“Pay Day” for Hedge Funds


Next week the plan comes full circle.  Conceived at the peak of the foreclosure deluge several years ago by a handful of investment bankers as a way to make new fortunes out of crisis that was paralyzing the national real estate economy, the plan was audacious, very expensive and potentially immensely profitable for those who saw it through.

According to BloombergBusinessweek, next week the Blackstone Group will begin selling the first securities derived from the 40,000 single family rentals it has purchased for $7.5 billion over the past two years.  If successful, the new single family rental equities will create a new secondary market and a new business for several dozen institutional investment firms.  American real estate will never be quite the same.

The plan is all about securitizing–or converting into bonds that can be sold to large institutional buyers like pension funds and foreign governments—the cash flow that single family rental leases generate—to create a secondary market. Secondary markets have developed for other a number of other real estate-related securities, including medical offices, senior housing projects, self-storage facilities, casinos, student housing and even cell towers.  Securities based on these asset classes are bought and sold by institutional investors, their value based on the cash they generate supported by the value of the underlying real estate.

Last year several dozen investment firms backed $20 billion to purchase as many as 200,000 homes. Investment bankers at Keefe Bruyette and Woods estimated that total potential returns could reach as high as 20 percent on some investments depending on leverage and how much home prices can appreciate in the months or years ahead.

Despite the rosy prospects and the vast sums the funds raised, the road to where they are today has by no means been an easy one.  Until recently, it looked as though concerns raised by the major ratings services would delay securitization for many years.

Resistance from the Raters

Three ratings agencies, Standard & Poor’s, Moody’s and Fitch, conduct extensive research and rate securities offerings to help investors understand and assess risk. Ratings based on risk determine the price securities command.  All three took cautionary stands last year on the prospect of single family rentals and they proactively issued reports that were largely negative.  At the top of the list was quality of property management; after all, the quality of management have a lot to do with vacancies, maintenance costs and rent rates.   Fitch said it would require years of data to assess the quality of property management. Moody’s warned that even structuring deals to create more investor protection may not overcome the problem caused by limited information about management.

Fitch said it will assess management company experience and operating capacity; market analysis; lease terms; tenant underwriting and property marketing; operative efficiency and management continuity.  “While we have had conversations with some of the market-level data providers, one of which we found to have a robust data warehouse, the history only dates back to 2008-2009. For these reasons, Fitch is unlikely to assign a high investment-grade rating to such transactions,” the firm said a year ago, lowering expectations that any SFR would get rated for years.

Property management has, in fact, been a challenge for the hedge funds.  Wally Charnoff, CEO of RentRange who works closely with several of largest funds, said as much in my August interview with him (Single Family Realities: An Interview with Wally Charnoff, the “Data King of Rental Housing”).

“A lot of players are still underestimating the property management piece.  It’s not just not a matter of buying a piece of property and getting a purchase price so that you can get a good return on investment.  You also have to maintain and manage the property and manage turnover.  That’s operationally challenging and I think that we will see some consolidation and some are more efficient at that than others,” he sid.

After working with local management companies, most hedge funds reportedly are setting up their own management companies in order to assert control and quality standards.  In Minneapolis, for example, a leading fund initially retained an excellent leading local firm but decided instead to bring into the market a small firm it already owned but had no experience in the local market.

For those funds that can solve the property management puzzle, there’s another small pot of gold at the end of the rainbow.  After SFR securities are sold off, their management subsidiaries continue to earn fees for taking care of the rented homes, at 10 percent of rent revenues or more.

Despite the challenges, Blackstone apparently has received top ratings for its first offering.  According to Bloomberg, Moody’s Investors Service, Kroll Bond Rating Agency and Morningstar Inc. are grading the debt and an unnamed rating company has assigned its top rating to the bonds, higher than Standard & Poor’s rating of U.S. government debt. The Financial Times reported Wednesday that the deal would get a AAA grade.

No other fund has yet been able to solve the rating puzzle.  If this first offering moves ahead smoothly, Blackstone will be in the drivers’ seat for the near term.

