A Blackstone deal in the runup to the financial crisis, its acquisition of Equity Office Properties Trust from Sam Zell in early 2007 was recognized at the time as a sign of a market peak. Is history about to repeat itself with Blackstone’s rental securitization?
Recall that this deal was launched with great fanfare as major banks salivated over the prospect of creating a whole new type of investment to satisfy the private equity industry’s need to cash out of its single family home land grab. Mind you, this is far from the only exit. One approach, which is much more straightforward, is to spin the company out that manages the properties as an IPO. Industry experts argue you need a portfolio of only 1000 homes to go to market. But only a few deals got done before the Fed’s renewed seriousness about the taper gave investors the jitters.*
Of course, PE firms can also exit by selling homes individually. But that is a slow process and does not sound as sexy or sophisticated. And there’s a practical reason to regard this way out as a last resort. Remember the management part? As you start liquidating the homes, you are spreading overheads over fewer and fewer homes. While some activities can be cut more or less pro-rata, others can’t be as readily dialed down.
So enter the Blackstone rental securitization of last October. It was a modest $479 million deal and was six times oversubscribed. Investors no doubt believed that the initial deal would have to be priced on very favorable terms to assure its success, given Wall Street’s eagerness to launch a new product type.
But there’s still the wee problem of fundamental risk. As Bloomberg tells us:
Rents collected on the collateral for the first U.S. rental-home securities declined by 7.6 percent from October to January, according to Morningstar Inc.
Payments declined as expiring leases and early tenant departures left residences backing the bonds of Blackstone (BX) Group LP’s Invitation Homes vacant, Becky Cao and Brian Alan, analysts at Morningstar’s credit-ratings unit, said in a report. While 8.3 percent of the properties were vacant or occupied by delinquent renters in January, renewals on 78.5 percent of leases that expired the prior month exceeded the analysts’ expected rate of 66.7 percent.
One of the big risk elements in this deal is that it was sold before anyone in the market has reached “stabilized rentals,” where the portfolio is mature enough that enough of the units have been through a lease expiration or two so that investors have an informed idea of what renewal rates look like.
Notice several things: when I first heard PE investors in this strategy describe their expectations two years ago, they were anticipating only one week of vacancy a year, which is less than 2%. They’ve clearly gotten more realistic. The transaction was marketed with a modeled vacancy rate of 8%, so the 8.3%, which included delinquencies, does not look bad relative to that.
But what the 7.6% fall indicates is that Blackstone is having to cut rents to get renewals. We’d predicted that. Private equity investors were salivating over how tight rental markets were, and somehow failed to factor in that their very conversion of formerly owner-occupied homes into rentals would increase supply and lead to more competitive conditions for tenants, which would show up in higher vacancy rates and/or falling (or at least not rising) rents. Now admittedly, real estate is local, so there are undoubtedly markets around the US that are still tight. But certain area were particularly popular with investors, like Las Vegas, Atlanta, and Phoenix. A city with underlying growth like Phoenix might have enough of an increase in population and incomes to weather the large-scale PE conversion. Others are more vulnerable.
The big test for Blackstone will be the first quarter, the peak period for rent renewals in this transaction.
Mind you, this blip hasn’t hurt the AAA investors. The AAA investors have 40% subordination, meaning 40% of the deal consists either of lower-rated tranches or other risk buffers. But as one might expect, the prices on the riskier tranches which are the first to take the hit if cash flow comes up short, fell after the Morningstar news was made public. And that alone could prove fatal to this type of deal.
As we discussed in ECONNED, dealers do not want to wind up stuck with the riskiest inventory from securitizations, so the ability to sell these deals is constrained by the ability to place the more speculative tranches. For subprime mortgage backed securities, the way to escape these limits was to create CDOs, which became a Ponzi (the risky tranches of CDOs were similarly unwanted and were sold to other CDOs). We’ve discussed other risks to these deals, such as localities imposing tougher conditions on absentee landlords and regulators taking an interest in the servicing of rental properties. So the jury remains out as to whether this deal was the beachhead for a new product category, or whether investors were foolish to be buying what Blackstone was selling.
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* Mind you, that does not mean that IPOs could not necessarily have been launched, but not at the prices the PE firms wanted.
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These deals sound crazy to anyone thinking about buying with his own money. But those buying them are using other people’s money, where the idea is to look good in the short term and be retired before the long term explodes.
In search of yield has lead to non-local money pouring into my little community. And the result will not be good. The outsiders will lose and the community will be left with an oversupply of properties waiting to be slumified. The deal makers … well they’ll be off to some other community.
Malinvestment caused by ZIRP
In a related piece, private equity investor Raymond C Mikulich and his team are bringing a new rent-to-own program to Houston TX. Yippee!
http://www.houstonchronicle.com/business/columnists/sarnoff/article/Rent-to-own-deals-aim-to-open-doors-5237536.php
Yves, Do you have any knowledge of Mr. Mikulich? I did a quick Google search and found that he apparently paid $17.9 million for Central Park apartment in 08. Curious if you have any insights, thoughts?
Housing generally is going to take a hit over the next year or two.
