Hedge Fund Watch: How are Funds Impacting your Market and Business?

[Steve Cook]

With plans to spend billions on foreclosures and to convert single family rentals into a new asset class of securities, well-heeled hedge funds are creating both challenges and opportunities for the individual investors and small partnerships that ignited the residential investing boom.

How are hedge funds impacting your market and your business? Help us chronicle how they are changing face of residential real estate.

[Brandon Turner]

Hey Steve - I was actually going to come onto the forums to ask this very question! Great minds think alike! :)

My thoughts: I read somewhere that they estimate 40k-80k foreclosures will be bought up by these hedge funds. Have you heard a number like that? I also believe there are like 3-4 Million foreclosures per year. So, even at full force they aren't putting a huge dent into the situation. (I could be wrong - anyone have thoughts on this?)

Also - we all know that landlording is tough and you have to really get a screaming deal to make it work well and provide good returns. My guess : these hedge funds won't be able to hack it. They'll find their investment is actually making them a loss - and they'll eventually dump all the properties. Just a prediction.

Thoughts?

[Steve Cook]

Hi Brandon!

Thanks for starting things off.

The best and most widely quoted estimate of the size of the hedge fund phenomenon is baed on a report from investment bankers at Keefe Bruyette and Wood. Earlier this year they estmated several dozen investment firms backed by $6 to 8 billion in private equity hedge funds plan to purchase between 40,000 and 80,000 previously foreclosed homes. That's probably six months old and very conservative.

Regarding total foreclosures, there have been 3.9 million completed foreclosures since September 2009. There were 830,000 completed foreclosures in 2011, and through October, we are running 17 percent below last year's level.

In addition to completed foreclosures, there are about 1.3 million properties in the foreclosure inventory.

[Tiger M.]

Steve Cook I have been similarly concerned, see discussion herehttp://www.biggerpockets.com/forums/56/topics/79566-pay-attention-if-you-are-in-the-real-estate-market

[Jake Kucheck]

The purpose of these funds, so far as I can tell, is not to derive yield from direct investment, but instead use the rental projections to sell the underlying assets to risk-averse institutional investors (read the same pension funds and municipalities that got swindled during subprime) at inflated prices.

Quick numerical example:

Buy a house for $200,000 that rents for $2,000/mo. Put in your pro forma that you expect $4,000 to go to vacancy and maintenance annually, and you are left with a 10% annual yield. Then, find an institutional investor willing to use the same pro forma, and take the same asset at a 5% yield, allowing you to sell that same property, having done nothing to it, for $400,000 (a 100% profit). Rinse, lather, repeat.

Of course, we all know that a $2,000/mo rental does NOT always produce $20,000 in NOI, but it doesn't matter, so long as the hedge funds can get their REITs and pension funds to analyze the data in the same incorrect way. Garbage in, garbage out.

My point in all of this is that hedge funds will likely be buying, mostly, what individual investors would have passed on anyway. They may get some smokin deals too... but likely by accident.

[Steve Cook]

Jake,

You make an interesting point. I would add that many of the funds are setting up their own property management subsidiaries to manage the rentals after the assets have been securitized, allowing for additional profits.

Steve

[Chris Clothier]

Jake Kucheck and Steve Cook -

You are both correct and in the Memphis market, one funds plan includes buying properties doing very little work placing a property management company that they control over the properties and selling the monthly cash flow to AIG (that was there state intention, but they gave no indication that this was going to take place).

We have dealt with this the same way we always have. 1. Make fair offers 2. don't over-pay for anything 3. Never back out of a signed contract. There is not a whole lot else you can do. You have to continue to operate the same way you always have just taking more time to make sure you do treat everyone you do business with better than an out of state large fund would. From what we have seen and heard, it is going to be difficult for them to make the return spreads that they were hoping for, but they could have us all fooled. They may only be looking for net 7-9% return and that may be an easy sell to risk-averse institutions.

We have also seen them buying a lot of property that simply doesn't meet the standards of many individual investors and certainly none that we would purchase or sell to investors whose properties we manage.

So we will see ultimately what effect it has on our market.

[Steve Cook]

Chris,

Great to hear from you!

