Rent Backed Bonds and Idiotic Humans


The world around us is chaotic and destructive.

This is a good thing.

Today’s post is a follow up from last week – if you haven’t read that article, you can read it here.

When nature gets beaten up, it doesn’t wither and die.  It doesn’t tuck it’s tail.  No, it comes back stronger.

Animals die, species die, but the whole endures and becomes resistant to the events of the past.  Human progress is the same beast.  Ideas, methods, and people get dislodged destroyed to make way for the new, but always as a march towards improving our lot in life.  It’s this ability to get whooped and come back stronger that Nassim Nicholas Taleb coins Antifragility and explores in his book “Antifragility: Things that Gain from Disorder.

Consistent stress is natural and healthy.  The trouble is humans can’t handle the pressure.  We’re terrified of the uncertainty…as we should be.  It’s all well and good to tell a group of antelopes they’ll be stronger in the long run if the lion eats a few of them, but that doesn’t make the feline’s dinner feel any better.

Fear drives us to idiocy.  Whenever we can we attempt to mask the natural ups and down to make us feel safe.  This doesn’t work.  The chaos is still there, building sufficient pressure to burst through our safety measures.  All our efforts to create a false sense of security end up making the inevitable chaos far more debilitating than it otherwise would have been.

Specific topics are explored in more detail in part one of this article, but now the time has come to bring it back to real estate.  In today’s installment, I’m going to explore a frightening trend.  Us human folks are at it again, taking a jittery and uncertain atmosphere and attempting to smooth it over so we can feel safe.

Rent Backed Bonds

First, a quick history lesson.  Here is a rough course of events that led to the 2003-2007 real estate bubble and the 2007/2008 correction.  This is overly simplified.

  1. For time immemorial, banks made loans to people to buy homes.  If the buyer didn’t make good, the bank was on the hook.
  2. Then one day the government decided it was really important to encourage banks to lend aggressively.  So, they created some organizations to buy the loans (FNMA and FHLMC were the main two).  This made the banks more money since they now could loan to otherwise non creditworthy individuals and offset the risk to the government.
  3. Still the banks weren’t happy, so they took matters into their own hands.  They starting creating new “instruments” backed by the mortgage payments.  The theory went that even though an individual loan might be risky, if you get enough together, it becomes safer.  The ultimate recourse for these instruments was the underlying real estate.
  4. These new instruments received AAA ratings, and sold like hot cakes.
  5. Banks made a lot of money and decided they wanted to make more money.
  6. The “safety” and profitability of these instruments encouraged more and more to be made.  Eventually the banks just wanted any loan they could get their hands on, because they knew they could package it and get it off their books.
  7. Eventually enough poor loans were made that it sideswiped the entire industry.

Now let’s look at what’s happening today.

  1. For time immemorial, landlords rented properties to tenants.  If the resident didn’t make good, the landlord was on the hook.
  2. Then one day the government decided it was really important to encourage landlords to rent aggressively.  So they created some organizations to pay rent for those who couldn’t afford it (Section 8).  This made the landlords more money since they now could rent to otherwise non creditworthy individuals and offset the risk to the government.
  3. Still the landlords weren’t happy, so they took matters into their own hands.  They started creating new “instruments” backed by the rent from tenants.  The theory was that even though an individual tenant might be risky, if you get enough together it becomes safer.  The ultimate recourse for these instruments was the underlying real estate.
  4. These new instruments received AAA ratings.

Don’t Panic Yet

We’re now seeing the first of the institutional investors hitting the market with these rent backed bonds.  As of today, the only way to issue one of these instrument is to own the real estate, which carries with it a host of problems (lack of liquidity, high transaction costs, low margin, etc).

However, more institutional players are rushing into the game.  In the last year, three new REIT’s IPO’d with a total market capitalization of 3 Billion.  That’s very small.

Prior to December of 2012, there was not one single family REIT.  This is a clear emerging trend in the market (and one I hope to capitalize on).

The trouble is as more institutional players jump into the market, we could see a flurry of rent backed securities.  My prediction:

  1. Institutional investor rents property
  2. Investor sells proceeds from rent onto third party (possible Blackstone as they’ll have experience in the game)
  3. Investor gets high percentage of future potential rent proceeds today, and use these funds to buy more property
  4. Blackstone bundles a large number of these “rent promises” and issues a “safe” new instrument

Once we start seeing these third party instruments crop up, accountability will become a distant memory.  The person selling the new products won’t care if they perform in the long run.  He makes his quick buck and if anything goes wrong, the buyer’s only recourse is against the tenant.

