REO Rental Play or Paper Tiger?

Although it seemed a fiercely effective concept at first, inventory shortages and a fleeting shadow inventory have some asking if REO-to-rental is worth its stripes.

By Rachel Williams

REO Rental Play or Paper Tiger

“This is an asset class. You need to buy it right. You need to have a revenue model for it and an operational model for it. It needs to be purchased, refurbished, and it needs to be, of course, rented.”

—Ron D’Vari, NewOak Capital

In the first quarter of 2013, the U.S. Census Bureau reported the national homeownership rate dropped to 65 percent—its lowest level since 1995. Coinciding with this trend is recent research released by the Joint Center for Housing Studies at Harvard University. In their report titled “The State of the Nation’s Housing in 2013,” the Center’s researchers found from 2007 to 2011, 2.4 million homes transitioned from owner-occupied to renter-occupied.

Many consumers are unable to obtain a mortgage or lack the funds for a down payment, and some are finding it hard to embrace homeownership after feeling the effects of the subprime meltdown firsthand or witnessing it play out in their neighborhoods. Add to that the 4.5 million or so households locked out of homeownership at least in the near-term because their credit reports now include a foreclosure, and all signs point to a burgeoning rental market. Apartment living, however, may not be an adjustment many consumers want to make, particularly those who were previously homeowners. Enter the single-family rental home.

With so many Americans either not able or not willing to enter homeownership, single-family rentals are an increasingly tantalizing option. The U.S. consumer’s growing demand for rental properties did not escape the notice of institutional or private investors, who responded by looking to the distressed marketplace for rental property opportunities. Even the GSEs got into the act with the 2012 launch of the Federal Housing Finance Agency’s Real Estate Owned Initiative. According to a report earlier this year by Goldman Sachs, with foreclosed homes typically selling for 30 percent below the price of other properties, they offer investors greater potential for higher yields. For example, Goldman says the yield on an REO home in Las Vegas—even after considering vacancy rates, taxes, and insurance—is 8 percent versus 6.2 percent for a non-foreclosure rental home in the area.

Data from Fannie Mae’s economics team show from 2005 to 2010, single-family units as a share of the renter-occupied stock grew from 30.8 percent to 33.5 percent, the largest increase among all rental property types. Analysts from Fitch Ratings reported in February that current estimates suggest $6 billion to $10 billion of new money has been invested in single-family rentals. According to CoStar’s Mark Heschmeyer, within the past two years alone, more than 65,000 single-family REO assets were picked up by investors looking to profit from the disconnect in pricing and former value. Heschmeyer notes, however, that because of the short time frame these ventures have operated, there is limited rental operating history and even more limited exit results for new potential investors to weigh the still-untested concept.

“There is a lot more capital investment needed to bring properties up to rental condition as opposed to REO [resale condition]. It’s a huge, huge learning curve.”

—Cheryl Lang, Integrated Mortgage Solutions

In addition, the housing recovery has gained a stronger foothold in the past year, making discounted REOs harder to find as evidenced by market indicators such as steady home price increases and declining foreclosure inventory. In fact, as of May, Lender Processing Services reported a year-over-year jump in home prices of 8.1 percent and a year-over-year drop in foreclosure inventory of 27 percent.

What was once declared to be the next big play in housing now seems to be shrinking into the background with declining interest from investors, an absence of funding, and a lack of distressed inventory for bargain buys, without even the promise of properties to come considering the industry’s shadow inventory assessments have contracted to fewer than 2 million properties. There is still potential for big returns, however, particularly for those who got in early betting big on home price appreciation.

While investors can learn from traditional rental models, the REO rental market requires professionals dedicated to the unique challenges surrounding REO to truly thrive.

“One of the biggest problems with REO-torent today [is] the gap between knowledge and actual execution power,” according to Ron D’Vari, CEO and co-founder of NewOak Capital, a financial advisory and investment banking firm. “The operational challenge has been that REO-torent was not considered an asset class until recently.”

