REQUIRED READING: A confluence of factors has positioned pre- and post-foreclosure rental and lease strategies as appealing options for servicers.
Last May's federal Protecting Tenants at Foreclosure Act (PTFA), decried by many in the industry as well intentioned but poorly drafted, does not consider the honoring of tenants' bona-fide leases an option, but rather a requirement. But the legislation, by forcing servicers into a landlord-type role, has redefined the constantly changing loan-servicer job description. The PTFA has introduced a host of compliance concerns for servicers, but it has also been a boon for the property management space. As financial institutions' legal departments digested the unwieldy legislation, vendors crafted service offerings specifically designed for it.
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"The legislation that came forth on May 20 has resulted in different and creative thinking for all those individuals with tenants in homes," says Paul Hayman, president of TenantAccess, a property management company. "It's been painful, but a good thing."
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Another major development came in early November, when Fannie Mae introduced its Deed-For-Lease Program (D4L), which allows qualified tenants and former owners the chance to stay in recently foreclosed properties for up to 12 months. On the heels of that announcement, analysts with rating agency DBRS reported that several nonconforming servicers were testing out rent-to-own programs with real estate owned (REO) properties.
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"[W]ith foreclosure inventories growing and timelines for REO sales lengthening, servicers will continue to look for creative ways to dispose of these homes," the analysts wrote. "As a result, DBRS expects that we will soon see the D4L program utilized in the nonconforming residential mortgage market."
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If the D4L serves as an alternative model of REO management, the PTFA laid the groundwork for implementing the model.
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"They are more apt to venture into deed-and-lease as their fear of the unknown subsides and systems and controls are put into place," Hayman says of servicers.
Back to the future
Lease-and-hold strategies are not new; rather, they're reemerging after a long absence caused by steadily appreciating property values. As 2008 ushered in a new "normal," distressed-asset investors snatched up properties in the hope of generating attractive cashflow rental returns.
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"Obviously, selling a property at a price that allows for 20 percent to 30 percent to be generated versus U.S. government 10-year bond yields – then of 2.5 percent to three percent – did not, to us, make rational economic sense for the selling owner of REO," says Tim Bolger, senior vice president with the First American National Residential Rental Services (FANRRS) division, which launched in 2009.
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There are other notable benefits to be realized from renting or leasing REOs. Costs related to securing the property are eliminated, and the risk of noncompliance with blight ordinances diminishes. Moreover, occupied REOs are less likely to fall into disrepair, as presumably, a tenant would alert the servicer or field service company of structural damage before it turns seriously debilitated. Foreign investors of distressed assets recognized these benefits early and capitalized on them, says Alan Paylor, president of REO Leasing Solutions (R2L).
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"They were going long on their investment, and leasing was the strategy they used when buying commercial – apartment buildings, etc.," he says. "Delving into the residential side, they were buying distressed assets at 50 cents on the dollar and still renting them out with a long-term cashflow strategy.
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"They just looked at it differently than we did," adds Paylor, who formerly worked with a specialty servicer.
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Servicers are dipping their toes in generic deed-for-lease programs and rent-to-own initiatives and discussing rental as a foreclosure-avoidance strategy. Of the 15-20 clients that Bolger has spoken with in-depth about rental strategies, three-quarters are considering pre-foreclosure scenarios, he says.
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"For the most part, deeds-for-leases are fully operationalized with other pre-foreclosure rental strategies being in a pilot or even less-developed stage – concept discussions," he says. "I anticipate that some of these pre-foreclosure strategies will prove to be extremely effective and, as a result, become the market standard in the near term."
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Deeds-for-leases are essentially deeds-in-lieu, which Paylor says were traditionally executed with liquidation in mind.
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"Part of that process was, the minute you went deed-in-lieu, you were just taking it to sell it," he says.
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Dean Baker, co-director of Washington, D.C.-based Center for Economic and Policy Research, has long advocated what he calls the "Right to Rent Plan," which, like Fannie's D4L, would allow former homeowners to remain in their homes. Baker's proposal calls for a court-administered process with independent appraisals of market rates. Mortgage holders would be able to resell properties after foreclosure, but buyers would have to allow homeowners to ride out their predetermined rental agreements. Fannie Mae's program allows up to a 12-month stay; Baker wants five- to 10-year terms.
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"Right to Rent would give former homeowners the right to remain in their homes as renters for a more substantial period of time," he wrote in a December 2009 policy brief. "The right to rent for a substantial period of time also would give homeowners much more bargaining power when trying to work out mortgage modifications, resulting in far more homeowners avoiding foreclosure altogether."
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Sen. Charles Schumer, D-N.Y., raised the rental issue last year during a congressional hearing with Treasury and Department of Housing and Urban Development (HUD) officials, calling the option a "last resort." He outlined the perks: For banks, generating rental cashflow would be favorable to paying foreclosure costs; neighborhoods, afflicted by fewer vacancies, would begin a gentle rebound; and borrowers would sidestep the social stigma, moving hassles and broken relationships that are all potential by-products of foreclosure.
