Investors large and small are closely following on the efforts to convert blocks of single family rentals into securities and sell them to securities investors, similar to the way mortgages are securitized into mortgage-backed securities by Fannie Mae, Freddie Mac and leading banks. If successful, SFR-based securities will become a huge new source of financing and will transform single family rentals and residential real estate investing, just as the secondary mortgage markets changed mortgage finance forever.
One of the most important ways that Fannie and Freddie, who together securitize about half the nation’s mortgages, impact mortgage lending is the rules they set for mortgage originators who want to do business with them. For example, the huge battle over appraisal standards a couple of years ago, known as the Home Valuation Code of Conduct (HVCC), was essential a fight over appraisal standards proposed by Fannie Mae that every lender it bought would have to meet if it wanted to sell mortgages to Fannie to be securitized.
Fannie and Freddie won’t have that kind of power over securities based on single family rentals, but the ratings agencies that determine the quality of individual securities offerings will. Ratings agencies carefully review and rate offerings, a function that involves not just price and yield but also risk. Investors in SFR-backed securities, like those who buy mortgage-backed securities, are expected be a conservative lot, institutions largely interested in a safe return on their investments. The higher the risk, the lower the quality, the lower the rating, the less demand there will be and the less an offering will realize.
The Fitch SFR Report
Yesterday Fitch Ratings, one of the world’s leading securities rating agencies, issued a fascinating report outlining the standards and criteria it will use to rate securities based on hundreds of single family rentals purchase from small investors and local real estate markets and bundled together by investment firms. Noting that interest is strong, Fitch said trading in SFR-backed securities could begin as soon as the end of this year or the first quarter of 2013.
Fitch made it clear that the entire class of SFR-backed securities poses some unique risks and that high investment grade ratings will be difficult to attain due to the lack of historical data and “ambitious growth strategies by regional operators”. From the starting line, Fitch is going to rate SFR-based securities conservatively, which could put them at disadvantage with other securities and investment options. It views the new asset class as a cross between commercial and residential properties, since rental cash flows and the underlying value of the property may both be needed to service and pay for the transaction.
Securities seeking a better rating are going to have to meet stringent requirements that look beyond price and yield. The promise of a good or exceptional return will not be enough to win a higher rating.
Fitch outlined the factors that it will use to rate offerings. First will be the local employment base and the desirability and quality of neighborhoods where rentals are located, since these will determine demand. Next, the underlying quality of securities will involve property management quality and expertise. Durability of cash flow, stability of value over time, liquidity and other structural considerations will be important considerations. Fitch will assess management company experience and operating capacity; market analysis; lease terms; tenant underwriting and property marketing; operative efficiency and management continuity.
Signaling the conservative approach Fitch will take to the asset class, it announced it will likely impose rating caps on SFR transactions based on several performance issues such as limited data for the sector and for individual management firms, historical data for market rents, rent roll histories, vacancy rates and supply and demand.
The New Rules: Quality and Track Record
Should the plans securitize SFRs become reality and succeed, how will the rules change of the game change for the SFR business?
First, these rules put pressure of property management firms to meet high standards of operating quality and to be able to prove the quality of the properties they manage with date. Properties managed by individuals or management companies without a history will be at a disadvantage and will be worth less. Probably the larger management firms and those being established by the privately financed new entrants into the business to manage the large numbers of properties they are buying will have an advantage. “Fitch’s analysis will focus on management expertise and continuity, cash flow durability, value stability, and the transaction liquidity and structure,” the report said.
Second, the promise of a SFR securities market has already led to the development of a national market for SFRs as the hedge-fund financed investment companies look for properties coast-to-coast. The new rules will add value to SFRs located in stronger tenant markets where local employment and the local economic outlook are strong. Conversely, those located in weaker economies, even though they may be well managed and attractive properties, will be at a disadvantage. Markets will large numbers of SFRs will not necessarily be more attractive. “While many of the more notable states, such as California, Florida, Arizona and Nevada, have a significant volume of distressed and REO inventory, investment decisions are more driven by local employment conditions and neighborhood desirability,” Fitch said.
Third, the Fitch report suggests that securitizing SFRs will not as easy as some have thought. “Fitch Ratings said it is unlikely to grant the best credit grades to securities backed by single- family U.S. rental properties, a move that may curb potential sales of the debt if other ratings companies follow suit,” reported Bloomberg yesterday. The Wall Street Journal said Fitch won’t rate the initial offerings at all, which will make them difficult to sell.