The single-family rental securitization market won't exceed $20 billion
Over the past eight years, as homeownership has declined, 4.5 million homes have been purchased and converted into rental properties by investors. Seeking to increase their returns and free-up capital for more investment, institutional investors have issued eight securitizations based on these loans in the past twelve months, totaling $4.4 billion. How high can this market go? Some have predicted that the market for single-family securitizations will reach as high as $1 trillion but the dominant presence of small investors in this market means this number is unlikely to ever exceed $20 billion.
And here's why.
Small investors own most of the 4.5 million rental homes. The home ownership rate has dropped from 69 percent in 2004 to 65 percent today. This implies that approximately 4.5 million homes that used to be owner-occupied are now investor-owned rental properties. Most of these properties have been purchased and managed by small investors, with purchases by institutional investors representing 4-5 percent of the 4.5 million homes that have changed ownership structure, considerably more in a few communities like Phoenix. The overwhelming majority of these investor purchases, by both large and small investors, have been made in cash.
Rising home prices mean investors want to stay in the market but leverage their investments. With increasing home prices squeezing investor returns, large investors are looking to borrow against their single-family rental properties to decrease the amount of capital invested and hence increase the return on capital. (Information on borrowing by smaller investors seems to be non-existent.) Large financial institutions have set up lending facilities for institutional investors in the single-family rental business and eight securitizations of single-family rental properties by large investors have been completed in rapid succession: Blackstone’s Invitation Homes deal, which closed in November, 2013, was first followed by two more Blackstone deals, two deals by Colony Homes, and one deal each by American Homes, Silver Bay and American Residential Properties. Together, these deals total $4.4 billion.
Note that there is very little institutional buying at the present time, as prices have increased to the point where the returns on new investment are insufficient. This is exactly why we are seeing the securitizations now, well past the peak in buying activity. Why not just sell the homes and pocket the gains? The investors believe home prices have more upside, they have built extensive property management networks, and with leverage, they can continue to earn a return that is attractive to investors.
So the rise in home prices has fueled a desire to stay in the market as well as a need for improved leverage which means these securitizations will continue for a period of time. But here is why the market is nowhere near $1 trillion.
$20 billion is the likely cap on this securitization volume. $20 billion is the likely cap based on simple math. Securitizing single-family rental properties enables an investor to borrow approximately 70 percent of the value of the properties. At most, $25 billion has been raised by institutional investors for the purpose of purchasing homes for rental income:
- 75% of that is eventually placed into securitizations or $18.75 billion;
- Investors receive 70% of the value of those properties or $13.1 billion in securitization volume;
- 75% of the $13.1 billion or $9.8 billion is then used to buy more properties;
- Investors again receive 70 percent of the value of those properties or $6.9 billion in securitization volume;
- The total generated, based on the original $25 billion, is $20 billion ($13.1 + 6.9 billion).
And $20 billion is an optimistic number. These numbers are an upper bound to securitizations by existing investors, barring new raises of equity capital, for two reasons.
- First, assuming 75% of institutional REO-to–Rental operators will employ leverage through securitizations is quite high. While most institutional investors will chose to employ leverage, many will borrow short term from banks rather than securitizations, as they believe it is more cost effective.
- Second, assuming that 75% of securitization proceeds will be redeployed into further purchases is high, given how much institutional buying has currently slowed.
Betting on loans to small investors. With home prices up, returns less enticing and property acquisitions tapering off, some of the institutional single-family rental operators are going into a new line of business—making loans to smaller investors, with plans to securitize those loans. These operators believe that the home ownership rate will continue to decline (albeit at a slower pace) as borrowers in states with long foreclosure time lines continue to lose their homes.
These operators also see that the trend toward rentals is supported by favorable demographic factors: new household formation is heavily minority, with limited household or family resources for a down payment and millennials, burdened with student loan debt and delaying marriage, have a lower demand for home ownership.
As home prices are bid up, smaller investors, who can do their own property management and thereby lower their total property management costs, will remain interested. But these securitizations based on loans to small investors face two challenges:
1. There are other good financing options for small investors.
While the homeownership rate is likely to continue to decline, there is no reason to think that private equity will supplant the two existing options that small investors have for financing their rental income purchases: the GSEs and commercial banks. Private equity is not the most efficient provider of funds for smaller investors who want to borrow funds to finance the purchase of a rental property. Fannie Mae offers financing to single investors for up to ten homes and Freddie Mac offers financing for up to four homes. Combining both, an investor can potentially buy 14 homes with GSE loans, at rates that are apt to be far more favorable than the rates that a private equity fund would need to charge to maintain their desired return on capital. Commercial banks will also often provide small commercial loans for these enterprises.
2. Rating these securitizations is difficult.
Even if institutional investors were the most efficient providers of financing, the difficulty of rating these securitizations poses a significant obstacle. To confidently develop a rating, a rating agency needs to see assurances that the properties are consistently monitored and that a mechanism exists for addressing performance failures by the smaller investors. Assessing the small investors segment is new and it is much more difficult to monitor a large number of small investors than several large investors. And each of these smaller investors must provide consistent information to allow for effective monitoring. Even if the monitoring issues could be overcome, addressing performance failures with small investors is difficult as well. How are homes transferred to the institutional sponsor of the deal if the small investor fails to keep up the property? The small investor, the institutional sponsor and the rating agency must work out a process for this scenario, a particular challenge when the institutional sponsor does not have other properties in the geographic area.
The bottom line: While there will be many more deals backed by institutional purchases like those that have already been made, there will be a very limited number of deals backed by loans to smaller investors. As a result, the scope for single- family rental securitizations is more limited than many predict and unlikely to grow beyond much $20 billion.