Evaluating The Nation’s REO Options

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Evaluating The Nation's REO Options WORD ON THE STREET: An estimated 1 million or more properties will likely pass through real estate owned (REO) inventory in 2011, with another million or so per year expected in both 2012 and 2013.

REO properties are weighing heavily on the market for owner-occupied houses in at least three ways.

First, REO properties increase the total inventory of properties for sale. While the numbers are difficult to measure precisely, we estimate that in the second quarter of 2011, roughly 500,000 to 600,000 of the 2 million vacant homes for sale in the U.S. were REO properties. This extra supply is particularly problematic because demand is quite low. High unemployment and tight credit standards are currently precluding many families from buying homes, and other potential buyers may be staying out of the market due to uncertainty about their incomes.

Even ignoring the potential inventory represented by the large backlog of distressed loans that have not yet been foreclosed upon, the current inventory of existing homes for sale represents approximately nine months of sales compared with a norm of five to six months, suggesting additional pressure on house prices as the market struggles to clear the excess inventory.

Second, the downward pressure on prices is compounded by the high proportion of sales considered to be distressed sales. Currently, around 40% of sales transactions are considered to be distressed sales – that is, short sales or sales of REO properties.

And third, high vacancy rates and the low level of maintenance that often characterize foreclosed properties make a neighborhood a less desirable place to live and thus depress the value of surrounding homes.

In contrast to the market for owner-occupied houses, the market for rental housing has been strengthening of late. For example, apartment rents have turned up in the past year, and vacancy rates on multifamily rental properties have dropped noticeably. The relative strength of the rental market reflects increased demand, as families who are unable or unwilling to purchase homes because of tight mortgage conditions or income uncertainty are renting properties instead.

Rental demand has also been supported by families who have lost their homes to foreclosure. The majority of these families move to rental housing, most commonly to single-family rentals. Unfortunately, these conditions supporting rental demand may persist for some time.

The weak demand in the owner-occupied housing market and the relatively high demand in the rental housing market suggest that transitioning some REO properties to rental housing might benefit both markets. Such conversions might also be in the best interests of lien holders and guarantors if recoveries from renting out properties exceed those from outright sales. Over time, as financing conditions ease and the number of REO properties to be sold declines, the share of properties sold to owner-occupants and sold to investors for rental will adjust commensurately.

Small investors are already converting some foreclosed properties to rental units on a limited scale. Larger-scale conversion, however, has been hindered by at least two factors.

First, managing single-family rental homes is expensive, unless the properties are concentrated within a geographic area and investors can be certain of acquiring a critical mass of properties. Second, regulatory guidance and standard servicing practices have typically encouraged the government-sponsored enterprises (GSEs), the Federal Housing Administration (FHA), servicers and financial institutions to actively market REO properties for sale and to consider rentals only as a short-term income generator while the properties are being marketed.

In August, the Federal Housing Finance Agency (FHFA), working with the Treasury Department and the Department of Housing and Urban Development, issued a request for information seeking ideas for the disposition of REO owned by Fannie Mae, Freddie Mac and the FHA, including ideas for turning these properties into rental housing. Together, the GSEs and the FHA hold about half of the outstanding REO inventory and so may be able to aggregate enough properties to facilitate a cost-effective rental program in many markets.

In thinking through how a rental program might be structured, I want to highlight three possible design considerations.

First, as I noted earlier, achieving a cost-effective program may require obtaining a critical mass of properties – perhaps a couple hundred or more – within a limited geographic area. In this respect, the comparative advantage of government is in solving the aggregation problem.

The combined portfolios of the GSEs and the FHA are large enough to achieve the necessary scale in a number of markets. However, the structuring of such a program might require the flexibility for a pooling entity to acquire properties from more than one seller or to contract for the acquisition of a minimum number of properties over time. With such flexibility, the scale potential of the GSE-FHA portfolios could be supplemented with properties from servicer or financial institution portfolios.

Second, it is important to ensure that such rental conversions are executed in a responsible manner and in the best interests of renters and local communities. Replacing the blight of a foreclosed home with the blight of a rundown rental property would provide little assistance to the affected neighborhoods. Examining how best to ensure that landlords keep their properties well maintained will be crucial.

Third, in many markets, house prices have fallen to such an extent that better recoveries may result from renting properties rather than selling them. However, in other markets, converting REO properties to rentals may not be in the narrow best interest of financial institutions or mortgage investors but may be in the best interest of local communities. For these markets, it may be useful to consider the possible role of new incentives and, if so, what form those incentives might take.

