With the housing market apparently showing long awaited signs of stability, it's not hard to understand why a program allowing investors to purchase the government's stock of real-estate-owned (REO) homes in bulk and rent them out is generating so much buzz.

The Federal Housing Finance Agency's (FHFA) REO-to-rent initiative has become a hot topic with many investors saying they were keen on purchasing distressed debt directly. And participants said that if the government were to offer to help finance these purchases, the REO-to-rent program would likely attract big players such as private equity firms. That could potentially provide much-needed collateral for either rated or unrated private mortgage securitizations, jump-starting this long-dormant market.

The ideal setup, said one securitization investor, would be to have the fixed-up houses rented and then sold as bonds through some securitization process to investors that would be levered 50% by government financing. In other words, if the house is worth $100,000, the government would lend the investor half of that amount and the investor would pay the other half. Rental returns, said the securitization investor, are something that would be attractive to buyers, and after three, four or five years - the length of the loan would be calculated according to the renter's credit record - the GSEs would offer the renters a 100% LTV loan so that they can buy the house that they are renting.

"This program could have people falling over themselves to try and get involved, and it would offer [mortgage] borrowers an opportunity to rehabilitate their credit while also addressing the foreclosure problem," the investor said.

For an idea of where the hottest REO markets are, see below:

Of course, buyer interest is not limited to those in the RMBS sphere. More than 4,000 responses were submitted to the FHFA's August 10, 2011, request for input (RFI) on options for REO properties held by Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA).

The program, which was first floated six months ago, is widely viewed as one of the most promising policy actions to help the U.S. housing market to date, because of its potential scale and because it is not dependent on either federal funds or congressional approval. The FHFA launched the pilot program with Fannie Mae loans in Febuary.

For investors, some of whom are already putting large amounts of money to work converting distressed properties into rentals, the program also offers another way to go long on housing as the market shows signs of recovering from a price collapse that began five and half years ago.

"The big view is that America is dirt cheap," said Paul Hayman, chief executive of PropertyAccess, a property management firm that is advising two multimillion-dollar funds - one backed by Australian investors and another backed by European investors - looking to acquire U.S. distressed single-family homes. "For much of the world, the U.S. is one of the most stable countries, and here we have residential real estate at a fraction of what the value was five years ago. It is probably as close to bottom as you will get."

Although the pilot scheme will target only Fannie Mae loans, the eventual plan is to include all GSE-held REOs, including those from Freddie Mac and the Federal Housing Administration (FHA). Fannie was chosen for the bulk sale piece of the pilot in large part because it has more assets to sell. On Feb. 27 it launched a 2,490-REO package targeting the hardest-hit metropolitan areas of Atlanta, Chicago, Las Vegas, Los Angeles, Phoenix and parts of Florida. The initial phase of the program is designed for prequalified bulk investors. Any investor desiring to participate in the pilot program must first submit a prequalification request form published by the FHFA.

Meanwhile, Freddie Mac will work on the financing side. Together, the two parts of the program are expected to help clear the backlog of vacant distressed inventory that has been hanging over the housing market, keep a lid on prices and meet the growing demand for rentals from people who can no longer afford to buy or are unable to finance the purchase of a home.

The 300,000 REO homes held by Freddie Mac, Fannie Mae, the FHA and the Federal Deposit Insurance Corp. (FDIC) at the end of 3Q11 amounted to just one-third of all REO properties. However, Paul Diggle, a property economist at Capital Economics, believes that the impact of the program can be even greater considering that many of the homes in shadow inventory will eventually become REOs.

He believes the program can also help put a floor on house prices later this year.

Securitization Has a Role

At this point, it is still uncertain how these REO rentals will be converted into securities. However, the level of response that both the FHFA's request for input, mentioned above, and the REO-to-rent program generated at the recent American Securitization Forum conference in Las Vegas last January indicates that investors are more than willing to step up.