You and I have talked about the competition these funds are creating for small investors, oftem driving up prices.

I just posted an analysis of the latest foreclosure data on the BP Blog. Demand is so strong that foreclosure prices are rising faster than prices of normal properties. Processing is still very slow but there are still 1.3 million foreclosures in the pipeline, about 150% as many as hit the market last year.

We know that those properties are concentrated in judicial states. So will we have a situation where supply is thin in the sand states where most investors and hedge funds are concentrated and a glut in markets like Cleveland, Philadelphia, Akron, Buffalo where inventories haved piled up?

Steve

[John Espinosa]

Guys, this is all great info...

Question,
Since these hedge funds seem to be content with low cap rates, and doing minimal work, whats the outlook on them jumping up the ladder on wholesale buyers lists?

I know of at least one person who has already begun turning properties over quickly to hedge funds.

[Tiger M.]

I read this that give a good idea on how to too look at these guys coming into the markethttp://www.biggerpockets.com/renewsblog/2012/10/22/beat-hedge-fund-buying-real-estate/

[Steve Cook]

John,

Excellent question. I've been wondering the same thing.

In a way, the four REO-to-Rental pilot projects that FHFA just announced are wholesale deals that may foretell the future. These deals involved sales as well as rentals and the companies that won the projects were not traditional property managers but full-service well-financed operations like Colony Capital. By the way, Colony announced today it is raising another $150 million to buy foreclosures.

I wouldn't be surprised to see more lenders doing wholesale deals if they aren't already.

Pluses: Lenders get a lot of properties off their books and save on marketing and carrying costs. There is no negative impact on local housing markets. Hedge funds get a lot of properties in a single location at a good price and reduced acquisition costs.

Negatives: Individual investors and first-time buyers never see these deals.

Steve

[Callum K.]

As a buy-and-hold investor, this topic once scared me, however for some reason I am led to believe that this influx of cash is influencing the RE market rebound more than we might realize. I know all of my properties have increased in value by at least 10% in the past 6-9 months and I know the economy has not improved all that much so it shouldn't be impacted by more employed people seeking homes like it was in the early 2000's. If my assumption is correct and there are now large pools of money coming in that are not interested in the industry as a whole but is more keen on a quick buck. The people I would like to hear from are the property managers. If they are seeing lots of business recently from funds or large portfolios then that tells me that we are talking about more rentals and less owner occupied. This will in turn drive down rental rates but increase home values. If all this is true, then perhaps in the next few years the solution will be best to get out of home rentals and into property management for a few years. I'd say the time to act isn't now, but I am certainly interested to see what/how these hedge funds move.

I have several friends who work for hedge funds and I know their ability to move cash around is much quicker than most. So much cash creates unprecedented liquidity that allows them to get in and get out and leaves the rest of us hanging.

Very interesting topic!

[Jonny S.]

The Hedge Funds are all over Los Angeles county. As a wholesaler, I am taking on the philosophy of if you can't beat 'em then join 'em.

I did some research and got in contact with some of the acquisition heads and have been wholesaling direct to them for the most part. They have deep pockets and are hungry for properties.

In fact one of them even went as far as saying "throw away your buyer's list and sell everything to us."

Just have to adapt and change with the market I guess.

[Mark H.]

I think it's easy to forget that not every American amasses much wealth over time. With divorce, job loss, forced retirements, etc - it isn't just "first time buyers" who are getting priced out of the housing market by speculation like this. In my area, anything under $150k is getting multiple bids, and we have a lot of 40-50-60 somethings that are being forced to rent, even though they would save money by buying.

[Albert Hasson]

I have heard that a combination of increased prices (25% past year) and greatly diminished REO inventory has sent the institutional investors packing here in Phoenix. Would be interested to know if anyone else in the area is seeing this or heard this.

[Brian Burke]

If you really dig into all of the announcements, plans, and hype, three seems to be about $8 billion going into play. Some estimates of remaining shadow inventory by respected analysts are as high as $840 billion. That means that capital is coming into play to capture ONE percent of the potential opportunity.

The bulk of the larger groups in this space operate the same way. They buy in the same areas, they buy the same types of properties, they underwrite the same way, and run their operations in a similar manner.

