The Economics of Large Pools of Property Assets
For spot REOs [REO = 'real estate owned', the euphemism for properties repossessed in foreclosures, ed.], which are primarily all single family, condos and some 1-4 family units, the pecking order of potential buyers could not be simpler:
- Owner occupants.
- Small investors who own no more than a handful of units.
- Large investors who own multiple units in one market.
- Large investors who own multiple units in multiple markets.
- Mega bulk investors.
For some strange reason, our government is comtemplating bypassing all the more suitable buyers listed above in favor of the worst buyers possible. There can be no explanation for this aside from stupidity and/or corruption.
The logic behind this is simple. Economies of scale so to speak tend to work in reverse when it comes to spot REOs. At each level of the pecking order, the expenses one incurs are higher rather than lower. For example, an owner occupant or small investor may purchase a property that requires minor repairs and budget nothing but 'sweat equity' for these items. A large local investor may have a crew or an inexpensive contractor for these repairs. A mega bulk investor has to contract a local manager, who then gives the job to sub-contractors to have the work performed.
Spot REOs are in various places all over the map. The houses in the best locations are usually gobbled up at top prices immediately. The second tier ones may require a few rounds of price reductions and re-appraisals to move them off the books. Then there are the junk units that may not be marketable at all for one reason or another. When an asset manager is burdened with hundreds of properties to sell, the junk properties usually are set aside, resulting in a growing 'dead pool' as time passes.
If there are to be bulk sales, these are certainly properties that should be included in the pools. However, for a mega bulk buyer, there may be no discount that is steep enough to justify buying them. For example, if a bulk investor buys 1,000 apartment units in five completely run down projects, then those are five projects where investors can hire a team for each site and bring the respective property back to the standards associated with its highest and best use. If there are 1,000 different locations spread all over a region, then we are looking at 1,000 different projects – logisitically an entirely different proposition. These properties may be located in, say, Atlanta and may only have a price tag of $20-30 million, certainly not low enough to whet the appetite of a big investor, not to mention a mega bulk investor.
The GSEs reportedly carry an inventory of approximately 200,000 in REOs on their books. If those were divided into $1 billion pools at an average price of $100,000 per property, that would require 20 pools consisting of 10,000 properties per pool. Unlike the purchase of loans or securities, buying such a pool involves taking ownership of properties and assuming liabilities that one may be eager to assume.
Do you have any idea what it takes to assemble a pool of 10,000 REOs and prepare the required due diligence packages? If the GSEs were able to miraculously conduct one of these billion dollar bulk sales every quarter, it would still take 5 years to liquidate their existing REO inventory.
An Alternative Proposal to Mega Bulk Sales
Location, location, location. The metro areas that have somewhat stabilized do not need mega bulk sales in any form. The metro areas that have excessive REO inventories usually have large supply/demand imbalances where a bulk sale may tend to exacerbate the problems. Just imagine the poor homeowners struggling with an already underwater mortgage, only to find out that their newest neighbor is some hedge fund who bought the same house at a discount of 30%-40% – or most likely more. Imagine the poor little investor with negative cash flow trying to compete against the hedge fund for a tenant in such a down market.
How much of a discount is required in order for a mega bulk buyer to offset all the inefficiencies associated with a bulk purchase and still generate a reasonable internal rate of return? It is a near certainty that mega bulk buyers would demand a very big discount, combined with some sort of below market financing and some form of indemnification.
Here are a few alternatives that illustrate how incredibly stupid the mega bulk sales idea is. For the purpose of this illustration, I am going to make the assumption that a bulk buyer is going purchase at 70% of the most recent appraisal and is happy with 70% financing at the prevailing rates available to an owner occupant. This assumption is generously conservative – in reality I cannot picture any mega bulk buyer willing to pay so much for the GSE inventory.
Alternative 1, target the owner users:
Sales price set at the most recent appraisal.
Nothing down financing at prevailing rates for owner users.
No points, no fees, no closing costs. They are all factored into the loan.
A minimum credit score of, say, 650.
Buyer must show they have been paying rent for the past six months at or above the project PITI (principal, interest, tax and insurance).
This alternative would open the door to a great many buyers. They are not going to hurt the market because they are paying full price. They are not going to hurt the other properties listed for sale, because they would not be buyers if a down payment were required. They would have already demonstrated that they can afford the monthly payment in the form of rent. As owners, they would most likely improve the property, which a tenant would not do.
In comparison to a bulk sale, an owner user is paying 30% more, offering the GSE a big cushion on top of all the aforementioned benefits.
Alterative 2, target small investors:
Sales price set at the most recent appraisal.
20% down payment. Financing at prevailing rates for owner users.
No qualifications needed, the downpayment is the security.
This alternative would open the door to all the local investors that may currently have a tough time with financing. Based on the Federal Reserve's analysis, these properties are supposed to generate an 8% cap rate or even better return. With a 20% down payment, the property should generate a copious cash flow for the buyer. These buyers are not going to hurt the market because they would be paying full price. They would be more likely to take care of the property with the pride of ownership, much better than what can be expected of an impersonal hedge fund owner who is at several removes via a few layers of asset and property management staff.
In comparison to a bulk sale, a small investor is paying 30% more and is putting up 20% cash.
There are numerous other ideas to correctly market REOs but just the two alternatives mentioned above should put a big dent in any inventory. If the properties are not selling at a satisfactory pace, there are many follow up steps that could be implemented. I will discuss those in a future post.
