A week ago the third of the three major securities rating services weighed in with its views on how it will rate the risk involved with securities backed by single family rental contracts. Moody’s report wasn’t good news for the hedge funds counting on a secondary market in SFR contract-based securities to generate cash flow for their business models.
In May, Standard & Poor’s report began by outlining the advantages of such a market. Written before the inventory drought hit foreclosures, the report noted that: “Such a market-based solution to reducing the overhang of REO inventories from bank and government balance sheets is desirable from a public policy perspective. Like the Resolution Trust Corp., which used securitization to dispose of more than 2,600 real estate loans through mortgage trusts following the savings and loan crisis of the 1980s, the FHFA’s new program, which aims to bundle and sell these assets, appears to have a similar goal.”
But it was also clear that many questions needed to be answered, for including “what would be pledged as collateral to support an REO-to-rent securitization is a subject of debate.”
Earlier in August, Fitch Ratings lowered expectations considerably that a secondary market in SFRs would become a reality any time soon. (See The Rush to Securitize Single Family Rentals: The Fitch Report Changes the Rules). Fitch focused on the risk involved with management issues and the lack of data to assess risk.
Now Moody’s discussed the main types of risks that securitizations backed by cash flows from single-family rental properties would present. These are related to the performance of the manager of the properties and those posed by the variability of cash flows from the rental and ultimate sale of the properties. The lack of historical data on the single-family rental market is another concern.
“Numerous real estate market participants have asked how we would analyze the credit quality of these securitizations,” says Kruti Muni, a Moody’s Vice President and co-author of the report. “No one has yet presented a specific transaction or deal structure to us, therefore, we have not yet completed development of a formal methodology.”
However, Moody’s says the transactions would likely incorporate two key structural elements: first, an operator or manager who will be in charge of renting, maintaining and ultimately selling the underlying properties in the transaction and, second, having the rental and then the sale of the properties as sources of cash flow.
“The risk that an operator could fail to perform its duties would be one of the key risks these transactions would present,” says Moody’s Muni. “The presence of a manager that actively handles all aspects of the properties would be similar to what is present in cell tower or container lease asset-backed securities (ABS).” Moody’s also notes that the securitization will also likely benefit if the operator is the sponsor with its economic interests aligned with those of investors.
The risk to investors with the unprecedented rental-home bonds would be tied mainly to the quality of property managers and the variability in net revenues from tenants and eventual home sales. Moody’s warned that debt issuers may not always be able to overcome limited information by structuring deals with more investor protection.
In other words, offerings will be rated based first on the quality of their property management and that quality will be determined by multi-year track records that don’t exist . The lack of historical data is expected to kill deals. “Despite the wide availability of information on property prices for single-family residences, including sales in distressed markets, there is little historical data on the single-family rental market, ” says Moody’s Muni.
The media clearly saw the Moody’s report as a huge setback. “Potential issuers of securities tied to U.S. home rentals may not be able to obtain the credit ratings they seek because of a dearth of historical data on the business,” wrote Jody Shenn of Bloomberg.
One potential player did a commendable job of spinning the situation in the Wall Street Journal. “The major rating firms’ reports about the potential deals ‘not only reinforces the fact they have spent the time and resources to educate themselves on this sector but also signifies they expect to be formally engaged to rate financings in the near term,’ said Michael Wade, co-head of asset- and mortgage-backed securities capital markets for Jefferies Group Inc.”
Let me translate that. “Even though the ratings agencies are throwing up hurdles that would buffalo an Olympian, the fact that they are doing their job and paying attention is a good thing that means we’ll be going into business any day now.”
So here’s the bottom line as I see it. Should a secondary market develop for single family rentals, it’s going to take several years at least before it gains much traction. Well-run, well-documented, transparent management firms expert in the single family market with great records on vacancies and cost-controls will be in great demand, and the opportunity exists for one or more regional management companies to become dominant. A secondary market will permanently drive up the cost of distress sales and shrink further the discount by soaking up available inventories.
Leave a comment and tell us what you think.
Photo: Jo Guldi