They are much less concerned with rental yield than buying as many houses as possible, as fast as possible. They underwrite to 5-7% net yield, which in many markets calculates to prices that actually exceed market value. The whole game is a macro play on housing prices, and it carries very high pricing risk.

In order for these groups to simply break even, housing prices must rise at least 20% to cover their exit and renovation cost. Simply, it's just not a good model.

It's not all bad news. Despite having to compete against more than one of these groups in my areas, I'm still able to get robust deal flow. Increasing my price bracket for flips allows me to operate outside of their influence. In lower price brackets, I'm still able to get a lot of houses that have enough margin to flip, but don't meet my metrics to hold as a rental because the yield is too low for me (even at wholesale price). The funny thing is, the large funds buy most of them from me after flipping them, at retail price. Go figure. They have also raised the value of my rental portfolio. I knew these guys were coming, and I told all of my investors that would be exactly what would happen...

Finally, Steve commented about the REO-to-rental pilots. I was a qualified bidder on the 2,500-house FNMA pool sale earlier this year. Ultimately, I chose not to bid because as I was underwriting the assets of one of three sub-pools that I was interested in, I could see a lot of issues with the assets that I found less than thrilling, and I could see the handwriting on the wall as to where the bidding was headed. All I can say is that all of the talk about this program and its effect on the RE market and individual investors was coming from sources that were forming their opinions without knowing the facts. It is not a threat to those of us that typically operate in a one-off strategy, whether homeowner or investor.

The bottom line: the landscape is changing, but it always does. Being a real estate investor is like sailing a boat in a stream that winds through a meadow. If you try to sail in a straight line, you will run aground. You have to shift course to stay afloat. Change up your strategy to react to the changing landscape. Use some creativity, and you will be just fine.

[Steve Cook]

Brian;

Thanks for your excellent comments. You make some points I hadn't considered, especially the inflationary effect they are having on various aspects of the business.

I was interviewed by NPR's Marketplace Monday and the reporter's final question addressed how I saw this playng out. I wish I had chatted with you first!

One of the big unanswered questions is the how important the securitizing of rental contracts will be to these funds. What do you think will happen if a secondary market does not develop in the next two or three years... or maybe never?

One source told me he thought half the funds would fold if they cant securitize their rentals. Following the cautionary statements by the ratings firms. at least one, the Och-Ziff Capital Management Group LLC, a $31 billion hedge fund, has announced it is pulling out. Others are getting budge financing from a grouo of investment banks to stay in the game.

Steve

[Eric L.]

Great discussion. One of the hardest questions I had to answer before investing in buy and hold real estate was, "Why isn't there a Walmart of rentals?" Real estate is by far the largest consumer expense, so if someone could figure this out they could create the next Walmart or even Standard Oil.

Surely, property management was the answer, but property management is really just like any other business. It simply takes processes to manage a real estate portfolio. There are home warranty companies that operate nationally. They have maintenance contacts in every city and if you have an issue, you go online, explain the problem, and the plumbing company they contracted with for that city comes out, goes through the process and fixes the problem accordingly. Property management seems to be a hurdle, but one that could be easily jumped.

Surely some of these hedge funds will be pumping and dumping, but is this the start of a trend? Will there be large corporations in five years that will turn into brand names buying and holding these properties across the county?

[Mark H.]

Originally posted by Eric L.:
Great discussion. One of the hardest questions I had to answer before investing in buy and hold real estate was, "Why isn't there a Walmart of rentals?" Real estate is by far the largest consumer expense, so if someone could figure this out they could create the next Walmart or even Standard Oil.

Surely, property management was the answer, but property management is really just like any other business. It simply takes processes to manage a real estate portfolio. There are home warranty companies that operate nationally. They have maintenance contacts in every city and if you have an issue, you go online, explain the problem, and the plumbing company they contracted with for that city comes out, goes through the process and fixes the problem accordingly. Property management seems to be a hurdle, but one that could be easily jumped.

Surely some of these hedge funds will be pumping and dumping, but is this the start of a trend? Will there be large corporations in five years that will turn into brand names buying and holding these properties across the county?