Not that this collateral has not been seen in securitizations before. In fact, last year Residential Credit Solutions (RCS), which was founded in 2006 and operates as a subsidiary of Residential Credit Holdings, sold a $110.6 million RMBS collateralized by performing and delinquent mortgages, real estate loans and property. According to a press statement, more than half of the collateral backing the privately placed deal was described as delinquent or REO.

However, the vision is that future deals of this type would be on a larger scale.

The idea is that securitization can be used to assist with the acquisition process. Post-REO acquisition, mortgages with assignments of leases and rents can be recorded to secure notes sold to investors. This process would effectively make the securitization investors the lenders, with the rents and the real property serving as the collateral, SNR Denton lawyers said in a research report the firm published in February.

"The Federal Reserve Board in its recent white paper has advocated innovative approaches to addressing the foreclosure problem through bulk sales for rentals," said Patrick Dolan, a securitization partner at Dechert. "Important issues in that regard will be the availability of financing to purchasers and the potential use of securitization in such rental operations."

Ron D'Vari, CEO and co-founder of NewOak Capital, said that this structure would be like CMBS, where the individual loans are each cross-collateralized by a portfolio of the single-family homes that will be rented, and a CMBS-like securitization would be backed by a portfolio of those loans for further diversification.

"The loan-to-lease happens in commercial real estate all the time in multifamily transactions, so from a financial solution this concept is not new," D'Vari said. "It would still be hard to implement given the institutional management challenges of scattered single-family properties and other unknowns."

For example, D'Vari explained, if the federal government said that renters who fall behind on their payments cannot be evicted using the usual procedures, that would have a negative effect on the ability, enhancement requirements and economics of a securitized transaction.

"Right now it's probably premature to talk about securitization because the investment opportunity now is to provide the funds for the acquisition of the properties," said Rick Sharga, executive vice president at Carrington Mortgage Holdings.

Sharga said that somewhere down the road, and conceivably once the programs are up and running, securitization could come into play. "Most likely an investor could structure a security based on some percentage of the value of the underlying properties. The investor would earn a return on the security, and the issuer (a company like ours) could use the proceeds to invest in the next group of properties," he said.

Another possibility, which would create a new type of structure, would make use of the actual lease agreements with the rental properties and bundle those, according to Dechert's Dolan. "If the leases are financeable and assignable - these are the things you look at when you are financing leases," he said.

PropertyAccess' Hayman said that essentially what would be securitized will be the investment portfolio, while the underlying value is the lease that is attached to it.

This is where a well-established property management firm would come in "because if the underlying value is the exit value of the house plus the annuity of the lease income, then the data for those two pieces is extremely valuable." He added that the reporting as well as the maintenance of the physical assets for eventual disposition are also extremely valuable.

In any case, the program is likely to have a positive impact on non-agency subprime securities. According to an Amherst Securities Group (ASG) research report, the REO-to-rent scheme would first lead to lower severities in exiting RMBS deals.

"In the subprime world, the average loan size is much smaller than other product types," ASG analysts explained. "Lower-priced properties are generally more attractive to investors, as they provide higher capitalization rates (annual income/purchase price)."

In the rental market, a $500,000 house generally rents for less than 5x that of a $100,000 home, analysts stated. However, they explained that at liquidation, the lower-priced homes have historically experienced a much higher foreclosure discount compared with higher-priced homes.

"We would expect a bulk sales program to help narrow the foreclosure discount on these lower-priced homes, increasing the recovery value of the securities to investors," the analysts added.

Govt. Financing Will Only Help

Dennis Stowe, CEO of RCS, said that most of the investors he spoke with at the ASF said they planned to raise specific distressed mortgage funds with the ability to invest in the program directly.

SNR Denton said that joint-venture transactions are another option for financing large-scale acquisitions of these REO properties. Under the structure, investors would purchase a controlling equity interest in a newly formed investment vehicle created to hold multiple assets with the bidders responsible for the management and servicing of the assets.

This process would be familiar to those bidders that have participated in structured sales conducted by the FDIC.

