A Waiting Game In REO Asset Management

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REQUIRED READING: As of mid-March, companies handling the management and disposition of real estate owned properties (REOs) found themselves asking the same question as they were in the last quarter of 2010: Where's the inventory?

Last fall's robo-signing debacle served as a catalyst for not only internal procedural reviews by servicers, but also new judicial requirements that pushed out foreclosure timelines in certain states. These developments, coupled with the foreclosure moratoria that typically accompany the holiday season, have created a massive backlog of loans and properties that many people predict are ultimately headed for REO.

The pace at which the pipeline clears depends on pre-foreclosure activities, and those – as with all macro discussions in servicing today – hinge, to some degree, on the ongoing negotiations between regulators and the industry. No one appears ready to estimate how many loans will be affected by the settlement expected to be brokered among state attorneys general, federal agencies and servicers.

"We've got a number of customers who are confident the work is out there, but no one's really certain when it's going to hit," says Keith Murray, CEO of Vendor Resource Management. "I thought we would have seen it by now, to be honest with you."

After new authorizations abruptly dropped off in the fourth quarter of 2010, many asset managers expected volumes to begin picking up in the first quarter of this year. While levels have risen slightly, they are, by and large, nowhere near the levels that most had anticipated. The release now appears likely to occur in the second quarter – that is, barring no major surprises, asset managers say.

Although REO volumes may be down in absolute terms, distressed properties are constituting an ever-larger portion of the marketplace. Overall home-sales transactions have fallen, but the REO proportion of all is on the rise, says Alex Villacorta, director of research and analytics for Clear Capital.

In early 2009, when REO levels peaked and home prices plunged, some Sand State markets were experiencing REO saturation rates of nearly 55%, he says. Today, the saturation rate in those markets is closer to 40%.

"For every peak in REO saturation we see, it's corresponding with a trough in home prices pretty remarkably over the last three to four years," Villacorta says. The upward trend in REO saturation, though progressing at a much slower rate than what happened two years ago, is "the disturbing part," he adds.

Improving conditions

While the outlook, at least on the surface, appears relatively stormy, there is reason to believe the eventual release of REOs, if and when it does occur, will have much different characteristics this time around. For one, the properties that are going through the foreclosure process nowadays are in relatively good condition when they reach REO. That factor could help steer pricing strategies away from a deep-discount, race-to-the-bottom mentality.

Servicers and lenders have improved in terms of protecting assets prior to
foreclosure, according to Michael Harris, president of Stewart Asset Recovery. Servicers are reacting more quickly and taking possession of properties when warranted, he says. Furthermore, servicers are also inspecting properties, pre-foreclosure, on a more regular basis, which results in better-conditioned REOs.

Timelines undoubtedly remain prolonged – the average loan in foreclosure has not made a payment in more than 500 days, according to the latest data from Lender Processing Services. But the lengthening process coincides with an increased awareness among mortgagors of their rights to remain in properties until ownership is officially transferred back to the servicer (or after the transfer, in some tenant situations). Occupied properties, of course, deteriorate much more slowly than vacancies.

Greater consumer awareness of cash-for-keys deals has also led to the improved condition of properties that hit REO.

"We've always had a good success rate with cash-for-keys, and I think it's been even better in the last six to 12 months," says Candice Miller, president of Goodman Dean. "Borrowers know that in exchange for relocation assistance, they must leave the property in fair condition – broom-clean, appliances and fixtures intact, etc."

Servicers are weaving in new strategies when pursuing cash-for-keys transactions. These strategies include doling out more money and taking a more flexible stance on transitioning borrowers out of homes. While it used to be that the compensation amount would correlate directly with the speed at which the occupant exited the premises, Fannie Mae and Freddie Mac, as well as lenders, are piloting leaseback programs that allow softer timelines, Harris says. A social-services component is also increasingly involved with cash-for-keys: Harris compares it to "destination services" that companies provide to employees who go through job-related relocation.