While existing statutes and regulations do not prohibit financial institutions from renting REO properties, supervisors encourage sales as the primary disposition tool. In light of the relative weakness of the owner-occupied market and strength of the rental market, along with the potential for a GSE-FHA program to solve the problem of insufficient scale in some markets, conditions are unusual enough that it might also make economic sense to clarify existing expectations to recognize that, in some cases, converting a portion of residential REO to rentals may be a reasonable option for financial institutions.

Depending upon the conditions in their individual markets, I believe having such an option could allow for better outcomes for institutions – that is, a superior net present value compared with traditional disposition approaches – and could, at the same time, contribute to market healing.

However, to be effective in promoting better outcomes, such an approach would require supervisors to clarify current supervisory guidance to address how existing standards might apply to the valuation of real estate converted to rental, the time limits applicable to such holdings and other aspects of managing those properties.

Financial institutions with large portfolios might be able to achieve scale in some markets on their own or possibly leverage the scale of a GSE-FHA program if such a program was created. Smaller institutions should also have the flexibility to act in accordance with the conditions in their local markets.

Responsible REO management

In addition to the consideration of conversion strategies at significant scale, there are steps that all REO holders can take today to ensure that they are not contributing further to the problems. They can and should make sure that they are adequately monitoring any third-party vendors with which they contract to maintain, market or sell REO properties. Certainly, the recent interagency review of servicers revealed the severe consequences that can result from failing to monitor third-party vendors.

Before converting REO properties to rental, REO holders could also consider ‘first look’ types of programs to enable owner-occupants, public entities and nonprofits windows of time to bid on available properties. A number of institutions have used such programs with successful results. And REO holders who sell large numbers of properties to investors should consider processes, such as those used by the GSEs, to screen and monitor bulk investors to reasonably assess their probable actions regarding maintenance and disposition after acquiring the properties.

Low-value properties

So far, I've talked solely about REO-to-rental as a solution for REO properties. But that's not going to work everywhere. In particular, some properties are too damaged, or otherwise too low-value, to be sold as owner-occupied units or be profitably converted to rental properties. In fact, we estimate that about 5% of properties in the REO inventory of the FHA and the GSEs are appraised at less than $20,000, and in some markets, the share is significantly higher. In many of these cases, the cost to repair or demolish existing structures exceeds their fair market value, and a different type of solution may be needed.

In recent years, local governments and community-based organizations have struggled to counter the effects of foreclosures on neighborhoods. One tool for controlling the temporary condition and ultimate disposition of REO properties is the use of a unique kind of entity known as a land bank.

Land banks are typically public or nonprofit entities created to manage properties not dealt with adequately through the private market. The life span of these entities may be time-limited, with sunset provisions. The notion of a land bank, as opposed to a land trust, is that properties are brought in and moved out of a land bank's portfolio rather than permanently preserved. Using this kind of mechanism, a community can gain control of low-value properties that may otherwise sit vacant and cause problems for the surrounding neighborhood.

Options available for disposing of the properties include physical rehabilitation, some period of rental, sale to new owner-occupants or responsible investors or, in some cases, demolition. Because it likely will take several years for the overhang of vacant homes to be sold, such a strategy would help some communities deal with the short-term crisis and then ultimately allow for the disposition of properties in a manner suitable to local market conditions in the longer term.

While few land banks currently have the resources to operate at significant scale, the land-bank model is one that has shown some success and could help many communities stabilize troubled properties if used more extensively. However, although such an approach holds promise, the current infrastructure for land banks is limited. First, not all states have passed legislation that is needed to permit land banks. Second, this is difficult work, and existing land banks have limited capacity to handle high numbers of properties at a time. More funding and technical assistance would be needed to scale these efforts up to an adequate level.

Of course, new funds are hard to come by in the current fiscal environment, but this appears to be an instance where relatively modest investments have the potential to yield significant benefits, such as reduced crime stemming from vacant properties, lower municipal costs to limit property deterioration or provide services to neighborhoods that are largely vacant, higher property tax revenue derived from property values not being unduly depressed, and other benefits that may be realized.

Elizabeth A. Duke is a governor on the Federal Reserve Board. This article was adapted from a speech Duke gave Sept. 1 before the Federal Reserve Board Policy Forum in Washington, D.C. To read her complete speech, click here.

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