It is also likely that the GSEs and the FHFA would achieve a better price if government financing were offered. To the extent that government financing can be combined with a mandate to rent these units, rather than sell them individually, it would satisfy both sides of the equation, explained NewOak's D'Vari.

An ideal situation, Stowe believes, would be to implement something like the Public-Private Investment Program (PPIP) structure. RCS, a servicer/sub-servicer specializing in underperforming mortgages, participated in the program as part of the joint venture with the FDIC to acquire $1.3 billion in assets seized from Franklin Bank. RCS paid $64 million for its 50% stake in the venture, and it now holds and manages the mortgages. The FDIC, which contributed the bulk of the funding to acquire the loans, holds the other 50% stake.

The Franklin deal was part of the FDIC's initiative to sell assets out of receivership and to test funding mechanisms that might be used in future sales of troubled assets under the agency's Legacy Loans Program (LLP). The LLP is part of the PPIP administered by the U.S. Treasury, together with the FDIC and the Fed.

According to Stowe, the PPIP also serves as a good model of how the government can sell off assets while also providing financing to make the collateral more palatable to investors.

"We put equity in, bought the assets and the leverage was provided by the FDIC," Stowe said. "It's term financing; you can have that three- or five-year window option out to whenever you think the real estate market is going to recover. That will obviously improve the disposition price if there is leverage attached to it."

Practical Considerations

Converting large numbers of REO properties into rentals comes with a number of challenges. The most obvious one is that to assemble the kinds of geographically concentrated pools that would appeal to a large investor, the GSE must keep a large number of properties off the market for a period of time. This is because properties filter through the foreclosure process at different rates. To create a sufficient quantity to appeal to large investors means holding some of the properties off the market and letting them sit vacant for some period of time, and that "isn't going to be good for these communities," said an FHFA spokesperson.

Another program being tested that would work as a complement to the bulk-sale approach is demand-oriented financing. This is where the FHFA, via Freddie Mac, would offer financing to investors. These buyers would then have the capacity to buy up REO properties and transition them into rentals. The financing would be provided through an existing product at Freddie Mac, according to a person familiar with the situation.

Such financing would give smaller investors the flexibility to create pools of property that are already available as opposed to accumulating much bigger pools of property over time, as larger investors would do. PropertyAccess' Hayman explained that an advantage to launching a program on a national scale is that it will allow investors access to a particular pocket of U.S. residential real estate. This can also be done without incurring the costs of establishing a new property management firm to service properties in specific areas.

"The U.S. is large, and economics will come into play more strongly in certain areas than others," Hayman said. "With a national distribution platform, investors can mitigate their risk with any strong regional variance because the risk can be dispersed over a much larger plate." He added that this would lower investors' cost of capital requirements.

Tried Hands at REO Rentals

The concept of purchasing REO property to rent, as opposed to flipping the property, is not a new one.

Fannie Mae currently has two such programs. One is the "tenant-in-place" program, which forecloses on the owner of a rental property but allows the tenant to remain in the home. The other is the "deed-for-lease" program, in which the agency executes a deed in lieu of foreclosure and leases the property back to the borrower for a period of time.

Freddie Mac likewise launched its own REO rental initiative in March 2009 that allows qualified tenants and former owners to lease their recently foreclosed properties on a month-to-month basis. Tenants can remain in the property on a monthly lease until the property is sold. "However, so far, the challenge is that most people up and leave, or would rather take cash for keys, so there is some question as to how much this kind of tenancy is actually in demand," a Freddie spokesperson said. "At any rate, our new program is under the FHFA umbrella, so we don't know that much about it."

Carrington has been renting out properties for Fannie Mae for several years now. "We actually got into this sort of inadvertently," Sharga said. "Several years back, when we started renting out properties on our own portfolio, we had REOs, and rather than sell them at fire-sale prices, we decided to see what we could do renting them out."

