by foreclosure processes or perhaps even short sales.

Trouble: What we don’t need is a real estate market which is “operationally efficient” to such an extent that we create yet another Bubble.  So, let’s read further into the Los Angeles Time’s article:

“These firms are also exploring ways of packaging rental income streams into securities, similar to the way mortgages were bundled during the boom years. Those mortgage bonds — often packed with risky home loans that produced mass defaults — turned into the toxic assets that helped bring down major banks during the financial crisis.”  (emphasis added)

There are some breaches in this model.  Real estate is a labor intensive business, if we think in terms of home maintenance, home marketing, and all the associated jobs which must be performed to rent and receive income from a block of home purchases.  Profit margins depend on rental income, and will the rental income stream support acceptable levels of profitability given the labor intensive nature of the housing market?   What happens to the business model if high competition for properties drives prices up beyond the  original cost estimates?  What happens if the profitability margin in the “revenue stream” doesn’t meet expectations?

Now we have to consider the other “Efficiency.”  The rental income will be securitized.  Packaged into bonds. The bonds will be sold in financial markets, and the efficient capital market theory tells us “the price of an asset reflects all relevant information that is available about the intrinsic value of the asset.” [EconLibrary]  What determines the value of the bonds?

What’s “relevant information?”  Do we include the rating assigned to the bonds by the rating companies?  We’ve seen this movie before and it didn’t end well.  In fact, the ratings companies seem to have gotten a bit of religion on the subject of slapping high grade investment ratings on questionable products:

“Ratings companies began commenting last year on how they would approach assessing potential securities backed by rental homes, a market fueled by the foreclosure crisis they helped create by granting inflated grades to mortgage bonds.

Moody’s said in August that items including a dearth of historical data on the business could make it difficult for issuers to obtain the grades they seek.

In its report today, Moody’s said it wouldn’t offer its “highest ratings” to deals backed by “equity” structures, rather than individual mortgages, also because they would offer less protection against “unauthorized sales” of homes and new liens. [Bloomberg, Jan. 2013]

Do we include the timeline in our calculation of the bond value?  Last November Blackstone opined that it had a two year window in which to buy up financially fragile properties, [Bloomberg] so are properties purchased in the 3rd year likely to be less profitable, and thus have a lower return for investors than properties purchased in the first two?  If the bonds are manufactured as they were during the Housing Bubble (mixtures of good and bad loans which blew up when housing demand and prices collapsed) then what is the “intrinsic value” of the assets (bonds)?  Will the bond packages include combinations of rental income from markets in which prices are going up, and from regions where the market is still depressed?   If so, then what is the actual “value” of the bond? How many markets have to see increased home prices before the admixture of cheaper and more expensive rentals in securitized assets gets “top heavy?”

Enter all the usual suspects.  Blackstone got an increased loan from Deutsche Bank this month to “underpin” its long term financing of the new REO to Rental securities.  What we know so far about this:

The new Deutsche Bank loan, upsized to US$2.1bn, includes an
original US$600m warehouse facility in addition to investments
from eight other banks and securities investors.

At least 20 banks and investors looked at participating in
the loan, and some passed because their charters would only
allow them to participate in bond deals and not bank loans.

Securitization specialists with knowledge of the deal said
Deutsche Bank expanded the size of the facility in order to
accommodate Blackstone’s increased commitment to purchasing
distressed single-family homes with the goal of renting them
out.  [ChiTrib]

Think of that warehouse as a paper storage facility in which all those rental agreement are stack up, only to be divided up, restacked, and used to back bonds issued by Blackstone.   We’ve seen this movie before too — it didn’t end well in its last incarnation.

Not to put too fine a point to it — but, are we about to get into the same “valuation” debacle about the actual value of sliced, diced, tranched, and securitized assets we witnessed in 2007-2008?

Double, double toil and trouble;
    Fire burn, and caldron bubble.

If we get ourselves into this mess again it’s going to take more than newt’s eyes, fillets of fenny snakes, frog toes, bat’s wool, and dog tongues to extricate ourselves.

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