PERSON OF THE WEEK: Lorenz Schwarz is president of Green River Capital (GRC), a real estate services firm specializing in real estate owned (REO) asset management, loss mitigation, single-family rental (SFR) and component services. MortgageOrb recently interviewed Schwarz to learn more about where the REO-to-rental market is heading, now that REO inventory is declining, and how this will affect the future of the SFR market.
Q: Where does REO inventory stand now, from what you are seeing?
Schwarz: This is a tough question to answer on a national basis, as different regions are seeing very different trends. Also, this is not dissimilar from asking people across the country about the economy, in that the numbers don't always reflect perception or the true ‘look and feel’ of the local markets.
Even though REO inventories are down 44% from their 2011 peak, according to CoreLogic, the current inventory of 430,000 is up almost 15% from the August 2013 low of 375,000. This rise in inventory can be attributed to several factors, including servicers' increasing activity following the independent servicing reviews, as well as changes in foreclosure sale bid strategies.
In support of the inventory increases, CoreLogic also reported that the number of completed foreclosure sales in the first six months of 2014 totaled 281,000. This represents a 14.6% decline over the total for the first six months of 2013, but more importantly, also represents a 7.3% increase over the number of completed foreclosures in the second half of 2013.
To put this activity into context and highlight the localized influences, the top five states accounted for almost 50% of the total activity and included Florida with 123,000, Michigan with 43,000, Texas with 33,000, California with 34,000 and Georgia with 31,000.
At GRC, we do not feel the increase in foreclosure sale activity is a long-term trend, but simply reflects highly aged files moving through the pipeline. Mortgage delinquency rates and the number of seriously delinquent loans are currently at six-year lows, with the number of seriously delinquent loans declining at an average quarter-over-quarter rate of 9.6% over the last six quarters. Consequently, REO inventories will follow this trend.
Q: How would you describe the level of investor activity today? Has it increased or declined? Are there certain areas that are seeing more activity?
Schwarz: To answer this, one needs to separate traditional investor activity from institutional investors. During the first six months of 2014, GRC sold more than 15,000 REO assets across the country. Investor activity accounted for 38.8% of these sales, down slightly from 40.4% for the same period in 2013. Not surprisingly, 75% of the 2014 activity involved properties under $100,000, and 85% of all investor sales were cash. Relative to GRC's portfolio, the five top states for investor activity in 2014 include Ohio at 50%, Indiana and Missouri at 46%, Pennsylvania at 45%, and Florida at 44%.
Acquisition activity among the institutional SFR investors has definitely slowed, as increasing house price index in the primary target markets compressed yields, and capital is constricted due to their respective credit facilities being filled. Additionally, many institutional investors have paused to now focus on better leveraging capital markets, securitization activity and further developing the infrastructure of their longer-term business models.
However, the decline in traditional multiple listing service, foreclosure auction and short sale acquisition activity does not mean all investors are backing off. Many are simply changing methodology in order to continue to seek yield and have expanded their acquisition strategies to include purchasing bulks of rental properties from other aggregators, and moving the model ‘upstream’ by acquiring non-performing loan (NPL) portfolios with the end game of servicing through the loans to capture the REO.
Q: What do you see as the short- as well as long-term future for the SFR market?
Schwarz: Over the past three years, institutional investors have acquired approximately 200,000 single-family homes for the purpose of converting them to rental properties. Even though this number is quite small relative to the overall U.S. inventory of 13.8 million single-family rentals, this activity attracted a lot of attention and created a new asset class in the capital and structured finance markets.
Throughout the first two years of the emergence and development of this asset class, there was a significant amount of skepticism, and the common question revolved around whether this was simply a trade or a business model. Our answer to the question of whether this is an actual business model was and has always been ‘yes.’
Many investors have realized extraordinary gains through arbitrage related to home price appreciation (HPA) and subsequent bulk sales; at the same time, a number of the large institutional investors have developed strong business models that have successfully leveraged the capital markets, models that will possibly extend into perpetuity.
I believe what we have seen over the past nine to 12 months is indicative of the short term. Institutional investors will continue to buy product, albeit at a reduced pace, and will continue to leverage the capital markets by financing their models through credit facilities and securitizations. We will also see additional bulk sales of properties between investors as well as increased NPL activity.