However, he said that up to now, much of the activity has come from individual investors who purchase a handful of properties each.

In January of this year, Carrington Holding Co., the parent company of Carrington Mortgage, announced an agreement with certain investment funds managed by Oaktree Capital Management to fund the purchase of up to $450 million in distressed single-family homes across the U.S. Sharga said Carrington has targeted $1 billion in total purchases of distressed real estate properties this year, all of which would be converted into rental units. Carrington will manage the homes as rental properties for a period of time but will eventually resell them when home prices appreciate.

Stowe noted that there are various REO-to-rent private market schemes that have established the required infrastructure for low property management costs. RCS, he said, is also in the process of monitoring a pilot REO-to-rent program in one of the company's investments. It is currently trying to identify which properties would work best for converting into rentals versus which should be sold.

In its January white paper, the Fed pointed out that poorly managed or maintained properties can adversely affect communities. It also emphasized that a large-scale program would need to ensure that communities are not damaged by rental practices. This approach, according to the white paper, might entail requiring investors to demonstrate some experience with property management and rehabilitation.

Whether the property is transferred to a large fund from one of the GSEs or out of a bank's portfolio, the objective is still to maximize that asset's value. This means to implement effective rental management during a real estate recovery period. This includes managing the customer, property repairs and maintenance and looking at benchmarks along the way to determine when the sell decision should be made.

Generally, the owner of multiple single-family residences would retain a manager to look over the properties: to lease vacant homes, collect rents, enforce the leases, repair and maintain and generally oversee the properties on behalf of the owner. But management agreements can be complex and must frequently take into account state and local law issues, SNR Denton lawyers said.

According to Hayman, very few of the regional property management firms that have sprung up in the wake of the U.S. housing crisis have managed more than 500 assets in total. His firm, PropertyAccess, recovers close to 1,000 assets a month, he stated. It is also heavily involved in data collection and the recommendations on which homes would work best as rentals.

Sharga explained that the process for determining when it makes sense to hold on to the property for renting as opposed to flipping it for sale straight away has taken some trial and error.

RCS has a good idea of the amount of distressed properties out there a special servicer that follows sales nationwide and deals with distressed borrowers and properties, "If you step back and look at the overall community, with the GSEs and everyone else, there are a lot of distressed portfolios out there," Stowe said. "When we deal with a delinquent borrower, we end up talking to over 80% of the borrowers that are over 60 days delinquent."

He added that by gathering information about these borrowers, the firm can find out what these homeowners can afford to spend on housing. Given this information, the company can then identify the properties and markets around the borrowers where renting would work because it will then have an idea of what the homeowner's budget is.

Buying in Bulk

For REO rentals to have an impact on the housing market, activity would have to scale up pretty significantly. The REO-to-rent program would allow investors a good opportunity to directly invest, on a larger scale, in distressed real estate. "That is why there is so much push for the FHFA to start releasing a large number of properties into the program," Sharga said.

The FHFA rental program, according to Sharga, can have the effect of narrowing the gap between the bid price and the ask price significantly. Rental rates are strong enough in certain markets that investors can earn a comfortable yield while managing the REO. "If you have done your modeling correctly, you don't necessarily need to buy these [REO] properties at a huge discount," Sharga said. "You can afford to pay near current market price, and that might make the opportunity more palatable for other lenders who have to sell these assets off."

Diggle of Capital Economics said that the problem for large-scale investors has always been assembling a portfolio of rental properties that is big enough and concentrated enough to benefit from economies of scale and lower management costs.

"We think that the primary factor that is going to get investors interested is the packaging into pools," he said in an e-mailed statement to ASR. "After all, cheap foreclosed properties are not in short supply."

Hayman echoed a similar sentiment and added that getting access to the REO properties is a bigger challenge than the actual money. PropertyAccess, for example, has more than 25 investment groups that each have at least $100 million to spend in this space.

"People recognize an inherently good idea when they see one, and this program makes sense in a lot of different ways," Sharga said.

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