Those national warranty companies have terrible reputations. Managing repairs can't be done remotely - if you look at auto dealerships as a model, they have "zone" reps to minimize the fraud and the graft - the home repair business is going to be harder to manage by a factor of ten at the least. There are national players in some categories of home repair that do an *adequate* (but not a great) job in their specialty, but they cost a lot more than the local guys.

In tenant-friendly states, creating a repair bureaucracy will lead to a massive set of unintended consequences. The temptation to juice the returns by selecting the low-cost supplier will be unbearable. Big businesses & hedge funds can't see past the next quarterly statement, so the idea of a "wall mart" landlord/property manager is going to be an unmitigated disaster for the tenants and whomever is fronting their cash. No doubt the pig-men will collect massive bonuses for all of their "financial innovation", yet again.

[Mike V.]

I would love to know how to get in touch with these hedge funds if they are going to be [potentially] buying properties form wholesalers. I don't know much about them, but if they would be interested in being on my buyer's list, I'd look at them. I'm not a guru or anything -- really starting out, so my buyer's list is very, very slim. Any clues as to how to get in with the buying fund managers?

[Steve Cook]

Hi Mike,

I find them just by Googling. They are not shy people and they put out news releases to attract folks like you.

As a matter of fact, I got a news release from one in Chicago this morning. I know that's a but of a distance from you but if you send me a message through BP I will be glad to sent it to you.

Steve

[Luis Castillo]

Sales will be great for a little while because they are taking all the inventory off the market. However, in seven years when these guys start unloading all these properties all the flippers are going to get caught with there pants down. They'll start unloading at below market prices and you will either have to lower your prices to compete or get stuck holding your inventory for years.

Luckily this problem will only be in certain areas. They are national but from what I hear they're targeting 10-15 cities.

Enjoy the good times while they last but make sure you have an exit strategy when the stuff hits the fan.

[Perry Apawu]

From what I am seeing, is that everybody just needs to keep there eyes on the market and adjust accordingly, keep a great exit strategy, and in the words of Robert Kiyosaki mind your own business, because worrying about the big guys and their billions of dollars is something that is far out of any individual investors controls !!!!

[Brian Burke]

Steve,

The funds won't fold if securitization falls off the table. They have multiple exit strategies, including rolling up into a REIT, taking the venture public via an IPO, bulk sales to other groups, and one-off sales to end users. They evaluated all of their options before they got into this. Different groups have different preferences from that list of options, but they are all on the table.

Yes, it is true that Och-Ziff decided to exit, and reports were that they weren't hitting their targets. That is likely true. Och-Ziff was one of the first groups in this space, and back when they got in, everyone was underwriting to mid 20s to low 30s IRR. Of course they weren't going to hit that. They had one more motivating factor to exit however: their assets had appreciated in value! If they exit early, they could get close to their target IRR because of the capital appreciation. If they hung out for a few years, as originally planned, their IRR would start to dilute. They HAD to get out. Groups are now underwriting to IRRs in the teens and have lowered their cost of capital.

It is also true that these groups are starting to obtain large allocations of debt financing. It's not because they are trying to stay in the game, it was the plan all along to employ leverage once it became available. There are a few banks coming online with product to accommodate this model.

[Brian Burke]

Mike V., you get in touch with these groups by finding the local real estate agents that are representing them. They have gone out to each market and identified a few agents to be their "buyers agents" and scout for property. For me, it was pretty easy to find them because they found me. It started by noticing who was writing offers for them on my flips, then it progressed to getting phone calls from them asking to buy anything and everything I have.

Call a couple of REO agents in your area and ask them who is writing offers on their listings. Chances are they will be well aware of who the players are. I wouldn't bother trying to call the hedge funds directly, unless you own a large portfolio of homes you want to sell, they won't want to talk to you...they'll direct you to talk to their agent if you can get them on the phone at all.

[Marc Bodinger]

Steve,

I was under the impression that hedge funds/private equity were thousands of properties at a time in these portfolio sales? I do not know the numbers off hand but finance news makes it seem like these firms are on a shopping spree especially in the hardest hit areas from the housing bubble.