"With this trend of lenders and servicers offering more and more aggressive relocation assistance, the number of actual eviction activities are decreasing, because we're able to effectively negotiate with the borrower," he says. Aggressive negotiating may be a necessity, considering the higher rates of occupied properties that flow Stewart's way. Historically, no more than 15% of the assets that reach the company's REO book of business were occupied, either by a borrower or a tenant. Today, that level is closer to 25%, Harris estimates.

As-is, repair or rehab?

By most accounts, the decision of how much capital to invest in fixing up REOs varies from one shop's department to the next. Repair trends "swing wildly," says Miller.

"In the past two years, two major clients of ours have flip-flopped policies: One went from an as-is to repair strategy, and the other went the reverse direction," she says. "It depends on each servicer, who's managing the portfolio and what their opinion is of the best marketing strategy."

Murray estimates that servicers' willingness to repair has been upped by about 10% over the last year, while Harris says the number of pure capital repairs "has gone down dramatically" in the last three years.

Servicers are obviously reluctant to invest in properties located in high-vandalism areas, and investment strategies tend to tie back to the overall conditions of the market in which a property resides. However, asset managers agree that, with supply levels set to rise and a chief desire of servicers being to sell to owner-occupants (who will both pay more for a property and work harder to close a transaction than would investors), repairs will become more commonplace.

Smaller lenders, particularly anxious to move the potentially excessive costs of REO maintenance off their books so they can free up cash for origination purposes, have largely employed a "liquidation-type strategy, where they're trying to get rid of property more quickly," says Harris. Whereas a quarter of REO assets used to go through some sort of rehab process, the percentage is closer to 5% now, he estimates. Still, he believes the number of repair or rehab programs will rise in the coming months.

"With more exposure to the general public of these assets, servicers will be trying harder to market their REOs to end users, as opposed to investors," Harris says. "Lenders, servicers, the GSEs� they're going to make stronger efforts to rehab to at least [Federal Housing Administration (FHA)] guidelines, if not conventional lending."

Meeting the minimum property-condition guidelines required by the FHA is a valuable proposition to servicers, Harris says, because it expands the buyer pool by making the assets eligible for the agency's 203(k) rehab loan insurance program.

Any opportunity servicers have to increase the number of potential buyers is huge, Murray concurs. "I have concerns, generally, about the availability of financing," he says. "What's sitting out there – the potential changes from a regulatory perspective, via Dodd-Frank, along with the interest-rate environment creeping up – all those things are shrinking the pool of potential purchasers."

The REO dilemma
Clear Capital's Villacorta likens the situation among REO sellers in the early part of 2009 (i.e., the peak of REO saturation) to the classic "prisoner's dilemma" – a game theory in which there are two prisoners and only three possible outcomes: If the prisoners, who recently met and teamed on a crime, remain quiet, they both receive a mild sentence. If one prisoner defects and the other remains silent, the defector goes free, while the silent prisoner receives a harsh punishment. If the prisoners turn on each other, the result is a severe sentence for both.

Put in terms of REO marketing, those that unloaded their REO inventory early on via deep discounts had the potential to come out ahead of the competition while simultaneously distorting market prices for subsequent sellers. What ended up happening, Villacorta says, is that everyone essentially "defected," resulting in a large inventory of low-price REOs. The lessons learned two years ago "should serve as a very fresh reminder that it's not in everybody's best interest to do that," he says.

In turn, the strong correlation between high REO levels and low overall prices appears only natural. Fair-market homes, especially in heavily distressed markets, must price themselves closer to the REO inventory, which, in the case of certain Sand State markets circa first-quarter 2009, made up the lion's share of for-sale properties.

"It's a great thing if you can have the best price out there, because buyers will look at your place first, but I think so much more is involved than just having the most aggressive price," says Miller. She describes Goodman Dean's servicer clients as "very price-sensitive." Servicers are less interested in chasing the market down than they are in pricing inventory properly for its market, condition and the season, she says.

"For us, the view is the conditions related to the loan that resulted in the default have nothing to do with the property," adds Murray. "We don't generally go to market with the strategy of discounting it just because it's an REO asset."

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