Onward back to feudalism!

[Lauren Johnson]

Posted on January 27, 2014 by Yves Smith @ Naked Capitalism

Private equity firms have been playing residential landlord for only a few years, but the impressive amount of capital they've deployed in this strategy means they've had significant impact in the markets they've targeted. And while PE investors might claim they've done communities a big favor by snapping up foreclosed and other distressed properties, playing a critical role in the housing recovery, some of these new landlords are already developing less than savory reputation. That should be no surprise, since PE firms in their traditional business play a numbers game, levering up and squeezing companies for more cashflow, leading to job losses and too often, bankruptcies. It's not just that the math of portfolio returns allow for some failures; more important, as Josh Kosman documented in The Buyout of America, private equity fund managers pull so many fees out of their portfolio companies that they make money even when a business collapses. So there's every reason to suspect them of structuring similar "heads I win, tails you lose" deals in the single family rental business.

Mark Takano, a Congressman who represents communities in California's Inland Empire, one of the areas hit hardest by the housing bust, is concerned, and with good reason. He has noticed that prices for rentals have moves up smartly even as economic conditions in his district remain poor. He hypothesizes that the PE wall of money that washed in is a big, if not the, contributor. He's also troubled by the idea that rental securitizations will only exacerbate the inherent problems of having big fund managers act as landlords: namely, that of not only being too big and removed to care much, but also having the securitization further insulated them from responsibility. He's asked for hearings into rental securitizations.

There certainly is reason to be concerned about conditions in the communities he represents. Even though financial experts recommending spending at most 30% of income on housing expenses, almost 1/3 in two cities in his district, Riverside and Moreno, spend 50% or more. And in Riverside, while median income is $5,524 below its pre-crisis peak, median rental costs rose by $756 in the same period.

Yet at first blush, Takano's charge sounds implausible: if private equity landlords have increased the supply of rental housing, how could that have led to more costly rentals? While stringent bank credit conditions play a big role, Takano believes that some renters would and even could be homeowners, were they not competing with all-cash buyers. His report explains:

When housing prices fell after the subprime mortgage crisis, investors had an extra incentive to buy properties cheap to rent and make a profit. The Inland Empire was particularly impacted because of its high rate of foreclosure. In an effort to help turn around distressed markets across the country, the Federal Housing Finance Agency sold hundreds of homes in bulk sales to large investors. In November 2012, Colony Capital purchased 970 properties in California, Arizona, and Nevada as part of an FHFA bulk sale. The Press Enterprise reported that in April of 2013, four out of every ten home purchases in Riverside County were by participants in an investment strategy, undoubtedly pushing out family buyers of modest means in the process.

Large investors can be more attractive to sellers, because they're able to purchase homes with cash, rather than financing the purchase through a mortgage. Competition from large investors and a low vacancy level make it more challenging for individuals and families to purchase a home of their own. According to the Inland Valleys Association of Realtors, the percentage of home purchases in the Inland Empire that were purchased outright with cash has doubled since 2008, jumping from 17 percent to 34 percent in 2012.

In the abstract, there's nothing wrong with renting, but whether it's a good deal depends on price and terms. And not only is the price not so hot, but many of the PE landlords look a lot like slumlords. The biggest home buyer, Blackstone, is also reputed to be one of the worst property managers. And Takano is correct to be focusing his concerns on rental securitizations.

Personally, I'm stunned that any investor with an operating brain cell would sign up for the rental securitization launched last year by Blackstone's rental operation, Invitation Homes, last year. However, it was a comparatively small deal ($479 million), Wall Street was eager to get it done (they hope more deals will follow, so it was likely made a priority for the salesmen), and for some investors, participating in a Blackstone deal is like buying IBM (computers, not the stock). In addition, Fitch refused to rate the deal, citing insufficient history.

Of course, using the Standard & Poor's "we'd rate a deal structured by cows" threshold, it's no wonder this deal passed muster. And in fairness, with a 40% cushion, the AAA investors do have a lot of protection. From a Bloomberg infographic (hat tip Lisa E):

But the real question is who will buy the riskier tranches, which account for 44% of the face value of the deal? The riskiest tranche presumably, like the equity tranche or RMBs, will get the upside if loss reserves in the deal aren't used up, so they should attract buyers. But the old RMBS deals, which had much more certain-looking cash flows, found it difficult to sell the tranches that didn't have possible upside, which were the BBB and often the A tranche. The remaining inventory got rolled into CDOs.

And there's a lot more not to like from an investor perspective. It preserves the investor disenfranchisement of requiring 25% of the investors to participate for most types of suits to move forward. And NC contributor MBS Guy points out a real doozy:

In order to provide AAA ratings, the Kroll and Moody's ratings both rely on the value of the underlying real estate, upon a sale of such properties.

Neither rating report addresses what would trigger a sale.

The more detailed Kroll report addresses it a bit more: if performance, in the form of debt service coverage ratio, falls to a low level the loan to the trust (backed by the portfolio of properties) goes into default. If a workout can't be arranged, then presumably the whole portfolio of loans would be individually foreclosed upon. This would be a mess: mass foreclosure of all of the properties. I can't imagine how this would be managed in real life.

So if we are lucky, these rental securitizations won't prove to be popular and the private equity barons will need to make use of other exit strategies. But investors in the US have the right to be stupid, so we can't rely on such a happy outcome.

Needless to say, there's even more reason to be alarmed from the standpoint of tenants and communities. The reports of private equity landlord neglect and misrepresentation are already legion. One staffer at a PE firm told us his firm believed they could shift most maintenance obligations onto the tenant. That is basically a notification that many, and likely most PE homeowners plan to take the concept of "absentee landlord" to a new level.

And even making the highly charitable assumption that PE landlords wanted to be decent property managers, a rental securitization makes it virtually impossible to happen. It uses the same servicing model that continues to be unable to meet legally mandated standards, like stopping dual tracking, even after umpteen settlements. Servicers are set up to be factories, with highly standardized processes. That proved to an abject failure for mortgages when defaults rose above their historically low levels. Servicers utterly lacked the infrastructure and processes to do anything on an individualized basis, when that's precisely what is required with delinquent borrowers. Rental properties are even less well suited, by virtue of property management always being a high touch activity.

The PE overlords will loftily assure the public that these concerns are dated, that residential property management really does scale, and they've hired contractors on a regional basis to do the dirty work. Remember that servicers also hired contractors to perform much simpler tasks like securing property, and they failed abysmally.

So please, call your Representative and tell him or her that you are very concerned about all the stories you've heard about what bad landlords PE firms are turning out to be, and that if they can go ahead with more rental securitizations, it will be even harder to hold them accountable.