REO Conversion To Rental Is A Clear Negative For The Housing Market

bridgeport CT foreclosure

Photo: Getty Images

People are brainwashed to think foreclosures are a bad thing for the housing market. Perhaps four years ago when a million loans all went into default & Foreclosure at the same time but not today. Today, 1st timers and investors — with an insatiable appetite for foreclosures, Real estate owned (REO) resales and short sales — are the bedrock of this housing market. I do not believe we can have a healthy housing market until the mistakes of the bubble years are undone and the can kicking comes to an end.I don’t follow the logic of “Foreclosure prevention” as a positive for housing, particularly mortgage mods or bulk REO-to-rent schemes. Both are just another form of can-kicking that will hurt and housing and mortgage markets on pay back.  There are always unintended and unseen consequences.

On an REO-to-Rental Scheme…

Before I begin with the facts…

Ask yourself one question… Would you pay more for a house next door to a slightly rehabbed REO turned rental? Or, for a house next door to a former REO purchased by an investor then fully rehabbed and resold to an owner occupant who actively maintains the property.

Ask yourself another question… given your house value depends on comparable sales, what increases your house value more? (The choice is clear…renting REO’s is a huge weight on house prices.)

a) An REO next door to you bought by a large institutional investor for a steep discount who then rents it? (this produces a much lower comparable)

b) A REO that was previously bought for a steep discount then rehabbed and sold at the highest price in the neighbourhood. (this produces a lower comparable then a sky high comparable. Plus it permanently solves the problem)

c) Which brings in higher tax revenue to the community?

Perhaps this is all a part of a big plan…perhaps this whole institutional investor REO-to-rent scheme is being put into place as a backstop in order to manage an avalanche of Foreclosures ready to hit in 2012 from the mountain of late stage defaults and modification redefaults presently in the pipe. If this is the case, it is long-term positive mortgage and housing, as the bubble toxic loans left over would be clearing sooner, but obviously more negative house prices and alike while the flush was occurring.

For the purposes of this note, let’s pretend they are not that forward looking and the REO-to-rent scheme is because they really think Foreclosures are bad for the housing market (and they really want to help out the builders).

1) Few realise that:

a) Foreclosures and distressed sales INCREASE neighbourhood house values and create a positive economic benefit when investors buy low, rehab and resell higher. Moreover, rehabs create jobs and the resale makes for TWO existing home sales transactions, commissions etc in a short period of time. Lastly, they make for a substantial increase in property tax revenue on rehab and final resale.

b) Foreclosures and distresses sales BENEFIT the neighbourhood and local area economy when they are sold to an owner-occupant who purchased in the open market and then rehabs, maintains and occupies.

c) Foreclosures and distressed sales LOWER neighbourhood house values and create little economic benefit when they are sold to professional investors at below market prices who turn around and rent them. Moreover, rental houses are always the worst maintained in the neighbourhood and decrease the values of houses in their immediate area. Lastly, these transactions are a huge drag on property tax revenue.

d) Due to epidemic effective negative equity (not having enough equity to pay a Realtor and put a down payment on a new house) the repeat buyer cohort has been cut in half since 2007. They are now make up the minority of national resales. Investors and 1st time buyers ARE the real estate market. Investors and 1st timers want REO and short sales. Anything done to prevent the flow of distressed property will hurt the volume of existing home sales and all of the economic benefit that comes along with them. An REO-to-rent program will bring about record lows in monthly Existing Home Sales volume. And volume precedes price.

e) Lastly, there is more than enough demand for distressed real estate by 1st timers and investors to absorb multiples of the supply presently on the market. The back log in REO resales is not about demand, its more about financial institutions willingness to accept losses and further kick the can.

2) Bulk REO-to-rent housing market and macro negatives:

a) 1st timers and investors now make up the foundation for the housing markets most in need to help (i.e., AZ, CA, FL, NV etc). They will go away if distressed inventory goes away or if they have to compete / dig through the leftovers of big, institutional investors. Without 1st timers and smaller investors, vital real estate markets around the nation will die (i.e, 65% of all sales in the Sacramento CA region are distressed)

b) 1st timers and investors want distressed properties (REO and short sales) at low prices. They underpin the market. REO and short sales are what is in demand

c) 1st timers and investors will not pay more for houses if distressed inventory goes away…in the new era housing market, particularly at the low end, house prices are more a function of local area incomes and not the property, house or rental returns

d) Organic (repeat buyers), who throughout history have controlled the market, will not come back for years due to epidemic effective negative equity preventing them from being able to sell (pay a Realtor 6% and put a 10% to 20% down payment on a new property) and rebuy.

e) Foreclosures and distressed sales INCREASE neighbourhood house values and create a positive economic benefit when investors buy low, rehab and resell higher. Moreover, rehabs create jobs and the resale makes for TWO existing home sales transactions, commissions etc in a short period of time

f) Foreclosures and distresses sales BENEFIT the neighbourhood and local area economy when they are sold to an owner-occupant who purchased in the open market and then rehabs, maintains and occupies.

