Dining with Vultures: Rent-to-Own, the Feds, and the Housing Sector
Wednesday, January 25, 2012
Rent is suddenly the rage for solving the housing debt crisis—and vulture capital with it. But the ambivalence conjured up by private equity magician Mitt Romney, who has simultaneously restructured himself into the leading Republican presidential candidate and America's most reviled business leader across the ideological spectrum, suggests that the housing crisis requires free and clear, as-is sales, even if they increase short-term losses. The federal government should exit the real estate business and let vulture investors convert busted planned communities into rentals.
The Federal Reserve estimates in a white paper that there were about 500,000 real-estate-owned properties for sale in the second quarter of 2011 (REO is the term for properties where mortgage lenders have taken ownership after default, usually by foreclosure), and that there will be potentially 1 million more foreclosures in each of 2012 and 2013. Last fall, at the behest of the Obama administration, the Federal Housing Finance Agency issued a Request for Information (RFI) seeking ideas for sales, partnership ventures, or other strategies to unload much of Fannie Mae, Freddie Mac, and the Federal Housing Administration’s (FHA) portfolios of REO properties and distressed mortgages. (The properties are primarily single-family homes; I will refer to these collectively as "residential real estate," in contrast to multifamily rental real estate projects that are commercial real estate.)
The RFI and white paper authors, perhaps after renting too many Nightmare on Elm Street sequels from Blockbuster (itself now bust), jointly dream of a disposition scheme that is a mirror image of the bubble-era Freddie-Fannie public-private partnerships. Under this old model, an implied federal guarantee simultaneously inflated housing prices while promoting "affordable" 100 percent loans to unqualified borrowers who had been priced out of the market. Now, the feds seek to support housing prices while enticing vulture investors to buy REOs.
The feds seek to support housing prices while enticing vulture investors to buy REOs.
The white paper notes the difficulty with price support: vultures will need to price in the high costs and illiquidity of single-family real estate. A distressed real estate buyer purchasing a 100-unit apartment building can do a single market analysis, title search, lease review, and engineering report, spreading the cost against all the rental space in the property. It can then hire on-site staff to monitor and manage the property 24/7. In contrast, a distressed real estate buyer purchasing 100 single-family units spread across a metropolitan area must perform due diligence on each unit, and after acquisition must separately lease, maintain, and monitor tenant behavior in each scattered unit. (Evictions of nonpaying or destructive tenants are often long and costly.) Worse, investors' ability to rent out units will often be subject to controls by community associations (the dominant form of residential real estate over the last quarter-century).
The white paper attempts to transform these reeking real estate carcasses into a gourmet vulture treat, finding six metropolitan areas with more than 2,000 Fannie, Freddie, and FHA REOs, and estimating that 40 percent have economics that would justify converting them into rentals. Taking a generous view of the white paper's assumptions, this amounts to 7,200 units scattered across the six metropolitan areas, plus another 14,400 rentable REOs taken back by various entities scattered across 140 metropolitan areas, for a total of 21,600 potential rentable REOs, or 4 percent of the 500,000 REOs on the market in 2011.1 Thus, even using the white paper's assumptions, rental schemes for scattered properties within these metropolitan areas will delay final disposition and add to the already high transaction costs of this asset class while resolving only a tiny fraction of the problem.
The RFI would make these high per-unit costs even more daunting by limiting investor exit rights. Many of the properties are likely to be so severely distressed that a turnaround is unlikely: borrowers who go into default often stop paying for property taxes and physical maintenance, and vandalize the units, which contributes to an estimated 27 percent drop in house value on foreclosure. Ordinarily, investors who see no turnaround prospects and no potential buyer will cease payment of property taxes and community association common charges, capping their losses by letting the property go to foreclosure. But the RFI's neighborhood stabilization goal would force investors to keep pumping good money in after bad.
Not satisfied with this assault on distressed real estate values, the RFI anticipates rentals to former owners remaining in their units and rent-to-own opportunities. Options depress values in the best of circumstances. Rent-to-own is worse: if home prices shoot up or the investor pays to spruce up the properties, tenants will get the upside by buying, while if housing prices scrape bottom for another decade, the investor will be stuck with a rental.
Given the RFI's planned bulk disposition of scattered, poorly maintained, high-transaction cost, high-legal risk single-family properties into locked-in rentals with limited upside, investors will demand decimating discounts.
Government entities have difficulty selling efficiently. Even if Fannie and Freddie can keep up their combined 2011 second quarter disposition rate of 100,000 homes, it would take nearly three years to work off their distressed inventory, which would deteriorate in the interim. Given the RFI's planned bulk disposition of scattered, poorly maintained, high-transaction cost, high-legal risk single-family properties into locked-in rentals with limited upside, investors will demand decimating discounts. This will further destabilize residential markets.