Year to date, we have seen seven securitizations come to market, comprising more than 27,000 properties and just under $4 billion in issuance. With the current appetite for the bonds and attractive pricing, we have no reason to believe the securitization pace will slow, unless, of course, there is a major dislocation in the markets. We think it is feasible to see another $2 billion to $3 billion of issuance in 2014, with 2015 wrapping up another $8 billion to $10 billion.
We see a lot of activity in store for the long term. With respect to the larger institutional investors, Tom Barrack of Colony Capital and Jonathan Gray, global head of real estate for Blackstone Group, have both publicly stated that they intend to continue to leverage the capital markets to extend their models far into the future. In a June interview on CNBC, Gray stated, ‘â�¦we will look to the public markets, my guess, in the next 12 or 24 monthsâ�¦’ Gray, who oversees Blackstone's $80 billion real estate fund, was very careful to qualify this timing to the market to when the business is mature enough and stabilized enough for investors to recognize it as a simple, straightforward business.
With all of this being said, the institutional activity is somewhat finite, and will focus around the 200,000 or so properties that have been acquired. As such, our interest and where we see the most opportunity is in the small balance lending space, which is focused on capturing financing on the 13.8 million SFRs owned by small investors.
Q: What do you envision regarding the future of multi-borrower securitizations, and what activity is going on now and how will it further impact the single-family rental market?
Schwarz: As previously mentioned, there are currently more than 13.8 million SFR properties in the U.S., which represents almost $2.8 trillion in property value. In October 2013, Keefe, Bruyette & Woods (KBW) published a paper estimating the opportunity to be $290 billion over the next six years. KBW arrived at this number by assuming a 15% capture rate on the pool of 13.8 million SFR homes currently being rented. To place additional context around the scale and immediate availability of this opportunity, data from RealtyTrac indicates approximately 53% of these homes are not encumbered by a mortgage.
At GRC, we are especially excited to be working with the lenders that are extending credit lines to small and medium sized borrowers in the $500,000 to $50 million range. Lenders like B2R, Colony, Dwell and First Key are very familiar with the asset class and operating model, as they have been involved from the ground level and plan to allocate several billion dollars each to this borrower class. This is a model that can and will be utilized for many years to come and has extraordinary potential to become a permanent financing option for the owners of these properties.
We feel this segment of the lending market has been underserved, as historically there have not been many viable options for low-cost financing for these investors. This model will allow local and regional investors to leverage equity from their existing properties and invest in additional properties. The institutional investors have played a significant role in boosting HPA in a dozen or so key markets, and this will allow smaller cities and communities to benefit from the same model, simply on a smaller scale.
The securitization of these loans is definitely a ‘when,’ not an ‘if.’ B2R, Colony and First Key have each publicly stated their intent to securitize these loans in multi-borrower deals, and it will be interesting to see who reaches the finish line first.
In anticipation of this activity, GRC has been involved in discussions with the future issuers and rating agencies to determine exactly how these deals will be structured and what criteria the agencies will utilize to underwrite the deals. Based upon these discussions, we have developed and are ready to launch an entirely customized suite of services and products that will be offered and available to all stakeholders in the securitizations.
Q: There has been a lot of discussion recently around renters being priced out of the market. Do you think this is a current or ongoing issue, and if so, what impacts are you seeing?
Schwarz: Affordability remains a hotly debated topic and includes both rent affordability and mortgage affordability. Demographic trends, larger macroeconomic trends and local employment dynamics obviously play a major role in both. It is difficult to determine the true impact of the SFR investors on rents, and I caution people to not confuse correlation with causation, and look at all variables in the equation.
Our observations indicate rental rates reflect simple supply and demand economics. As national homeowner rates have dropped from a 2004 high of 69.2% to the current level of 64.8%, demand for rental housing, whether single-family or multifamily, has grown commensurately. Multifamily vacancy rates are near 4%, down from a high of 8% in 2010, and publicly available information shows that the SFR investors are enjoying stabilized occupancy rates at or above 95%.
Demographic trends and socioeconomic behavioral patterns lead us to believe that demand for rental housing will continue to grow into the foreseeable future. Working-age adults have shifted from owning homes to renting homes, or are delaying the transition to homeownership. Additionally, Echo Boomers (a.k.a. Millennials) are maturing into adulthood, entering the housing market and will be searching for rental housing due to financial constraints precluding them from homeownership.