I think that anyone who gets into the single family home rental business is a fool unless they live local to the properties and either in the trades or have friends and family in the trades.
A single family home is a bear to maintain well and the only way I have found to make money renting them is to put in sweat equity just as I would with my personal residence. Renters, understandably, are not inclined to be as uptight about maintenance issues that do not immediately impact them.
For example, the paint on the bottom of the trim boards on my garage was peeling off and the wood was exposed. It was not an eye sore yet but I immediately scraped, sanded, caulked and painted all the the trim since I knew that if I let it go over the winter that the wood would start to rot out. A renter would have no reason to be so aggressive in either doing the maintenance or in letting a landlord know about it. Had those boards rotted it would have cost me a lot more time and money to fix. Not fixing them would have exposed the frame to rot and pests.
That is just one, very small, example. You could think of things like power washing to prevent siding from staining or cleaning gutters in a timely manner or a loose shingle. There are hundreds of small tasks necessary to protect and maintain a single family home that if left undone can be very very costly. Ever seen what happens when the pan under the washing machine leaks?
In a rented condo complex or apartment building, the maintenance guys would take care of those issues.
I think that these people who invest in these single family home rental companies are gonna get burned.
Yeah, there are very few efficiencies of scale for SFHs. The other thing that people seem to repeatedly ignore is that the rental market responds more quickly to supply and demand than the sale market. As the number of homes in various stages of “post-foreclosure” declines, the amount of housing available rises, lowering the rent’s that can be demanded. The oversupply of housing built during the bubble still exists, but somewhat less of it is “hidden supply,” so it is affecting rents. During the build up of the bubble, many bought “investment” properties with the thinking that they could just raise rents to a level that would allow them service the mortgages and get themselves a windfall when they sold. Certainly in the multifamily market there was an artificial scarcity created by the several months that condo conversions took.
I think they will soon be presiding over suburban slums. The real losers will be owners surrounded by these rental properties. The slumlords will just lower the rents to what the traffic will bear.
I would agree, that looks the likeliest outcome a few years down the road.
DanP1966 you are so right. We have had a couple of single family homes empty for a year, and have found that cash flows are not so much different than when we had them rented, because we’re not plunking down the money for maintenance.
The rental trusts probably have more than one angle. It sounds like they go hand-in-glove with the push for “open borders.” If the government subsidizes the rents of immigrant workers or low income workers it will support these trusts. If mobility of the workforce is achieved, and workers are shuffled from slower production to faster production areas, it could also support these trusts. Why was PE so eager to invest in all those rentals when US production is so feeble? We must be on the verge of a manufacturing renaissance. Using cheap, subsidized labor. Isn’t corporatism grand!
I think you are putting too much into this. This is about companies finding out people aren’t interested in buying homes and concluding rents will naturally rise and buying up properties before localities seize them or locals came back into the market.
Also, they housing market didn’t rebound, and the banks needed to do something with their foreclosed properties to pay off local tax liens (property taxes; small claims courts, and upkeep costs). What is the bank calling an asset is important. If localities start grabbing properties on a grand scale, the bank can’t buy off that many politicians, police forces, and bureaucrats all at once*. At that point, it would effectively be a massive tax increase on the banks.
Ultimately, the holders of these rental trusts want to unload them. Their loss of money is to be expected because renters don’t take care of places in most areas, not so much in traditional rent areas, the same way home owners do. Homeowners repair cracks right away. The renter doesn’t worry about it until he talks to the landlord or there is a problem. The land lord doesn’t want to be at the beck and call because it costs money or maybe the tenant is a complainer. Plenty of people don’t grasp the actual difficulty of property upkeep and the countless little things homeowners do that renters don’t do which prevent problems.
*American political whores are seriously cheap. They should be embarrassed by how cheap they are compared to virtually every other country.
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Why bother with securitizing houses when you can just securitze people. Buy them, and sell the bonds based on the expected return on investment.
Slowly but surely, the trek back to slavery is well underway.
Oh, that pesky 13th Amendment! Maybe Scalia and the other Berobed Clowns can gut it as effectively as they have the 4th Amendment! The plutocrats can dream, can’t they?
Bin done. It is called ‘Student Loans”.
blood, turnip, inability to get blood out of….
Renters are generally lower income and in a more precarious financial situation than home buyers. The idea that you can buy dispersed single family properties and make enough money for acquisition costs, financial costs, maintenance costs, and be able to charge rents high enough to do this…..when incomes of renters is stagnant or declining don’t make no sense…
Ah, but the hedge funds figured that out quickly and then created both the holding companies and the securities markets needed to unload the properties they picked up on the cheap. As usual, the big money got in first and will get out first, leaving more modest investors (the stupid greedy rather than the clever, feral greedy) holding the bag. Eventually these rock-ribbed Southern and Western Republican types will get their S&L style bailout of their faltering assets, because government handouts to anyone but themselves is a sign of creeping socialism and the evils of moral decline.
And kudos to Mike Whitney at Counterpunch, whose been following this for two years and predicted the big money heading for the exits quite some time ago.
What are the chances the plan all along was to dump these properties on the GSEs or even the Fed for a hefty profit, after securitizing the rents?