Hedge Funds and Mayhem

By -

PREFACE FROM TIM: The world is divided neatly into two types of people. Complete Dorks, and SocialTraders. I met the gent below, House of Cards, by way of SocialTrade, and when he saw how much I liked the stuff he was stacking, he wrote and asked if he could write an article for Slope. I told him I'd be delighted for him to do so. It is below, and it's outstanding:

It seems that hedge funds and banks are buying up foreclosed single family homes with the intention of bundling them and securitizing to resell. I think this is a dangerous idea.

Let me start by saying I have always loved real estate and I think owning rental properties is a terrific idea for individual investors in today’s low-yield world.  You can make money four ways:  It provides a steady income stream from rents.  Tenants pay down your mortgage, meaning you can profit further when you sell down the road.  You can use the tax advantages of depreciation and long term capital gains rates.  And it is a great shield against inflation.  I believe you can triple your investment (including after tax and adjusting for inflation) in just ten years (if leveraged: all cash doesn’t work out as well.)  Here’s a real world example from the Pacific Northwest:  A 25 unit, nearly new complex sells for $2,000,000.  Net operating income is $137,000 a year.  With 20% down, a mortgage (10 year term/ 30 year amortization) at 4.5% costs $97,000 a year, leaving an income stream of $40,000/year, tax free due to depreciation write-off.  In 10 years, mortgage will have been paid down $320,000.  If rents follow inflation as they have historically, both income stream and sales price increase, as well.  Show me any other investment that pays the patient investor so well.  A dividend stock paying 3%, on which you have to pay taxes? 

I think most rental properties in this country are still owned by smaller investors, moms and pops (perhaps more well-heeled than average) willing to be patient and care for their properties, building some nice nest eggs.  There are also larger syndications running hundreds or thousands of units.  But the notion of bundling tens of thousands of units in order to slice and dice them into the retail market seems like a pretty recent idea.

There have been many stories about investors with cash scooping up distressed houses in order to rent them out.  Market Sniper claims to have done it.  I personally know people who buy about a house a month, cash.  Hell, I’ve done it myself, but only when it was a screaming deal.  What’s not to love about a bargain?  But even with these investors busily putting up their cash, there is still a huge problem with distressed homes.

10 million
There were 137,000 new foreclosures nationwide in June 2012.  Freddie Mac sold 80,000 REOs in the first nine months of 2011. They currently own approximately 59,000 REOs worth $10.4 billion.  They have received $72 billion from Treasury and have paid back $15 billion.  How many of those billions are being passed on to the hedge fund purchasers of REOs at bargain prices and special deals for volume buys?  How much of that remaining $57 Billion will ever be paid back to the taxpayers?   But I digress.

It appears that hedge funds have bought up much of the supply in certain markets, such as Phoenix, Las Vegas and California.  But in other parts of the country, distressed properties are proliferating.  Do you hear anyone talking about Georgia?  Why not encourage the big money boys to scoop it all up?  Certainly the banks might be willing to collude with bundlers in order to clear their books of REOs.


Now to some numbers: For a $100,000 house, the cost to own and manage as a rental might be relatively more than for an apartment complex.  Real estate tax, landscaping, maintenance and repair, insurance, turnover expense and management costs will probably be more expensive than for a similar priced apartment.  On the other hand, utilities and garbage service would likely be paid by the renter, whereas these are normally two big expenses when running apartments.  Let’s assume that the operating expenses are equal to those of equivalent apartments.  For older apartments with aging components, 50% of gross rents is a common operating expense ratio.  (Newer apartments might operate at 30% of gross rents.)  Assuming equivalent NOI (net operating income), what does that mean in terms of the profitability for renting single family REOs?  At a rent of $1,100 a month, with a 10% vacancy rate, the gross rents might be about $12,000 a year with an NOI of $6,000.   That makes for a cap rate of 6%, on the lower side for most locations nationwide and historically, though some locations are lower.  (Nationwide average cap rates have been between 5% and 12% over the past 30 years.)  This might be optimistic, but it seems like a profitable product, one that investors might want to buy.

So far, it all sounds good.  If the masters of the universe can bundle 100,000 rental homes (just $10 billion) and slice and dice them into securitized and marketable instruments, they can off-load them onto the retail market (after they take their tasty commissions and bonuses, of course).  I’m sure they can find ways to leverage it up and jack up the returns to allow for more profit plundering for themselves, but I’ll just keep this simple. 

So what can go wrong?  Won’t Freddie Mac be happy these guys are taking all the REOs off their hands?  Won’t we all be grateful that they are working down the number of distressed properties and thereby saving the housing market?  Won’t the banks be doing God’s work?  After all, look at all that inventory out there.


And that’s just the REOs.  What about all of the shadow inventory?  About 1.5 million homes nationwide are distressed.


One problem I can imagine is that this influx of rental properties might have a negative effect on rental rates in markets saturated with SFR rentals.  Nationwide on average 15% of single family residences are rentals.  In parts of California, that number has grown to 24% (doubling in ten years.)  If hedge funds and big bank operators focus on the markets in Nevada, Florida, Arizona and California, as they seem to have been doing in the past couple of years, then the owners of apartments in those markets could be forced to lower their rents in order to compete, or they could have higher vacancy rates; either way is a recipe for a lower valuation of their property, which is always based on NOI.  This has always been a problem in the past when new construction of apartments got carried away.  If 100,000 new units are being built this year nationwide, what will be the effect of another 100,000 SFRs competing, as well?  For apartment owners operating on thin margins this could spell doom.  Couple that with an environment in which costs are rising (real estate taxes being raised by local governments in trouble, rising utility rates, etc.) and income that is stagnant due to renters who are unable to afford an increase in rent because of continued unemployment and concentration of wealth away from them, and soon some apartment owners won’t be able to make their mortgage payments.  

And what happens if someone gets the bright idea to buy and securitize apartment complexes, as well?  Initially, prices might go up due to a feeding frenzy over available units.  But the values of rental properties are based on NOI, and if prices go up and rents can’t, that just means that margins are reduced, making them riper for failure.

This could be the housing bust phase two.  Banks already screwed up two thirds of the residential market, for years to come.  What if they have a similar effect on the remaining and fairly unscathed one third of residential that is the rental market? 

Banks have shown they care only for profits.  When they sliced and diced mortgages, no one could figure out who owned what anymore.  What kind of havoc might they play on rental properties, which are more demanding than mere collectible notes; they require management, repair, capital expenditures… These are huge numbers of potential future underwater properties.  More bank losses, more bailouts, more bad debt thrown into the vortex.  How does that scenario play out in our financial future?

Thanks for listening to me fret, and best of luck to all you Slopers.

House of Cards