The saga of Americas’ first security backed by rents generated single family rental homes took another fascinating turn this week as Blackstone, the private equity giant seeking to open up a new asset class, smacked head on into the ratings agencies that put a kibosh on the idea a year ago only to learn at least one of them, Fitch, hasn’t changed it’s mind.
Blackstone began marketing the bond Wednesday, with some 300 potential investors expected in New York to peruse the nearly $480 million deal. Monday it will hit the road Boston on Thursday and Los Angeles on Friday, with the offering expected to be officially announced on Monday.
The collateral behind the deal is rental cash flow from 3,207 foreclosed single-family homes bought up by Blackstone, a private equity firm, in the wake of the financial crisis. Blackstone said nearly 90 percent of the homes underpinning the ABS are located in and around Phoenix, Arizona; Riverside, Los Angeles and Sacramento, California; Atlanta, Georgia; and Tampa, Florida.
A AAA Rating?
The $500 million transaction from Invitation Homes, a wholly owned Blackstone subsidiary, will be rated by Kroll, Morningstar and Moody’s, and will receive at least one Triple A rating. Blackstone announced yesterday it would receive a AAA rating… and with that announcement the latest chapter in this story became even more interesting. (See The Rush to Securitize Single Family Rentals.)
That at least one of the ratings will be Triple A shocked some investors relying on numerous rating agency reports over the past year that indicated a first-time REO-to-rental deal would never reach a rating higher than Single A.
“Almost every rating agency came out with criteria reports or commentaries this year saying an inaugural deal cannot get to Triple A. They said it would be Single A at most. It doesn’t make sense,” said a senior structured credit portfolio manager with expertise in REO properties. “I thought the agencies drew that line in the sand; they’re on the record.” (Strike Three: Moody’s Weighs In on Rating SFR Securities).
According to Reuters, one clue as to how the deal may get the top rating is that it will be secured by individual mortgage liens on each underlying property rather than an equity pledge in the property-owning SPV. That will allow for the creation of a so-called real estate mortgage investment conduit (Remic) structure, according to people close to the deal. Remics, which are also used in CMBS, allow for the pooling of a diverse set of loans from different originators and offer flexibility in assembling a security.
Rating agencies had preferred that mortgages were in place as legal instruments in any potential REO-to-rental securitization structure, so that bondholders did not get shut out of payments in case competing liens were placed on any particular property.
“Securitization technology can be applied to cash flows of any asset class, as long as there is a transparent and supportable basis for estimating the underwritten cash flows as the basis of paying the debt-holders,” said Ron D’Vari, CEO of NewOak Capital, a financial advisory and investment banking firm familiar with the structuring of similarly structured deals . “Single-family rental cash flows are no exception if they can be properly managed and modeled.
“One thing is for sure, investors will be looking for a lot of details and full proof of ability to manage single-family rental at a national level. Also, a simpler structure and conservative waterfalls matters. Full amortization of the senior notes makes them more attractive and provides deleveraging but will be less attractive to the equity.”
However, the Remic structuring may not satisfy the array of concerns that rating agencies still harbor.
Moody’s Rates an A
Moody’s Investors Service, which is expected to be one of the ratings agencies to review the securitization, generically outlined the main types of risks that securitizations backed by cash flows from single-family rental properties could present in a report issued earlier this month.
There are risks related to the performance of an operator or 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, Moody’s said.
The ratings firm noted that interest in launching so-called real estate owned (REO) to rental securitizations has increased over the past several months, driven in part by the sizable inventory of REO properties held by government sponsored entities (GSEs), residential mortgage-backed securities (RMBS) trusts and various financial institutions.
“Numerous real estate market participants have asked how we would analyze the credit quality of these securitizations,” said Kruti Muni, a Moody’s vice president and co-author of the report.
Moody’s report described the potential risks in single family rental securitizations as relates to both sources of cash flows.
“Rental rates can decline in weak markets, leaving rental income insufficient to cover expenditures and meet ongoing liabilities,” Muni said. “Another concern is the possibility that proceeds from the sale of properties will be insufficient to repay the noteholders’ principal.”
Fitch Sees BBB Rating
Fitch was even more adamant in its opposition. Fitch said Tuesday that it will not consider giving its highest AAA rating to securitized products based on single-family rentals (SFR), as the first such deal gets ready to come to market.
Fitch, which raised the most serious objections in August 2012 and was not ultimately chosen to rate the transaction, stuck to its guns, asserting that such deals do not deserve a Triple A.
“While near-record low rates and investor yield requirements are likely to drive demand for the underlying SFR assets in the short term, Fitch reiterates that several notable challenges would prevent the agency from assigning high investment grade ratings to transactions backed by SFR collateral,” the agency said in a new report.
“Fitch would more likely cap its ratings at the A level.”
The agency also noted that there were also concerns about investors buying up single-family properties en masse in just a handful of states and metropolitan areas.
“Because of the specific demographic targeted by these institutional buyers and the inelasticity of rents, transactions are highly vulnerable to unknown variables that could potentially impact the cash flows and yields. Among them include repair and maintenance expense, capital expenditures, rising property taxes, homeowners association restrictions, or the potential for municipality involvement.”
Fitch said that if liquidations are needed to pay off a bond at maturity, retail sales might be the only exit strategy. The impact of a large scale listing at the neighborhood level could have a significant impact on market clearing prices.
Fitch also said that while some participants have the wherewithal to withstand declining rents or rising costs, none have fully demonstrated their commitment to this asset class as yet, and that could leave investors shouldering a disproportionate amount of risk. While mortgages provide investors with first lien and perfected security interest in the actual homes, an equity pledge structure limits recovery to the sponsors’ equity in their investment.
According to Fitch, “Should a transaction underperform or face refinancing challenges at maturity, sponsors subject to potential enforcement may be more likely to consider bankruptcy protection. If a bankruptcy court allows the sponsor to incur post-petition debt secured by the properties, the value of the sponsors’ equity and investors’ recovery prospects diminishes.”
Given the incremental risk associated with transactions secured only by the sponsors’ equity, Fitch would likely cap ratings at the BBB category, absent mitigating factors.
Noted Reuters in its coverage today, “The new sector, built on what some naysayers are calling the housing “detritus” of the financial crisis, is not expected to be met with tons of praise in the court of public opinion, some industry participants say.”
“I think there’s a potential for a backlash on this,” said one RMBS investor.
However, Blackstone doesn’t seem to care very much, and perhaps with good reason. They always knew the ratings would be close to terrible on this first bond. Isn’t the pioneer of any new financial instrument the icebreaker who paves the way for others to follow and makes up in future deals what was spent initially? The Remic structuring may be the lever that opens the door for this first round. The underlying assets are foreclosures purchased two years ago or more. It would be hard for investors to lose when the rental homes could easily be sold a good profits to cover any losses.
One thing’s for sure. The next single family rental backed security will be easier—if there is one.
Photo Credit: Milestone Management