The white paper notes that subsidized financing may be needed to lure investors in, at further cost to current REO holders. The RFI goes one better, seeking to conceal losses through joint ventures with private investors wherein the feds will contribute their REO properties and bad loans. Getting cash in exchange for bad assets would reveal the true discount level, so the feds will prefer co-venturers who contribute bad assets instead. (For example, if Fannie and Bank of America each contribute 10,000 foreclosed properties in exchange for a 50 percent joint venture interest, it will be difficult to determine the level of the writedown.) Under the RFI, private co-venturers would manage this carcass cache, share "downside risk . . . and offer the potential for upside opportunities and additional recoveries" to the feds. This sets the stage for the nightmare's next phase: the government's ability to monitor the management of hundreds of thousands of distressed assets is minimal; its ability to monitor co-venturer performance of the conflicting goals, given the potential for deferred maintenance and manipulation of valuations and performance fees, is nonexistent.
Vulture investors got their name because they aren't pretty to watch while ripping the entrails from the carrion. Distressed asset buyers are either ruthless or go bust, and government entities have no business co-venturing with them. Washington Post columnist William Cohan, a former investment banker, describes his experience negotiating deals with Mitt Romney-era Bain Capital:
Bain would seek to be the highest bidder at the end of the formal process in order to be the firm selected to negotiate alone with the seller. ... Then, when all other competitors had been essentially vanquished and the purchase contract was under negotiation, Bain would suddenly begin finding all sorts of warts, bruises and faults with the company being sold. ...
At such a late date, of course, the seller is more than a little pregnant with the buyer. . . . Once Bain’s real thoughts about the price were revealed, the seller either had to suck it up and accept the lower price, or negotiate with a new buyer, but with far less leverage.
These were sharp tactics in arms' length market transactions, but government contracts, with their extensive protections and appeal rights, would give vulture investors far more leverage.
The white paper notes the difficulty with price support: vultures will need to price in the high costs and illiquidity of single-family real estate.
Vulture investors must pursue creative destruction at their own risk. The Resolution Trust Corporation, created in 1989 to liquidate Savings and Loans—an earlier crony-capitalist financial services industry kept on life support through socialized risk and privatized rewards—harnessed them more simply and successfully. The S&Ls left a huge portfolio of distressed commercial properties and mortgages, which the RTC packaged in as-is sales at distressed prices. Vulture investors, such as Sam Zell's Equity Office empire, took risks: buying packages at deep discounts, disposing of poorly fitting properties, then assembling rational portfolios and building value. Despite criticism of the fortunes made, the aggressive dispositions soon revived the commercial real estate market, resolving the S&L problem at an estimated taxpayer cost of $124 billion (approximately $206 billion in 2011 dollars). In contrast, Fannie and Freddie have already borrowed $153 billion from the U.S. Treasury to continue operating, and there are further losses in bailed-out banks and the looming $50+ billion Federal Housing Administration disaster.
The RFI attempts to address economies of scale by packaging properties in areas with large distressed asset concentrations and exploring transactions with multiple parties. Nonetheless, managing single-family assets scattered across multiple developments, even in a narrow geographic area, will be inefficient. The feds need to identify failed developments where their distressed assets are a substantial proportion of the units, with the goal of converting entire developments to rentals. Development conversion (as opposed to conversion of scattered units) will permanently reduce the overhang in the single-family ownership market and increase the supply of rentals to meet surging demand from cash-strapped consumers.
Some busted condo developments have already been converted to rentals by developers or foreclosing lenders. On conversion, a landlord can centralize management and adjust amenities and maintenance standards without cumbersome community association board approvals. Unfortunately, rental conversions will be hindered by the legal structure of community associations, whose governing documents may require near-unanimity to convert a development to rentals. In many developments, a substantial percentage of current owners may not be amenable.
If home prices shoot up or the investor pays to spruce up the properties, tenants will get the upside by buying, while if housing prices scrape bottom for another decade, the investor will be stuck with a rental.
Legal innovations will be needed to get beyond extend-and-pretend. States should amend their community association laws to permit conversions to rentals, regardless of the association documents, if more than 66 percent of the units vote to do so. (Dissenting homeowners can either be bought out or given a passive interest in the new ownership entity.) Where the feds hold interests in a substantial percentage of distressed units within a development, they should consider using eminent domain to wipe out community association covenants. And because of the fragmentary nature of distressed residential real estate, tax laws may need modification to encourage distressed unit consolidation, perhaps by loosening tax-free exchange law.
Skepticism is in order when the federal government involves itself in residential real estate: the clueless Federal Reserve minutes from 2006, just as the housing bubble peaked, are Lucy and Ethel at the Chocolate Factory in Ivy League Ph.D. drag. Instead of pursuing contradictory goals, the feds, like the RTC, need to sell distressed assets free and clear.
Jay Weiser is associate professor of law and real estate at Baruch College's Zicklin School of Business.
FURTHER READING: Weiser also writes “Will 1970s Haircuts Ever Come Back into Style?” and “Fool's Gold.” Scott Shane says “Scrap the Accredited Investor Rule.” Peter J. Wallison and Edward J. Pinto contribute “Bet the House: Why the FHA Is Going (for) Broke,” “Why the Left Is Losing the Argument over the Financial Crisis,” and “The Hidden Cost of Free Money.”
1. Federal Reserve white paper, January 4, 2012, pp.10-11.
Image by Rob Green / Bergman Group