Investors will find that in order to fully protect their assets and maximize returns, the straightest line from REO to cash-flowing rental involves strong industry partners with experience in both the rental space and in tackling issues unique to REO, from financial advisory firms that use technology to flesh out portfolio models to property managers who can dually handle rehab and tenant issues. With the right components in place, investors of any size or affiliation can shrewdly capitalize on the swelling—and long-term—consumer demand for single-family rental properties.

In D’Vari’s words: “This is an asset class. You need to buy it right. You need to have a revenue model for it and an operational model for it. It needs to be purchased, refurbished, and it needs to be, of course, rented.”

Addressing Portfolio Challenges

When it comes to working in the REO rental market, “the biggest challenge is how you do due diligence on a portfolio,” D’Vari cautioned.

David Hicks, co-president of HomeVestors of America, agrees. “Many REO brokers are having challenges because they are buying properties, some at pool, and not knowing what they are really buying,” he said. Hicks often coaches franchise owners on managing rental properties and has found that many who are new to the REO rental market may not have a very clear and concise picture of the status of assets in their portfolio.

“When buying REOs, [investors] tend to buy properties that are scattered in terms of location, so they don’t have as much control in terms of the areas as they [could] have,” Hicks said. Among the most important requisites he has for people who deal with REOs are market knowledge and familiarity. “[Make] sure that you know the market well enough so that you know how much you have to put a property through rehab-wise to make it rent-ready. If you go into a market with a rental budget without knowing the market, you can be in trouble,” according to Hicks.

Renee Deane, EVP of operations for Carrington Property Services, says some of the key markets for REO rental are Phoenix, Atlanta, Chicago, Las Vegas, Southern California, and parts of Tennessee—not surprisingly some of the areas that saw the greatest depreciation in the subprime meltdown. In order to do business in these markets, it is crucial that professionals understand local codes and market standards.

As D’Vari and Hicks point out, managing and modeling rental costs—from initial acquisition of the property to maintenance costs to setting rental rates for tenants—can saddle investors with unexpected challenges and expenses.

When handling REO properties, D’Vari advises having a clear picture of the properties. He says one critical need for anyone wanting to play in the REO-to-rent space is “the ability to remotely manage every asset and connect all the available information.”

The key to this is having a strategy in place for the property, from its acquisition to an eventual resale—“cradle-to-grave” as D’Vari calls it. “What portion of the asset do you want to do due diligence on? What do you want to bring back from the field? How much do you want to spend on that acquisition pre-closing? These are all important questions,” D’Vari said. “You have decisions from initial portfolio review filtering, to narrowing down properties to what you want to buy, to pricing it and putting it under contract, to deciding how you want to close and operate.”

Tackling Tenant Challenges

Perhaps the biggest difference between traditional REO sales and REO rental is, of course, the tenant. As in traditional REO sales, the types of renters taking advantage of available REOs run the gamut. Many have been homeowners in the past or are looking for a stepping stone between apartment rental and home purchase.

“Single-family rental as the new asset class in the commercial division has a lot of potential,” said Christopher J. Crippen, fund manager for US Residential Asset Fund, LLC. “It fills a missing gap in the multifamily-rate portfolios … usually a customer graduates out of their [multifamily apartment] property once they have a family.”

Recognizing the close link between singlefamily renters and future homeowners, many investors with rental properties incorporate a rent-to-own feature into their offerings. Crippen says this allows investors “to give potential renters or current tenants a financial workshop or snapshot to help them get into homeownership.” One model that Crippen has found works well involves the renter putting a little more down for the deposit, depending on what they can afford, and then they pay a little more each month, which adds up to a good-size down payment down the road if they choose to purchase the property.

While not all renters will elect to own down the line, many investors at least want to fill their properties with serious renters who will help maintain the value of the asset. Because of the cost associated with “refreshing” the property between renters and other hidden expenses, a good strategy is to attract renters looking for long-term rental terms.

“Institutional investors figured out pretty quickly that if they could rent out [their REOs] and hold on to them until the market turned around, they could probably make some money,” explained Cheryl Lang, CEO and president of Integrated Mortgage Solutions (IMS). As far as long-term outlook, Lang sees investors these days holding properties for five to 10 years before flipping them. “They are buying and holding and looking to the rental income to offset a lot of the expenses,” Lang said.

