One percent's rental nightmare: How Wall Street scheme blew up in its face

Big Money investors thought they had the perfect plan to buy up rental properties. There was just one huge problem

Published July 9, 2014 8:44PM (EDT)

Jamie Dimon                            (Reuters/Yuri Gripas/<a href=''>xeni4ka</a> via iStock/Photo montage by Salon)
Jamie Dimon (Reuters/Yuri Gripas/xeni4ka via iStock/Photo montage by Salon)

I’ve followed the Wall Street rental scheme for some time. You know the basics by now: Big Money investors decided to buy up all the foreclosed properties their pals at the banks created during the financial crisis, and rent them out to many of the same people who lost their homes. Then, they started selling securities backed by the rental revenue, just like the mortgage-backed securities from the crisis. Profiting off their own failure: It was Wall Street’s perfect plan.

There was just one problem: turns out that institutional investors have no idea how to manage rental properties.

That has become clear through a series of new statistics from early investors, who regarded themselves as the trailblazers of a hot new asset class. For example, nobody has purchased more properties and converted them into rentals than Blackstone, holders of roughly 45,000 nationwide. Invitation Homes, a Blackstone subsidiary, issued the first rental-backed security last November, and just released its first of this year, 2014-SFR1, worth $1 billion and based on 6,537 properties in selected markets, including Phoenix, Atlanta, Sacramento, California, several parts of Florida and Riverside County, California. Yet while these areas have tight housing inventory, vacancies at the Invitation Homes properties have surged.

As of May 31, the vacancy rate for the homes in 2014-SFR1 stood at 7.3 percent, a 33 percent increase over the previous month. It’s not a fluke: Vacancy rates for Invitation Homes’ initial rental-backed security from last year have spiked to a higher-than-expected 8.3 percent.

That doesn’t sound so bad, until you consider that the apartment vacancy rate for the entire United States is 4.1 percent, around half of the Invitation Homes rate. By one study, occupancy in the second quarter of 2014 was at its highest level in 13 years. In fact, we’re in the midst of a rental housing crisis in America, with demand on the rise and not enough supply to meet it. That’s why rental prices have risen consistently, up 3.4 percent over the past year, despite flat wages.

Investors – and their trade-group allies – have pitched single-family homes as a salve for this crisis, bringing more supply online and stabilizing the rental market. But it would be extremely difficult in this environment to put homes out for rent and then see the vacancy rates explode upward. Nevertheless, that’s exactly what’s happening to the properties in Invitation Homes’ rental securitizations. And there are only a couple of possible reasons here, all of them pointing to poor property management. We have plenty of anecdotal information about substandard remodeling, shoddy maintenance and difficulty in contacting managers. The higher relative vacancy rates put some data-driven meat on those bones.

Word is getting around in these communities about the pitfalls of renting from Invitation Homes, leading renters to seek other options. To take one example, in May, a couple in Los Angeles sued Invitation Homes over the slumlike condition of their rental property, which featured mold and rotted plumbing. The couple got sick from the mold, moved out and then could not retrieve their contaminated belongings for months. The company still contacts the couple, demanding back rent for the months when they didn’t occupy the home.

Rep. Mark Takano, who has been one of the few members of Congress to question the Wall Street rental scheme from the start, told Salon that the report of rising vacancy rates “highlights one of the concerns I had with these types of bonds in the first place.” He added, “Just how accurately can these private equity firms predict vacancy rates, and what happens to the bondholders and local communities if rates rise faster than expected?”

The bondholders should be fine – at least some of them. Like mortgage-backed securities, rental securities are purchased in tranches. The senior bondholders in the highest tranches get paid first with the rental revenue streams, while the junior bondholders in the lowest tranches must wait. They get a higher potential reward for taking on more risk, but with vacancy rates growing, they will likely lose money on the deals.

The real losers here are the local communities. If investor purchases put a floor on housing prices, as economists like Dean Baker have suggested, a faltering market where investors bug out will send prices collapsing through that floor. And that’s starting to happen, earlier than previous expectations. Early investors like Waypoint Real Estate are shopping thousands of properties acquired in California to investors, many of them in Rep. Takano’s Riverside County district. Och-Ziff Capital Management and Oaktree Capital already sold off their properties. And the scale of purchases for those staying in the market has slowed. As demand sinks, the housing market suffers in the biggest investor-purchase areas, which could feed back into the local economies and cause a slowdown.

Price reductions obviously have an impact for those who managed to recently purchase homes at the market rate and may now find themselves underwater. But the bigger concern is what happens to those rental properties in a fire sale, and the tenants in them. Under the contracts of the rental-backed securities, if performance falls below a certain level, the entire portfolio goes into default, which may lead to evictions for thousands of renters. The more vacancy rates rise, the closer we get to those performance targets, and policymakers and regulators have not prepared for an uncertain aftermath.

Finally, there is the problem of vacant housing itself. Single-family homes without occupants are prime opportunities for blight, which can wreck entire communities (just ask Detroit). Blight attracts crime and disease, drops property values and creates a vicious cycle where neighbors would rather leave than rehabilitate communities. If the property management companies cannot maintain the properties while they are rented, there’s little hope for the vacant ones.

Investors claimed their rental scheme would prevent the very blight they may now be creating with increases in vacant properties. Rep. Takano pointed out that the Morningstar credit rating agency, even while giving the top tranches of 2014-SFR1 AAA ratings, pointed out that “finding and retaining creditworthy renters could be costly and difficult to forecast.” Takano told Salon, “Now it seems that warning could be true.”

Investors think they’re solving problems with their rental scheme, while earning a profit on the side. But this so-called solution may create additional problems. Renters get abused by bad property management, junior bondholders lose out on their investments, local housing markets get riled by price swings, tenants in the rental properties could face future evictions, and neighbors must live with increasing blight. We don’t yet know if big-time investors are merely going through the growing pains of a new business, or if we’re seeing a vacancy spiral that won’t end. But with numerous dangers, Rep. Mark Takano believes Congress must get ahead of the issue.

“I urge my colleagues and federal regulators to keep a close eye on these bond deals,” Takano told Salon, “to help protect consumers and local communities.”

By David Dayen

David Dayen is a journalist who writes about economics and finance. He is the author of "Chain of Title: How Three Ordinary Americans Uncovered Wall Street’s Great Foreclosure Fraud," winner of the Studs and Ida Terkel Prize, and coauthor of the book "Fat Cat: The Steve Mnuchin Story." He is an investigative fellow with In These Times and contributes to the Intercept, the New Republic and the Los Angeles Times. His work has also appeared in the Nation, the American Prospect, Vice, the Huffington Post and more. He has been a guest on MSNBC, CNN, Bloomberg, Al Jazeera, CNBC, NPR and Pacifica Radio. He lives in Los Angeles.

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