Electronic market places to sell your leases will crop up (called secondary markets) and anyone with a rental property…not just institutional investors…will be able to sell their tenant debt.

This trend will run its course for a while until a sufficiently large disruption happens and the whole thing collapses.

Wrap It Up: We Do Silly Things

Humans like to make things nice and smooth and easy.  We’re optimistic to a fault.  When we start creating systems designed around this poor assumption, we get ourselves into trouble.  It might look like gravy for a while, but when things turn bad, they get real bad.

The recent housing bubble and subsequent correction is a great example.

The terrifying thing is we’re laying the groundwork to do it all over again.

What can we do today?  Not much other than wait and see…and hope we don’t caught up in irrational exuberance again.

Photo: sara biljana

About Author

Kenneth Estes

During Kenny's decade in finance he bought many single family rentals in rural areas, as a hobby. Along the way, he talked some brave souls into joining him as investors and recently retired from finance to take his hobby to the next level. Find more by and about Kenny on his personal blog and his recently created twitter account!


  1. Douglas Dowell on

    Thanks the continued scholarship Kenny,

    I am getting on the contrarian wavelength finally. Nassim is a great place to start. It seems his antifragility view points explain Warren Buffets success to me. His model of the world is built to capitalize on black swans it seems. The intuitive nature of his approach versus heavy math justified positions. VERY interesting stuff indeed.

    • Kenneth Estes

      Welcome the darkside. We prefer the term “realists” over “contrarians.” 🙂

      The jury is out for me on Buffet. Something like 80% of his wealth came from 5 trades. On the face of it, that sounds a bit like picking heads 5 times in a row. On the other hand, he keeps a lot of powder dry to take advantage of catastrophic events when they do happen. I don’t know, if I ever have dinner with the guy, I’ll let you know.

      I randomly read an article by Malcolm Gladwell on NNT in “What the dog saw,” and I was surprised by the fact that NNT is actually incredibly mathematical. He just quantifies his beliefs and incorporates them into his valuations. I get the impression he dumbs it down for us plebs when he writes his best sellers.

      • Douglas Dowell on

        I love it. Realist is appropriate. It seems Mr. Market has such mood swings it seems all it will really take is a discipline to spot irrationality and to me the real win is recognize it in our self.

        NNT is quiet a mathematician and is indeed working on a text. I think the misconception is he argues to throw out math all together where I believe he is saying just don’t blind yourself to the “error” constant.

        I appreciate his critique of economist in that if we are so advance is economics the bubble would of been avoided. However, I think the overall harm of the FED is offset by the good. Its a very interesting debate, and the FED deserve intense scrutiny but I still vote to keep it.

  2. Hi Kenny,

    I agree with you. The similarities are striking between the last economic decline and what seems to be happening with the current REO to rent model by REITs. While I don’t think it will go as far as individuals assigning their rents to a bond, I think the business models as a whole are too close to call.

    My question is, how can the average investor position himself to benefit from the pending collapse of the model?


    • Kenneth Estes

      There are number of ways to protect yourself. I think I’m going to be going with out of the money options. Very low initial investment, but large payoff in the event of something catastrophic.

      Either that or keep some flexibility in your investments. If this situation continues to develop shift your allocation from real estate to stocks.

      I think the former is much easier, but that’s a personal bias.



  3. I also don’t see individuals selling rent debt on the secondary market.
    I can see REITs, the Hedge Funds, other institutional investors and single big time individual landlords doing it.
    One would hope that after MBS debacle you’d think people would be more hesitant. Especially since a rent backed security has no underlying asset. For all the issues with the mortgage crisis the investors DID in the end have a tangible asset to seize, it just often turned out to not be worth what the investment was it had been used to collateralize.

      • I have looked a little more of the stuff coming out about the Blackstone stuff and it seems that they will be giving a priority lien on the actual properties as security to the lease backed security bond.
        Still not something I would buy but at least that only makes it kinda crappy vs. a full on steaming pile, IMO.
        (FYI my main reasoning being that since we have all heard accounts from investors in these markets saying the “Hedge Funds” are buying all the inventory and often paying at or above the market value the mortgages backing up the notes might not be worth what the securities they collateralizing were bought for.)

Leave A Reply

Pair a profile with your post!

Create a Free Account


Log In Here