In conclusion, any mega bulk sales by the GSEs would certainly be a big loss for taxpayers. If the mega bulk buyers think they are going to rip off the country the same way their predecessors did during the RTC giveaway, they may be in for a big surprise. They may eventually find themselves holding cans of worms all over the most undesirable markets.
As for the real estate market, I have no idea what mega bulks would do to the already depressed metro areas. They could prove to be very destabilizing. Maybe they would be the last straw that breaks the camel's back.
It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
Most read in the last 20 days:
- A Striking Chart
The Economy and the Stock Market As long time readers know, we are always paying close attention to the manufacturing sector, which is far more important to the US economy than is generally believed. In terms of gross output it is the largest sector of the economy, and it should of course be obvious that saving, investment and production are the only ways to create wealth. What's left of the Brooklyn Domino Sugar Refinery. Photo credit: Paul Raphaelson Contrary...
- Trump and Putin Narrowly Escape Assassination Attempt
The Gloves are Coming Off First a little bit of recent history. Readers are probably aware that some questions about the occasionally malfunctioning Deep State android... no, wait, we'll start again. Questions have recently been raised about the health of presidential candidate Hillary Clinton by various “alt-right” tinfoil hat-wearing conspiracy theorists, such as this one. The monsters are normally hiding under Hillary's bed, but lately they have come out into the open...
- Donald’s Electoral Struggle
Wicked and Terrible After touting her pro-labor union record, the Wicked Witch of Chappaqua rhetorically asked, “why am I not 50 points ahead?” Her chief rival bluntly responded: “because you’re terrible.”* No truer words have been uttered by any of the candidates about one of their opponents since the start of this extraordinary presidential campaign! Electoral map (note that the coloration may no longer be applicable...) That Hillary Clinton is...
- Why the Fed Destroyed the Market Economy
What Have You Done for Me Lately? Swing voters are a fickle bunch. One election they vote Democrat. The next they vote Republican. For they have no particular ideology or political philosophy to base their judgment upon. The primacy of the wallet. They don’t give a rip about questions of small government or big government. Nor do they have any druthers about the welfare or warfare state. In effect, they really don’t care. What’s important to the...
- Janet Yellen’s Shame
Playing Politics In honest capitalism, you do what you can to get other people to voluntarily give you money. This usually involves providing goods or services they think are worth the price. You may get a little wild and crazy from time to time, but you are always called to order by your customers. In the market economy, consumers reign supreme. There is no such thing as a “lost” vote in the marketplace; every penny spent affects production. Mises noted: “Consumers...
- Get Ready for a New Crisis – in Corporate Debt
Imposter Dollar OUZILLY, France – We’re going back to basics here at the Diary. We’re getting everyone on the same page... learning together... connecting the dots... trying to figure out what is going on. The new three dollar bill issued by the Apprehensive States of America. We made a breakthrough when we identified the source of so many of today’s bizarre and grotesque trends. It’s the money – the new post-1971 dollar. This new dollar is green. You...
- The Economy, the Stock Market and the Fed
John Hussman on Recent Developments We always look forward to John Hussman's weekly missive on the markets. Some people say that he is a “permabear”, but we don't think that is a fair characterization. He is rightly wary of the stock market's historically extremely high valuation and the loose monetary policy driving the surge in asset prices. The S&P 500 Index and the NYSE advance-decline line. Most market internals weakened steadily until early February 2016, but...
- Hanjin Marooning in San Pedro Bay
Global Trade Reversal Expansions and contractions in global trade have played out over long secular trends for thousands of years. The Silk Road, for example, was established by the Han Dynasty of China in 130 BC, and allowed for continuous trade between East and West for nearly 1,600 years. In addition to economic trade, the Silk Road was also a conduit for culture and knowledge among its network of civilizations. A map of the main ancient Silk Road - click to...
- Great Causes, a Sea of Debt and the 2017 Recession
Great Cause NORMANDY, FRANCE – We continue our work with the bomb squad. Myth disposal is dangerous work: People love their myths more than they love life itself. They may kill for money. But they die for their religions, their governments, their clans... and their ideas. Famous French hippie and author Voltaire. He wears the same sardonic grin in every painting, whether he's depicted at a young or an old age, doesn't matter. His real name was François-Marie Arouet; he...
- The Donald Versus Killary: War or Peace?
War: A Warning from the Past Although history does not exactly repeat itself, it does provide parallels and sometimes quite ominous ones. Such is the case with the current U.S. Presidential election and the one which occurred one hundred years earlier. The Donald probably has the better slogan... The dominating question which hung over the 1916 campaign was whether the country would remain neutral in regard to the horrific slaughter which was taking place on the...
- A Rift in the Space-Time Continuum
Weird and Unnatural NORMANDY, France – First, a quick look at the markets. The Dow bounced on Monday, recovering 239 points of the nearly 400 it lost on Friday. Why the comeback? FOMC member Lael Brainard: her comments on Monday were touted as the “reason” for the stock market recovering half of Friday's losses. We suspect the real reason is the triple witching on Friday... Photo via twitter.com The financial press has a ready answer: “Stocks gain...
- Crimea: Digging For The Truth
Renewed Escalation This summer witnessed a renewed escalation between Russia and Ukraine after Russian President Vladimir Putin accused Ukraine of sending saboteurs to attack Russian troops, targeting “critical infrastructure”. Kiev denied the allegations and claimed Russia’s “fantasy” was nothing but a false pretense to launch a “new invasion”. August 10: Russian president Putin announces that there was an altercation involving a group of Ukrainian saboteurs at...