This article evaluates recent efforts by syndicators to acquire and rent real estate owned properties (REOs) and points out the risks posed by such ventures. For more guidance on REO rentals and syndication, see the companion first tuesday March 2012 article, REO rentals: a syndicator’s guide.

The REO rental reality

Less than a year ago, the idea of renting real estate owned properties (REOs) in bulk was an afterthought in the discussion about distressed properties. Today, it’s a reality. In fact, REO rental schemes – the business of buying, rehabilitating, and renting REOs – in California’s hard hit and foreclosure-plagued communities is getting quite the accolade these days.

Take this story for example: a real estate developer buys single family residences (SFRs) in distressed California communities for discount prices at foreclosure auctions or in shortsales, renovates the properties and then rents them out for considerably less than the distressed owner’s original monthly mortgage payment.

In some cases, the developer even enters into a rent-to-own agreement with former owners or tenants. Much impressed by the perceived success of the REO rental schemes, investors channel funds into the developer’s operation to enable it to expand locally and nationally. [For more information about recent REO rental ventures in California, see the February 2012 San Francisco Chronicle article, Oakland’s Waypoint cashes in on empty homes.]

The investors declare the REO rental scheme a win all around – blighted and vacant neighborhoods are revitalized, struggling renters and homeowners-turned-renters snag a great bargain, the developer and investors pick up a modest profit and some distressed homeowners can even rent to get on track and buy their homes back. (Fees earned by syndicators for acquisitions, money raising, interim management and property resales are implicit in syndicated activities.)

Enamoring Fannie

These REO rental schemes have caught the attention of the Federal Housing Finance Agency (FHFA). In August of 2011, the FHFA called on the public for feedback on bulk REO rental schemes, since action clearly needed to be taken with Freddie Mac and Fannie Mae’s (collectively, Frannie’s) growing and burdensome REO inventory. [For more information about Frannie’s REOs, see the December 2011 first tuesday article, Frannie’s REOs lying around with nowhere to go.]

In response to public commentary, the FHFA finally launched a new foreclosure relief program called the REO Initiative. In the REO Initiative’s pilot phase, the FHFA will allow “pre-qualified investors” to purchase pools of foreclosed assets owned by Fannie Mae in the areas hardest hit and most depressed by the housing crisis. Investors must then rent the properties for a fixed period before cashing out.

Editor’s note — Unsurprisingly, among the regions represented in Fannie’s first bundle of REOs for rent is in Los Angeles / Riverside “region”. [For more information on the first round of REOs the FHFA has bundled, see the FHFA news release FHFA Announces Pilot REO Property Sales in Hardest-Hit Areas.]

In order to pre-qualify for the REO Initiative, syndicators must sign a Pre-Qualification Request which certifies they:

  • have the financial resources to acquire the property or pool of properties;
  • possess sufficient experience and knowledge in financial and business matters to administer and bear the risks of the investment opportunity; and
  • agree to keep certain information about the REO and related matters confidential.

California syndicators interested in pre-qualifying to bid on Fannie’s REOs – which currently comprise roughly 40% of all home sales in California – must complete a Contact Information Form, fill out and sign the Pre-Qualification Request and submit the request for Fannie’s review at homepath_structured_sales@activet.com. [For more information on the REO Initiative pre-qualification process for syndicators, see the Fannie Mae site Structured Sales – Investor Pre-Qualification Process.]

The end goals of the REO Initiative are two-fold:

  • to quickly release pressure from the backed-up REO pipeline (owner-occupant buyers are few and far between); and
  • meet the growing demand for rentals.

Ironically, the growing demand for rentals is due largely to the dislocation of owners kicked out of their homes due to foreclosure. [For more information on the future for rentals in California, see the first tuesday Market Chart, Rentals: the future of real estate in California?]

However, in this pilot phase, what Fannie is most interested in is essentially REO market research. They want to know what investors are interested in, how investors will go about orchestrating REO rental operations and what potential impact renting REOs will have on improving property values in depressed markets. [For more information on the REO Initiative’s ongoing developments, see the FHFA news release FHA Announces Interested Investors May Pre-Qualify For REO Initiative.]

Blips on the scam radar

With syndicators basking in the limelight as society’s do-gooders, and the REO Initiative program getting underway, REO rental schemes are indeed no longer an idea quarantined in the foreclosure relief suggestion box. But before blindly falling in step with the herd of supportive followers, cast a critical eye – REO rental schemes, publicized as the saving grace of the housing market, smell like opportunities for a scam. We point no fingers, but merely explain.

The risk of manipulating homeowners

Warm and fuzzy anecdotes handed out by promoters easily prey on the emotions of distressed homeowners.

In the REO rental fairy tale, the syndicator is cast as Prince Charming and the homeowner (and possibly Fannie) as the damsel in distress. Warm and fuzzy anecdotes handed out by promoters easily prey on the emotions of distressed homeowners. While they encourage these homeowners that they can still save their homes, they also blind them from the fact that keeping the home is likely to be the equivalent of financial imprisonment.  [For more information on factors depressing homeowner economic mobility, see the January 2012 first tuesday article, Migratory lockdown: underwater homeowners confined.]

The risk of promoting faulty speculation

The investors promoted to contribute capital to these syndicated REO rental operations are not interested in making a long-term investment which will generate a constant flow of income. These people are flippers only looking to make a quick return in profits on property resales. The promoters are typically not locally-experienced SFR property managers and there is no way they can efficiently rehabilitate and maintain these properties, especially if they are sprawled across large economically distressed regions in California, to say nothing of them being scattered throughout different states.

For the investors, this will be an operational disaster and far too costly and labor intensive for the dollars initially passed through and invested on top of the fees charged for property management — not to mention the backend fees incurred when the property is sold. Once the option to purchase held by a foreclosed-out homeowner is ready to be exercised (in say two years), the property value will not have risen enough to exercise the option to purchase and generate the anticipated profit promised the investors. [For more information on California’s future depressed price persistence, see the February 2012 first tuesday article, Sticky prices, tricky situation.]

In other words, a lot of money will be poured in at the front end of the transaction only to be consumed in part by 6 to 18% in fees. This money cannot be recaptured unless prices rise beyond those paid for the properties, which will not happen beyond minimal consumer inflation until at least 2016. And even then, prices will not return to the over-inflated highs seen during the real estate boom for another decade or longer. [For more information about the economic future of California real estate, see first tuesday’s Economic Historical and Recovery Timeline.]

There is also the added layer of risk for investors posed by equity purchase (EP) statutes when the syndicator purchases properties from sellers-in-foreclosure, via shortsales. Such deals are subject to a two-year right-of-rescission, should the seller-in-foreclosure prevail upon a claim of unconscionable advantage. Worse, this clock does not start to run until mandated disclosures are made, hopefully at the time of purchase. [Calif. Civil Code §1695.14]

These get-rich-quick real estate schemes have a history of failure, and speculative syndicators have the most unfortunate history of short-term memory loss (or complete ignorance) of past events.

These get-rich-quick real estate schemes have a history of failure, and speculative syndicators have the most unfortunate history of short-term memory loss (or complete ignorance) of past events. Nevertheless, promotional hype manages to continue tickling the fancies of investors to funnel money into these ventures. They just don’t mention that it’s likely only those investors who are first-in will realize any sort of payout. Did somebody say Ponzi scheme? [For more information on the effects of speculation in housing busts and booms, see the August 2010 first tuesday article, Speculations on speculator suppression.]

For more guidance on REO rentals, securities and syndication, see the companion first tuesday March 2012 article, REO rentals: a syndicator’s guide.