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"We had so many people in this country putting down three percent – people that, in essence, were really renting houses," Sen. Bob Corker, R-Tenn., observed during the 2009 hearing. "They really didn't own the home. They did in document, but they put no equity down."
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Prior to the PTFA, Freddie Mac implemented its own rental program, which offers qualified tenants and owner-occupants of foreclosed properties a lease option on a monthly basis. As William Apgar, HUD's senior advisor, explained in testimony before Schumer, Corker and others, participation was sparse.
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"One of the obstacles was, quite surprisingly, that the homeowner, having gone through the anguish of foreclosure�many of them said they didn't want to stay on a renter's policy," Apgar stated. Brad German, Freddie Mac's spokesperson, told SM at the time that former borrowers were seeking a longer-term housing option than the monthly policy affords.
Tenants, analytics
Whether treated as a foreclosure-avoidance tool or an REO management strategy, lease programs require certain tasks that even the servicers most up to speed with the PTFA might find daunting. Lease structuring, in particular, calls for local-market expertise and detailed knowledge of regulations.
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"The No. 1 thing that an owner of an asset must do is pull out a property management agreement and look at that and realize that a broker has got to write that thing," says R2L's Paylor. "You can write your own as an investor – you're able to do that – but when you have properties all over the place, each one of those leases has very unique requirements that you have to comply with."
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The November 2009 DBRS report on Fannie's D4L described one nonconforming servicer's rent-to-own program: "The renter (potential buyer) places five percent to 10 percent of the purchase price into a reserve account to lock in the option to buy. The difference between the actual market rent and the rent's monthly payment is added to the reserve account, which is used as a down payment on the property in one or two years."
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Though this type of program has been around for decades, TenantAccess' clients are not using it, Hayman says, citing unnecessary risk exposure for owners. Taking excess rent for a down payment can lead to claims of abuse, he mentions, and that type of commingling of rental policies with purchase options can make eviction difficult.
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"What's really important is you separate out the rental terms from an opportunity to purchase the property," he says. "A separate set of agreements is what we strongly recommend, combined with keeping the rental rate at market."
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Lease agreements can range in complexity, providing servicers with an opportunity to tailor purchase options to specific markets, properties and tenants. FANRRS' Bolger says the many variables create a "broad range of up-front costs to acquire these purchase options."
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"If you really want to get twisted, you could adjust these up-front premiums for the option to purchase by allocating some or all of the premium into the monthly rent payment with a European-style lockout for exercising the option to purchase until some specific date in the future," he says, commenting on the varying degrees of complexity. "Another twist would be to maintain the up-front cost of the premium but set different option purchase prices for each month, quarter or some other frequency for the term of the option."
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Using a lease program to generate cashflow for a portfolio full of vacant REOs requires a tenant-screening process, not to mention a marketing initiative considerate of term length and timing. R2L might recommend a three-year lease for a downtown Detroit property, Paylor says, whereas most leases run one year, with a monthly option kicking in afterward.
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"We look at it from a calendar perspective," he continues. "If a property's in Arizona, the very best time to rent is pre-winter, because you've got the snowbirds coming in and out. Florida's the same way. You have different time frames when leasing becomes extremely important."
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Rents obviously do not produce the same returns as monthly mortgage payments, and Paylor notes that a $3 million property is unlikely to garner more than $2,000 a month. A property that falls on the other end of the spectrum, however, can produce a rent not too far below that. The swings aren't huge.
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FANRRS' rent analytics use interior broker price opinions, "repaired" versus "as-is" comparisons and other data to produce a recommendation based on a net present value (NPV) model.
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"We have been seeing a fairly consistent 15 percent to 20 percent of analyzed properties coming up with "rent' as the highest NPV result," Bolger says.
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When the PTFA was signed into law last May, the National Low Income Housing Coalition estimated that 40% of households that lose their homes to foreclosure are renters. Bolger says that when the legislation's qualifying criteria of "bona fide lease" is factored in, the share might be closer to 25% or 30%.
Over the horizon
Though considered slightly radical at this point, one approach seems particularly ready for discussion: offering defaulting parties a lease-to-purchase program.
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"This program can be very exciting, but it's only for certain borrowers and situations," Hayman says. "These programs will be successful where it's a homeowner who's been established in that community and who's been there for two or three or five years already. It's a homeowner who has the ability to pay the rent, and it's a home that warrants the risk of the institution holding the loan."
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Brokers, who Paylor says typically dislike the property maintenance piece of managing leases, would welcome motivated tenants. Homeowners-turned-tenants, if viewing future homeownership as a real possibility, would have an incentive to keep the property in good condition.
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"That's worth just a ton in a property management world where people don't care," Paylor says.
