Question for people familiar with reo to rent and hedge fund strategy..

[Thomas Dionne]

Im just trying to figure out if one thing is true about what the hedge funds are doing, I read this 2 weeks ago and cant not think about it...

Everyone has seen how hedge funds in a lot of cases are paying retail rates and accepting lower cap rates. I have heard its because of the following, which if true, I dont see how this isnt a potential problem. I will use even numbers to demonstrate, i dont think they will make margins this good but it illustrates the point easier...

They buy a house for 100k.
They rent the house for 1000.00/mth
They claim that after vacancy and management fees they net 10k a year or 10%
They find a pension fund that wants to buy a security that yields 5% (again, using easy numbers)
Since the house is generating a 10% return, but its getting sold at a price that would generate a 5% return, they just sold the 100k house for 200k.... (10k/year on 200k investment)

I dont think the numbers are that sweet, but as long as the security they create is quoted at returning a rate thats more than the end "pension fund" investor is buying for, they have sold the house for more than they paid for it. If this is done without any regard to the value of the house... this seems bad.

Even if the end pension fund buyer thinks the homes are worth that much, are they confident that we haven't seen a temporary spike in home prices?

Can anybody confirm this or point me to where I can learn more?

[Dion DePaoli]

The description of the security and examples of the yield are not realistic.

First, the Rent-to-Securitization market is brand new. Brand new. As such, the methods to assign a credit grade to the security are not well understood by any rating agency. It is proposed that the first several securities of this nature will likely be issued with no credit rating. The lack of a credit rating is going to make it difficult for pension funds or mutual funds to purchase the issued security, there is minimal rating requirements and investment criteria depending on the investor class.

Additionally, the Sponsor of the security, or the first owner of the assets does not get off with no risk either. They are required to stay in the issue and will likely have to provide some form of guarantee to the bondholders. Conceptually the investor is buying the cashflow from the property not the equity in the property. These first couple issues will likely be or have some short term maturity to them say 2 or 3 years so they can be repositioned in the market after some trial and error.

Two of the bigger more active funds in the space right now are Blackstone and Two Harbors with each less than 2,000 units. A far cry from taking over the market.

The issues these asset pools will face is scalability and economics, specifically the spread between yield and cost of funds. The funds have so much capital under management that the asset accumulation for this 'class' must be large in order for it to have any impact. Not really at that point just yet. Additionally, setting up a security is expensive and an administrative burden. It is not understood yet if this will all work out in favor of the Sponsor and Issuer.

The counterparty investors will likely be simply more private money from private equity and not so much pension or retirement funds or any mutual funds or alike. The ratings, when they do get produced will not be favorable for this type of asset class, likely Baa or worse. There simply is not enough data and so the investment will be considered high risk. As such, the yield the bond offers will have to be high. Much higher than 5% likely closer to 8% or 9%. Also, we are not certain what type of demands the market will make on specific features within the security in order to attract the capital to purchase the bonds.

The legal impact of such a security is also unknown as of yet and could very well be a failure. The equity structure of this type of security could open up the the investor property level risk. How the Sponsor will handle concepts like 3rd party liens or unauthorized property sales or renewal of undermarket rental agreements is unknown. How the Investors will view those topics is also unknown.

I think it is something to keep an eye on but I don't think this is a monster that will really affect too many street level REI folks.