Implementing a Rehab Plan

While some investors may be familiar with property rehab and upkeep in terms of readying an REO for sale, renting out a foreclosed home involves a greater level of commitment than some owners may be prepared to give; in which case, it pays to enlist the work of a qualified, market-familiar property preservation company. As an added value component, once the work is done and the renter is moved in, many service providers can transition to the tenant’s first line of contact for issues such as maintenance repairs and rent collection.

Lang has noticed a similar disconnect between owners’ expectations and the reality of getting properties move-in ready. “There is a lot more capital investment needed to bring properties up to rental condition as opposed to REO [resale condition],” she said. “With traditional REO sales, we are used to just slapping a couple coats of paint on it, putting carpet in, and that’s essentially it. It’s a lot different for the REO-to-rental market and it’s a huge, huge learning curve.”

In order to adapt to this added and foreign business aspect, Chad Mosley, SVP of business development at Mortgage Contracting Services (MCS), has found communication is key. “In addition to a normal property, where there is a lot of communication between the servicer, the investor, the field services company, and the asset disposition company or real estate agent, now you have the additional human element of the person who calls that property home who needs to have open lines of communication for routine maintenance, for repair items, or anything that may come up at that property,” Mosley said.

An important part of keeping the lines of communication open is ensuring properties meet local municipal requirements and are kept up to code. Matthew Fulton, chairman of Market Ready, a property preservation and rehabilitation firm, has faced this challenge firsthand. “We are a … contractor for both of the GSEs and multiple asset management firms, community banks, and a variety of other lending scenarios. Every home that is purchased has a unique homeowner and specific guidelines,” Fulton said.

“In some communities, it’s a large HOA [homeowners association] with unique building codes that have to be met regarding the exterior colors, how the property is maintained, or what they’ll allow with grass levels, etc. I believe that investors in this space truly need boots on the ground (i.e., folks who have worked in the local markets … and can make sure there are no mistakes that could end up being costly),” and ultimately wiping out any ROI the investor hoped to achieve, Fulton explained.

Deane agrees and has found that partnering with local contractors can help investors achieve this “boots on the ground” approach. However, managing local networks can be a complicated process in itself, so Deane advises choosing partners wisely and working with an experienced property manager whose sole business is tenant relations and rental operations. In order to ensure industry partners work with the utmost professionalism, Deane advises putting them through a rigorous selection and approval process.

“They have to provide all of their licensing, insurance, and then we do regular scorecard performance on our property managers,” Deane said. This type of formalized training helps both the investor and their partners work more seamlessly together and offers the added benefit of raising comfort levels enough to entrust a third party to take over fundamental responsibilities while holding properties to industry and community standards.

In addition to traditional maintenance issues facing REOs, Hicks notes that often these properties require “above and beyond” repairs in order to compete in the crowded marketplace. “To be successful at rental properties, you need to be at the top of the rental market, but that is usually different than a retail market … [properties] do much better when [asset management companies] spend a little bit more on them before renting, so there is less maintenance on the backside of it,” Hicks explained.

An Ever-Evolving Marketplace

In the end, whether REO rental is a market in which you would like to do business for the long term or just reap its short-term benefits, it is an ever-present reminder that the REO market is an evolving animal. Capitalizing on the opportunities it presents is akin to taming a wild beast.

The REO-to-rental model represents a form of investment that offers unique challenges and unique rewards. The ultimate return on the investment depends heavily on obtaining assets that will be sustainable within their local geographic and demographic markets and maintaining that value with a model that allows the investor to meet the standards required by local law as well as the expectations of tenants.

This asset class has many idiosyncrasies, and success depends on a combination of strategy, logistics, and relationships with third parties who will be relied on to fill certain roles in the process. REO-to-rental is a new chapter for the industry in the post-crisis era. And though the chapter may be cut short due to the sheer dynamics of the current marketplace, those with their foot in the door may just find it holds a fairytale ending of steady returns if they can put the right characters into place and properly execute the plotline to capitalize on the intrinsic shift in homeowner and renter populations.

This article is from DSnews written by Rachel Williams.