Are Big Investors a Big Problem?

Highlights:

• The recent securitization of more than 3,000 single family homes has alarmed some housing analysts who fear that these properties could be dumped back on the market simultaneously causing prices to tumble.
• The structure of the security allows for flexibility in managing costs for the landlord, reducing the likelihood of an untimely sale of properties.
• A stress test scenario in one local market with active investors suggests that the return of the limited number of properties currently securitized would not have a significant downward impact on prices
• Because of the potential for growth in the securitization of single family rentals, this industry should be monitored for sustainability and the impact on the single-family for-sale market.

For a more detailed analysis, read on:

Investors have played an important part in the housing recovery, but recently concern has grown over their role.  In particular, the first ever securitization of single family rentals by Wall Street investors spawned fears that the large number of properties packaged into this type of security could be dumped on the market sending prices downward.  Current conditions are stable, but this nascent industry will need to be monitored.

Prior to the great recession, investors played a much smaller role in the market.  What’s more institutional investors were virtually non-existent.  The share of homes purchased by all investors was closer to 14% in 2003 and 2004 well below the 24% recorded in 2012.   In the most concentrated local markets, institutional investors who hold properties in excess of 200 made up roughly 6% to 7% of purchases in 2012.  Small mom-and-pop investors who hold only a handful of properties and a comparative advantage about local conditions are the majority.

It is estimated that institutional investors accounted for roughly 200,000 single family homes purchased between 2011 and 2013…a small sliver of the 12.4 million single family homes sold over that period.  However, institutional investor purchases are more concentrated in certain markets.  Furthermore, in the fall of 2013 one institutional investor borrowed to finance the purchase of a pool of more than 3,000 homes.  This loan was turned into a bond that was securitized and sold as shares to investors who would benefit from the underlying rental stream as the institutional investor repaid the loan.  This phenomenon raises questions as to the implications for the housing market.

The successful securitization of single family rental properties and the strong demand for the security suggests that both the institutional investor and buyers of the security believe in the strength of this instrument and the single family rental market supporting it.  However, as this is a new type of investment, the long-term sustainability is not clear.  In particular, this structure will require the institutional investor to have strong capacity to maintain the properties at a low cost and to fill them with renters.  Fluctuations in either costs or revenues might undermine the model and there is little historical data for analysis.  Furthermore, the bond that backs the securitization comes due and must be renegotiated every 3 to 5 years.  What might happen if this business model becomes unprofitable, the entity goes into default, or if the security is not rolled over?  Would the investor unload their properties on the market simultaneously sending prices downward?

In the short term, if particular properties become less profitable due to rising costs, the sponsor can sell off less than 10% of the properties from the pool so long as it returns 105% of the original allocated loan amount.  However, the amount that must be repaid rises to 120% of the original allocated loan amount if the properties make up more than 20% of the pool…a disincentive to sell properties that appreciate in value.  What’s more, there is a cap on how high the interest rate on the bond supporting the securitization can rise, which creates a buffer so that the interest that must be paid to purchasers of the security won’t eclipse the institutional investor’s margin on rental income.

In the long-term, the institutional investor can extend the deal like rolling over a commercial loan.  Alternatively, it may decide that it does not want to continue for cost reasons or if the value of the underlying properties has risen significantly.  In this case the sponsor may sell part or all of the pool of properties.  These properties could re-enter the single family rental market in another securitization or with a different landlord or they could enter the single-family market for owner-occupants.  Profit is a strong incentive and investors in the single family rental market are unlikely to unload properties in unison for the impact that this would have on the liquidation price.

There is always the possibility that an entity might dispose of a large volume of properties at a single time potentially destabilizing the market.  Phoenix has roughly 13,700 institutional investor owned single family rentals, one of the largest investor markets, making it a good model.  Of these, 1,090 were included in the Invitation Homes, LP single family rental securitization in November of 2013.  If the homes wrapped in the Invitation Homes deal (32% of the deal…the highest share by far of any metro area or state) were returned to the Phoenix market simultaneously, the months supply would rise from 5.5 in February to 5.7, likely not having an impact on prices (6-7.5 months supply is considered a neutral market, lower than that would cause price appreciation and conversely for greater).  If all institutionally owned properties re-entered the market, the rate would jump to 8.6 months…roughly half of what it was in 2008 near the peak of the Phoenix market’s correction.

A months' supply of 8.6 would weigh on price growth, but investors are unlikely to sell all their holdings at once and that level is improbable to cause prices to drop like they did in 2007 and 2008.  What’s more, a rise in supply and moderate drop in prices would likely create owner occupied demand in the current tight market, absorbing some of the new inventory.  On the rental front, the current months supply for single-family rentals is 2.8 in Phoenix.  A measured increase in the rental supply would help to ameliorate the strong rent growth.  However, a large number of securitized properties might return to the market when conditions are less advantageous than today creating a more serious problem.  What’s more market analysts indicate that the volume of single family rental securitization could increase significantly in the coming years and that securitizers are considering pooling homes managed by groups of smaller investors-landlords, a trend that could expand the number of securitized properties dramatically and introduce new risks.

Investors have played an important role in stabilizing the national and many local housing markets.  The recent creation of securities backed by single family rentals should be regarded with caution and monitored.  At present, the volume of securitized properties would not destabilize even the most concentrated local market, but as this industry grows that balance could change.