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.
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