Another demographic trend that will affect certain markets is the growth of minority households in the U.S. According the U.S. Department of Commerce, the Hispanic population is forecast to grow 41% between 2010 and 2025, increasing from 41.1 million to 58.9 million. Home ownership rates among Hispanics in Q4 2013 was 45.5%, which means the largest growing minority sector also experiences one of the lowest minority homeownership rates.
So, to answer the original question, affordability is an ongoing issue. At the end of the day, all signs indicate demand will remain strong, and it will take many years for supply to catch up.
Q: With today's growing SFR market, how has GRC changed or adapted its services or business model?
Schwarz: GRC was introduced to the SFR institutional lenders pretty early in the game, which allowed us to capture and subsequently maintain a first-mover's advantage. We started with a sound concept and worked closely with the lenders, investors, law firms and rating agencies to develop a unique suite of diligence services that fit within the economic parameters of the deals, and concurrently built a platform that was highly scalable and capable of processing large volumes at a high velocity.
To service the SFR market, we took key personnel from the various functional areas of our REO business and matched their experience and skill sets to the services required to diligence the properties being financed. With this group we formed our Component Services Division, which to date has performed diligence and valuation services on more than 150,000 single-family homes that have been placed into credit facilities and securitizations.
As this space evolves, we are continuously looking into the future, evaluating our product offerings, and seeking ways to leverage our core competencies to better serve our clients and business partners. We are prepared to introduce two new services specifically designed for the multi-borrower securitizations, both designed to identify and mitigate risk associated with property management, tenant services and cash handling.
The first is a surveillance system that will absorb information from the property management companies, perform complex analysis and present the results through an interactive data visualization user interface. The purpose of the platform is to compare property performance data to underwritten assumptions, and by using a series of exception engines and decisioning tools, identify and remove outliers and anomalies and focus on behavior and trends that may adversely affect the financial performance of the portfolio. Additionally, by evaluating data from multiple property management companies, we will be able to perform comparative analysis across multiple key performance indicators.
The second service is a backup property management function that will enable us to immediately assume management of the properties in the event that a property manager has to be removed, stabilize the portfolio, and assist the borrower or lender in identifying and securing a permanent solution.
Q: What are the primary considerations or concerns of the rating agencies as it relates to these multi-borrower securitizations, and have those factors changed over the past year or two?
Schwarz: We believe that there will be three distinct areas of concern related to the multi-borrower deals that we did not see in the single borrower deals. The first relates to the financial strength of the borrowers, who obviously don't have the massive financial backing of a Blackstone or Colony Capital. The rating agencies will place a great deal of focus on the underwriting practices of the lenders, as well as the consistency around how each borrower and each loan was qualified.
The second relates to the physical properties securing the loans, especially the condition of the properties and the scope and quality of rehabilitation. The institutional investors acquired their properties over the last two to three years and have substantial documentation around the extent of rehabilitation they performed. The small investors may have acquired these properties 10 or 15 years ago and most likely did not retain detailed documentation of the work they performed. I am not implying they did not do good quality work, but simply that it will be much more difficult to verify and validate.
The third pertains specifically to the property managers. Within the single borrower deals that have come to market, the property management companies were directly affiliated with the sponsor, creating a unique alignment of interest, a single property management software platform and, once again, the financial backing of a large institution. We understand that multiple property management companies that will be involved in the multi-borrower deals and will be managing properties on disparate systems. Obviously, the risk increases significantly under this scenario, which is why the rating agencies and bond investors feel that surveillance is such an important and necessary aspect of controlling risk within the structure.
Q: With rental houses in these securitizations likely being more spread out, how does property management need to adapt?
Schwarz: We firmly believe the institutional investors have done a good job in developing a scattered site property management model by leveraging their centralized management structure with local and regional resources, and they prudently targeted acquisition activity in areas where they could assemble critical mass and take advantage of economies of scale.
In each of the securitizations brought to market, the rating agencies conducted extensive diligence on the sponsor and its property management entities, and came away with levels of comfort that supported the institutional grade ratings assigned to the deals.
As we move into multi-borrower deals and perhaps single borrower deals with third-party management companies, a greater deal of diligence will be employed at the local market level.
Rating agencies will have to become comfortable with disparate resources being able to coordinate activities and reporting – and adapt to the institutional mindset.