g) Foreclosures and distressed sales ONLY LOWER neighbourhood house values and create little economic benefit when they are sold to professional investors at below market prices who turn around and rent them.

h) Institutional bulk REO-to-rent investors will not spend the time and money improving properties to the same extent a private investor looking to resell or rent will. Moreover, rental houses are always the worst maintained in the neighbourhood and decrease the values of houses in their immediate area

i) There is more than enough demand for 3x the distressed sales that presently occur on a house by house basis through the Realtor network but the banks and servicers meter the asset sales so as to manage losses

j) Existing home sales will plummet to record low levels without distressed resales. In fact, a private investor that buy REO to rehab and resell account for two existing sales transactions on the same property within a short period of time. I can’t imagine that NAR is in favour of an REO-to-rent plan

k) HALF of California existing home sales would disappear without distressed inventory and sales. That would be an economic disaster

l) If distressed sales (REO + Short Sales) make up the majority of sales in these markets, any plan to do away with them will do away with THE market. 

m) Smaller investors who have been buying distressed property to rent for the past few years will be sellers all at once knowing big, institutional investors buying bulk REO to rent will drive their rental returns much lower. 

n) What happens in 3 to 5 years when all these institutional investors want to sell all these beaten up rentals at the same time?

o) Based on our research, 12 to 15mm foreclosures and short sales will occur from bubble years lending. To date there has been less than 5mm. The market has only begun the clearing process and demand is there for a much greater volume of loans and houses to clear over the next three to 10 years. A bulk REO-to-rent program prevents the natural clearing process that is well underway. 

3)  The best, easiest and quickest way to clear foreclosures is for the servicers to price them to sell at the courthouse steps.

That’s because when a house sells at the steps they don’t count as comparable sales for the purpose of appraisal valuation. Moreover, investors who buy these generally fix up and resell bringing surrounding house values up in the process. The courthouse steps auction process has been in place forever and has gone from 5% of all Foreclosures to nearly 30% in CA over the past few years. This works. It seems to me that a law mandating that servicers can’t hold foreclosures for longer than 90 days would prompt them to use the courthouse steps as a primary method of liquidation. Lastly, courthouse steps 3rd party foreclosure sales make for a substantial increase in property tax revenue on rehab and final resale.

4) One positive is that this kill rent prices and keep CPI tame for years, which is probably a big part of the plan.

5) An example of how distressed sales ARE the market in CA.

If all the distressed sales (red) were to go away the real estate market — and all ancillary sectors — would grind to a virtual stand-still.

 

 

6) But, then again, a bulk REO-to-rental scheme is most likely a non-starter anyway

Finally, let’s put all of this into perspective using my proprietary default & Foreclosure database because based on the massive volume of distressed in the default & Foreclosure pipe ready to hit the market in 2012 bulk REO-to-rent is really a non-starter.

So, the media and investors are all giddy by big named investors chattering about buying a whopping $1 billion bulk REO buy. If a $1bb deal like this was closed tomorrow that leaves $64bb in real estate valuation in Q4’11 in the state of CA alone jammed into the default & Foreclosure pipe to be absorbed.

In Q4’11 in CA alone…

a) $43.1bb in house valuations were issued a legal Notice-of-Default or Notice-of-Trustee Sale (investors can’t make a dent in this)

b) $6.9bb were taken back as REO (investors could dent this. In fact, the NOD/NTS to REO ratio being so large (REO Small relative to defaults) shows the extent of can-kicking and how the can has been kicked right into a huge brick wall)

c) $2.4bb were sold to investors at the courthouse steps waiving cashiers checks (the ultimate solution for Foreclosures)

d) $14.8bb were kicked down the road via new-vintage, higher leverage worse than Subprime loans (otherwise known as mortgage mods) of which 80% will come back around within 24 months.

DISCLAIMER:  This message and attachments are for the sole use of the addressee and are privileged, confidential and exempt from disclosure. If you are not the addressee, copying, dissemination, or distribution of this communication is strictly prohibited. You must delete the e mail and destroy any copies. In publishing research, Hanson Advisors and MAHA, Inc (the Company) is not soliciting any action based upon it.  The Company’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, the Company does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing in the Company’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither the Company nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, the Company and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate.  The Company is not liable for any loss or damage resulting from the use of its product.  The Company is CA Corp registered in the state of CA.

This post originally appeared at MHanson.com

NOW WATCH: Money & Markets videos

Want to read a more in-depth view on the trends influencing Australian business and the global economy? BI / Research is designed to help executives and industry leaders understand the major challenges and opportunities for industry, technology, strategy and the economy in the future. Sign up for free at research.businessinsider.com.au.