The blog of the Urban Institute
October 20, 2021

Institutional Investors Have a Comparative Advantage in Purchasing Homes That Need Repair

October 19, 2021

Large institutional buyers that purchase single-family homes to rent them are often criticized for snatching the limited supply of available homes away from potential owner-occupants. And the criticism has increased in today’s hot housing market.

Most of the homes institutional investors buy need repair. And because of operational and financing advantages, these institutional investors can repair these properties more quickly and efficiently than an owner-occupant generally can.

Institutional buyers have two significant comparative advantages over owner-occupants in purchasing homes that need significant repair. First, they have expertise and can realize economies of scale when doing major renovation work. Second, they have a financing advantage because they can pay cash sourced from capital markets, whereas owner-occupants often need a rehabilitation mortgage that is typically more expensive and difficult to acquire than a standard home purchase mortgage.

Rather than disparaging institutional investors, it makes more sense to understand how these institutional investors operate and explore whether these lessons could make home renovations easier and less costly for owner-occupants so they can more effectively compete for these properties. Unfortunately, there is no easy way to help owner-occupants compete, and encouraging more owner-occupants may take a direct government subsidy.

The institutional single-family rental business model: Renovation after purchase

Before acquiring a home, an institutional buyer’s in-house team assesses a property’s structural features—heating, ventilation, and air conditioning (HVAC); roofs; and more—and prepares a detailed renovation budget and scope of work. They consider fixing anything broken and determine whether renovations will increase the property’s rental value.

Once they acquire a property, they submit a request for bids from vendors in each market. The institutional buyer usually negotiates a discount price for the work, based upon the volume of business they give the vendor. They also negotiate discounts and extended warranties for products that are commonly used in the renovation process, such as appliances and HVAC systems.

Two of the largest single-family institutional buyers’ annual reports illustrate the substantial amount institutional investors spend on these renovations, even with the volume discounts. The Invitation Homes 10-K (PDF) indicates that it spent $39,000 per home for up-front renovations completed during 2020. American Homes 4 Rent’s 10-K for 2020 (PDF) notes that they typically spend between $15,000 and $30,000 to renovate a home acquired through traditional acquisition channels. This is considerably more than the $6,300 we calculate the typical homeowner spends during the first year after purchasing a home.

Their extensive experience, internal capacity, reliable vendor relationships, and discounts yield more cost-effective renovation than a homeowner could generally achieve for the same work. This expertise and cost advantage is factored into the purchase price of the property, giving investors an advantage when bidding on these properties.

Institutional investors have a financing advantage

Institutional buyers generally pay cash for the properties and then finance their purchases later through the securitization market (PDF) or lines of credit or loans from a bank, insurance company, or other institutional investor. This means the full purchase, including rehabilitation costs and financing, is separate from and not contingent on financing.

In contrast, an owner-occupant generally needs a loan. Purchase mortgages are not designed for a major renovation because the loan amount is based on the property’s current value and does not account for borrowers’ repairs that could enhance property values.

Two types of mortgages allow a homeowner or potential homeowner to fund a renovation: the Federal Housing Administration’s (FHA’s) 203K program and Fannie Mae or Freddie Mac’s renovation finance programs. For these programs, the loan amount is based on the property’s after-repair market value.

But 2019 Home Mortgage Disclosure Act (HMDA) data indicate the number of such loans is relatively small (174,000 loans versus 4.437 million total purchase loans in that year). The number of rehabilitation loans associated with home purchases is likely even smaller, because that 174,000 includes loans taken out for an existing homeowner to finance a major rehabilitation project.

Sellers are usually more reluctant to accept a bid from a buyer using a renovation loan than an all-cash buyer because the likelihood of closing is considerably lower. HMDA data from 2019 show a denial rate of 36 percent on conventional rehabilitation loans and 29 percent on FHA rehabilitation loans—much higher than the denial rate on purchase loans.

2019 Denial Rates by Loan Channel and Loan Purpose

Loan channel

Purchase loans

Rehabilitation loans

Cash-out refinance loans

Non-cash-out refinance loans

All loans

Conventional

9.1%

36.3%

18.7%

14.8%

14.9%

Federal Housing Administration

12.8%

28.8%

35.5%

35.3%

19.6%

Source: Urban Institute calculations from 2019 Home Mortgage Disclosure Act data.

 

What’s more, the renovation loan programs have more limitations and are more expensive than traditional mortgages. The FHA 203K program has two forms: a limited form for up to $35,000 in repairs (not including major structural repairs) and the standard version for structural repairs that requires the borrower to hire a US Department of Housing and Urban Development consultant to oversee the renovation process.

In the Fannie Mae HomeStyle program and the Freddie Mac CHOICERenovation program, the risk of cost overruns or shoddy work rests with the lender; the government-sponsored enterprise (GSE) has recourse to the lender during the construction period. Though the GSEs do not require a consultant, many lenders hire contractors to oversee the work as a loss mitigation technique and often charge separately for this. The bottom line is that additional entities that are not doing the renovation are charged with overseeing it.  

And the lender has more responsibility than in a typical purchase loan. In the standard 203K program and the Fannie Mae and Freddie Mac renovation programs, the lender typically pays the contractor directly, after conducting inspections to make sure the renovations are completed as promised.

Recognizing that lender recourse can limit lender participation, Freddie Mac is offering a new program starting November 1 for more limited renovations or repairs (up to 15 percent of the purchase price in high-need areas, 10 percent in other areas) that will not require lender recourse.

Moreover, none of the renovation loans provide much flexibility to the borrower once the work plan is agreed to; the loans are particularly difficult to navigate if the project grows or changes midstream (which is likely, as anyone who has ever renovated a property knows).

Can the playing field be leveled?

Though it is unlikely that the playing field can ever be fully leveled, this analysis encourages us to consider how to bring expertise, scale, and financing opportunities to aspiring homeowners. There is no silver bullet, but we can design and implement pilot programs to begin to bridge these gaps. These pilots could include direct government expenditures to subsidize costs or government partnerships with home improvement companies or building supply companies. The successful pilots could be expanded to promote homeownership.

Furthermore, we should be mindful that institutional investors play an important role in the market by improving the quality of the housing stock and increasing the supply of decent rental housing. As long as they are not predatory, they are providing valuable upgrades to homes that need repair. It is important to have policies that promote both homeownership and the maintenance of a high-quality rental stock.


The Urban Institute has the evidence to show what it will take to create a society where everyone has a fair shot at achieving their vision of success. 

Show your support for research and data that ignite change.  

 

(The Good Brigade/Getty Images)
 

SHARE THIS PAGE

As an organization, the Urban Institute does not take positions on issues. Experts are independent and empowered to share their evidence-based views and recommendations shaped by research.