The world of rental real estate may soon expand with the addition of two preposterously large investors, Fannie Mae and Freddie.
Why they want to enter the rental game is very simple: an 8 percent cap rate.
According to a new and much-publicized Federal Reserve white paper, 8 percent is the return which could result from renting foreclosed housing units now owned by Fannie Mae and Freddie Mac. The catch is that the 8 percent capitalization rate is hardly a sure thing — it takes a lot of financial twists and turns to justify the 8 percent figure. No less important, it may be that 8 percent is actually a low estimate — logic suggests that savvy investors may do far better.
In January Federal Reserve Chairman Ben Bernanke sent a white paper to Capitol Hill describing some of the strategies which could be used to ease the foreclosure crisis. One major idea is to rent empty homes now held by Fannie Mae and Freddie Mac.
This is a big deal because an additional one million units are expected to become REOs in both 2012 and 2013, according to the report.
There are substantial attractions to REO rentals — the properties would be occupied and by itself that would mean less vandalism and decay, fewer neighborhood eyesores and actual cash flow to offset ownership costs until the properties can be sold off. To it’s credit, Fannie Mae has had a Deed-for-Lease program in place since 2009, a program which has allowed some defaulted homeowners to stay in their properties as tenants for as long as a year.
How Much Cashflow?
If Fannie Mae and Freddie Mac are going to enter the rental business in a big way than one ought to ask how much they might benefit.
“One method of gauging the profitability of renting a particular property,” says the report, “is to calculate its capitalization rate, or cap rate — the expected annual cash flows from renting the property relative to the price at which the REO property holder could expect to sell it in the owner-occupied market. Preliminary estimates suggest that about two-fifths of Fannie Mae’s REO inventory would have a cap rate above 8 percent — sufficiently high to indicate renting the property might deliver a better loss recovery than selling the property.”
How one get’s an 8 percent cap rate from the explanation above is difficult to understand because the Federal Reserve’s projected rate of return is based on an unknown future price.
The usual standard in real estate is different: According to the Language of Real Estate by attorney John Reilly, the cap rate “is designed to reflect the recapture of the original investment.” Given the same income, the cap rate for a property can differ greatly depending on whether results are compared to the acquisition cost or the final sale price.
In the case of Fannie Mae and Freddie Mac the “original investment” price for a foreclosed property might be seen as the outstanding loan amount plus unpaid interest, lender claims and related fees. In contrast current value reflects only what the property will actually fetch in the marketplace less marketing costs.
For instance, the National Association of Realtors says short sales and foreclosures typically sell at “deep discounts” of perhaps 20 percent. In the second quarter of 2011 RealtyTrac explained that “the average sales price for homes in foreclosure or bank owned was 32 percent below the average sales price of homes not in foreclosure.”
If the real market value of Fannie Mae and Freddie Mac foreclosures is less than the original loan amount it also means the cap rate for investors can be higher — and perhaps a better economic opportunity.
Imagine that a property has an 8 percent cap rate based on an original loan balance of $200,000. To make the mortgage investor whole the property would have to net at least $200,000 at auction but as a short sale or REO it sells for $175,000 — creating a real cap rate of 9.1 percent.
The Federal Reserve’s estimate says that 40 percent of the real estate owned by Fannie Mae and Freddie Mac can yield an 8 percent return. What the other 60 percent would yield, if anything, is unclear.
The Federal Reserve also says there are about 60 metro areas where Fannie Mae and Freddie Mac hold at least 250 units that could be used for rental units. There are some 5,000 REOs in Atlanta while Chicago, Detroit, Phoenix and Los Angeles, each have between 2,000 and 3,000 units.
In metro areas where Fannie Mae and Freddie Mac have large numbers of vacant properties they may be able to gain efficiencies of scale by having one rental office and one set of contractors. Alternatively, a lot of distressed homes in one place are likely to also mean depressed prices. Case-Shiller reports that annual home values as of October were off 11.7 percent in Atlanta, 4.8 percent in Chicago, 5.1 percent in Phoenix and 4.9 percent in Los Angeles. Bucking the trend, Detroit home values rose 2.5 percent.
The Investor Opportunity
We are at a time when home values are generally falling, rental rates are typically rising and mortgage rates are at or near historic lows.
- The Federal Housing Finance Agency says home prices dropped 19.2 percent between April 2007 and October 2011.
- REIS.Inc. says apartment rentals have risen for eight consecutive quarters while vacancy rates have fallen.
- Freddie Mac says 2012 started with 30-year fixed-rate loans which averaged 3.91 percent, “matching its all-time record low.”
Perhaps most importantly, investors can have a very different set of economics when compared with Fannie Mae and Freddie Mac.
“Investors can pick and choose homes with the most favorable locations, markets, pricing and condition — the homes most likely to rent or sell with the best terms,” said RealtyTrac vice president Daren Blomquist. “But while investors cherry-pick the market, REOs and short sales were not chosen by lenders. They are the by-product of loans gone bad and it follows that as a group they will differ from carefully-selected investment properties.”
The conditions which make times so difficult for Fannie Mae and Freddie Mac may well be attractive for outside investors. For instance, the Waypoint Real Estate Group and GI Partners say they will spend up to $1 billion to purchase distressed single-family homes for investment. Carrington Mortgage Services also says it will invest $1 billion to buy foreclosed single-family homes.Not huge apartment buildings. Not undeveloped lots or lake-side communities. Just existing and distressed single-family homes. The kind of local housing open to investors of every size.
Peter G. Miller is syndicated in newspapers nationwide and operates the consumer real estate site, OurBroker.com.