You’d think that investors would run away from a new Wall Street innovation as fast as Congress runs away from a good idea. But instead, they’re flocking to the latest product peddled by large banking interests, even though they look almost exactly like the mortgage-backed securities that were a primary driver of the financial crisis. These new securities, backed by rental payments, also have real-world implications for millions of renters, who could end up turning in their monthly checks to Wall Street-based absentee slumlords.
Over the past couple of years, private equity firms and hedge funds have bought up over 200,000 single-family homes, mostly discounted foreclosed properties in communities wrecked by the housing crash, such as Phoenix, Atlanta, Tampa, Sacramento, Los Angeles and Riverside, Calif. They have spent billions to scoop up these vacant homes at fire-sale prices, renovate them, and rent them out, promising investors double-digit annual returns on the rental revenue. Private equity firms like Blackstone, which owns more than 40,000 single-family homes, think they can build an entirely new asset class out of this scheme, controlling the rental market for single-family homes. The irony is rich: Wall Street created the conditions for millions of foreclosures, then they sweep in to buy up the homes and rent them out, often to the same people they kicked onto the street.
In order for this to work, firms need cash to outbid the competition. So Blackstone teamed with Deutsche Bank, Credit Suisse and JPMorgan Chase to put together the first-ever rental revenue bond, named “Invitation Homes 2013-SFR1.” Basically, Blackstone took out mortgages with the banks on 3,207 of its rental properties, in exchange for $479 million in cash, and they will forward rental payments to the bondholders to pay back the loan.
Blackstone plans to use the $479 million to purchase more homes. This facilitates the single-family rental scheme, by giving firms a fresh source of cheap money to spend on cornering rental markets, wrestling them away from traditional mom-and-pop rental management companies. The entire industry has looked hopefully upon the Blackstone effort as something they can replicate. One investment firm president remarked, “We’re rooting for them.” Investors are eyeing the securities as well: With interest rates still minuscule, they want to invest in something that can guarantee them a higher yield.
Like mortgage-backed securities, the bonds would get sold in tranches, with the senior levels getting rental revenue first, and the junior tranches taking the rest. Rating agencies like Kroll, Morningstar and Moody’s have blessed the deal, presenting the senior tranches with a triple-A rating, essentially labeling it as perfectly safe for investors. You’ll remember that mortgage-backed securities were bestowed triple-A ratings during the housing bubble, and that this spurred massive purchases, fueling demand for more and more home loans to create more securities. You can see the same thing happening in the rental market if these securities catch on. In fact, while the most attractive foreclosed properties have already been snapped up, homebuilders are constructing new properties specifically for single-family rentals. Some analysts are concerned that this gold rush will create a new housing bubble in the communities where Wall Street firms are purchasing homes.
Let me be clear: A rise in renting would not be a bad trend, especially if it created a reasonable alternative to buying a home. The consequences of not paying the rent are certainly lesser than defaulting on a mortgage. And we’ve seen how homeowners have been abused in countless ways. A robust single-family rental market would provide more housing choices in attractive locations. And viable rental options could theoretically put a check on bubbles – if home prices get too high, people will just turn to renting – making overall housing costs more affordable.
Additionally, securitization in the abstract is not necessarily something to fear. When done right, it efficiently allocates capital to productive investment opportunities that could even have social value. For example, the solar power company SolarCity just announced solar securities, which could boost the renewable energy space.
But securitizing rental revenue is beset with unknowns. The rating agency Fitch underscored many of these concerns when they justified their opposition to rating the Blackstone bond.
First, until the financial crisis, Wall Street firms had no record managing rental properties, and it’s unclear whether they would be able to quickly fill vacancies, negotiate local rent laws and handle repairs. Because the purchases are concentrated in a handful of metropolitan regions, local variables (like communities not wanting Wall Street to buy up all the rental properties) could have an outsize impact. And single-family rentals could fare poorly in an economic downturn, if prospective renters lost their jobs and could not afford to live on their own. With Wall Street owning the newly vacant properties, they could react to a downturn by liquidating them to pay back the bondholders. “The impact of a large scale listing at the neighborhood level could have a significant impact on market clearing prices,” Fitch writes; in other words, the market could crash under the weight of the mass sell-off, with an impact far beyond the individual properties. Just as securitization inflated and collapsed the residential housing market, it could do the same for rentals.
The consequences for 14 million single-family renters in America could be worse. Fears that Wall Street firms would try to trim costs by ignoring maintenance and upkeep have so far been realized. As Ben Hallman at the Huffington Post recently detailed, Wall Street-owned rental homes are riddled with mechanical and plumbing problems. The firms basically freshened up foreclosed properties with a coat of paint and rented them out, ignoring serious deficiencies like broken toilets and even vermin infestations. And predictably, the landlords are impossible to reach to get repairs done. “I've been renting homes for 15 years and I've never had a landlord be this ridiculous about getting stuff repaired,” said one renter of Invitation Homes, Blackstone’s single-family rental subsidiary.
The problem mirrors issues that bedeviled securitized mortgages. In that instance, lenders had no concern for the well-being of the homeowners, because they sold off their loans to other investors. Here, Blackstone passes off the day-to-day operations to local property managers, who get paid whether they perform repairs or not. In fact, Wall Street firms apply plenty of pressure to fix up homes cheaply and quickly, to get them in shape for rental and kick-start the monthly payments. So there’s no reason for anyone in the process to care about quality.
Strong tenant laws are supposed to counteract this slumlord misbehavior. But what if investment firms corner the market on rental homes and use political influence to subvert those laws? That’s already happening in places like Huber Heights, Ohio, where Magnetar Capital now owns nearly 10 percent of the homes. They have appealed to the city to cut their property taxes, a windfall that would save Magnetar $1.39 million.
The potential for abuse is high, because there’s so much money on the line. As institutional investors increase their purchases in cities, they muscle out traditional homebuyers for the scarce properties available. And the added market share allows them to be even more brazen. Residents of the largest apartment complex in Manhattan, Stuyvesant Town, are facing large mid-lease rent increases after ownership reverted to CWCapital Asset Management. You can easily see a trend here, as Wall Street firms use their wealth and power to mute opposition from city councils and demand more from renters.
Plus there’s the concern that securitization of rental payments will lead to the same kind of risky, illegal practices we saw with securitization of mortgages. Nobody should welcome a return of innovations like CDOs (where the riskiest tranches get sliced up and repackaged as “safe” securities) or adjustable payments (what if renters were sold “teaser” rates on their monthly payments that reset to prices they couldn’t afford?). And nobody wants to think about the strong-arm tactics that would be applied to force payments out of tenants, regardless of the circumstances. This is a rerun, and the first movie ended rather badly.
If Americans weren’t seduced by the mythical dream of homeownership and turned to renting, that could certainly be positive. But it’s hard to trust that the same financial titans who blew up the economy won’t distort and pervert the rental market to such a degree that people simply looking for a place to live won’t again get squeezed by Wall Street greed.