The Price Explosion

Few of the three dozen or so hedge funds and REITS in the REO to rental business could have foreseen the speed with which the pipeline of discounted foreclosures would dry up and increase acquisition pries.  From discounts below full-priced homes of 30 percent of so at the time the plan was conceived, the foreclosure discount has disappeared in most markets where hedge funds are active.  In fact there is growing evidence funds are being forced to pay full price or more for properties off the MLS (Tracking the Hedge Fund Big Dogs: Buying from the MLS).  Moreover, the funds chose to enter local real estate markets at a time prices are rising faster than they have in nearly a decade, racking up double digit prices increases, especially in the lower price tiers that make the best conversions to rental.

Another factor driving up acquisition costs is the need to hold down future management costs by buying properties as close together as possible.  Tales of properties being purchased off the MLS for prices above list in markets like Atlanta and Tampa usually fit this category.  The hope that by spending five or ten percent more to acquire a home in a neighborhood where the fund already has a presence, savings in management expenses will justify the expense.

Soaring acquisition costs have driven a number of players from the field, notably Och-Ziff Capital Management Group and Carrington Holding Services and others who quietly left the business.

Rent Rates under Pressure

Single family rents are difficult to track in a business dominated by small owners that only recently has supported the research necessary to produce current data, but rents have reportedly stayed strong and vacancy rates low through the first three quarters of the year (see Vacancy Rates Record Low, but Not Rents). Rents have held their own despite a huge increase in rental units, both single and multifamily.  ,.  Nationally single family rentals have increased from 14.8% to 18.2% of all housing over the past six years and about 300,000 new apartment units have come on line in the past year.   That suggest demand is strong, and bodes well for the future.

“Securitization is the next step in the evolution of the single-family rental business,” Rob Bloemker, chief executive officer of investment firm Five Ten Capital LLC, told Bloomberg. “It brings consistent and conforming standards to lending, which will help bring larger pools of capital in and get comfortable investing in these types of loans.”

Lending standards and large pools of capital will certainly bring even more change to the real estate business as a result of securitization, making it easier for the next generation of single family rentals to end up on Wall Street.  Most people who will be affected, however, probably won’t understand why housing is changing so much so quickly.   Small investors will become an even smaller part of the picture.  More tenants will be living in newly rehabbed homes managed by impersonal managers who may be better at collecting rents than fixing toilets.  People who prefer to rent will have a much larger choice of properties and communities.

However, some things change while others stay the same.  In a few years, a small piece of a tenant’s monthly rent check will end up deposited by an institutional investor alongside a small piece of their neighbor’s monthly mortgage payment.
Photo Credit: European Parliament

About Author

Steve Cook is the editor of Real Estate Economy Watch and writes for a several leading outlets in addition to BiggerPockets, including Equifax and Total Mortgage. He also provides communications consulting services to leading real estate companies. Previously he was vice president of public affairs for the National Association of Realtors.


  1. I was a very small fraction of 1% of this equation. I provided valuation support for the properties that were purchased under the Blackstone umbrella. The valuation that I provided somehow didnt match with that of which was ultimately disclosed in their financials. They produced literature showing substantial gains by making modest improvements to the properties.
    For example, they would show that their acquisition costs were similar to $25k, with $15k in rehab, that netted end values of $65k. While most investors would be happy with this type of return, the small/medium sized investors on this forum understand that this can be a hard model to fit. This is especially true as we have all witnessed the sheer number of properties that they bought at, near, or above list.
    I expect that the institutional buyers are going to take the brunt of some of this value correction, along with the articles stated under-estimated costs of capital expenditures over the long term. It could loom into a financial hiccup for the buyers of these bonds.

    Great article Steve. Let us know what else you learn as you follow this puzzle.

  2. After seeing what “securitization” did for the residential mortgage market and home ownership, I can’t wait to see the effect that securitization has on the residential rental market, what could go wrong? :/

  3. How could these buyers foresee that after buying all of the available inventory at inflated prices that discounts would dry up?
    Bunch of geniuses here…

    Other thoughts :
    – Anyone who’d by a security backed by nothing more than a bunch of residential leases is a fool.
    – If this garbage gets a AAA rating it just shows these ratings are as useless as they were for all those MBS with tons of sub-prime notes.
    – I still feel the winning institutional investors will be the ones that sell their inventory to “The bigger fool” in markets they artificially inflated.

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