Meet Your New Landlord

Monday 03/17/14

     Last week the market fell amid tensions in Ukraine and more signs of slowing in China. One of the more concerning events last week was the crash in copper prices. Chinese Growth had been a major tailwind for copper, but as Chinese growth continues to slow, copper prices have become increasingly volatile. Geopolitical concerns were also on the radar of most traders as markets fluctuated on every new headline from Ukraine. Amidst all the flashy headlines economic indicators showed continued weakness, despite expectations for a strong rebound now that much of the bad weather has passed. Housing data has remained weak although it will be important to see if interest rates continue falling as this could perhaps reverse some of the deteriorating trends in housing. In this week’s newsletter we will take a look at a group of cash buyers who helped the U.S. housing market recover after 2008. This newsletter is a continuation from the last newsletter on housing.
     Cash buyers have certainly filled a void that was left after a wave of defaults pushed U.S. home prices to extremely low levels. So who are all these cash buyers? When I worked as a banker in Phoenix, AZ just after the mortgage meltdown I met many of these cash buyers first hand. For the most part, they were wealthy individuals who didn't like traditional investments like stocks and bonds. They saw the housing crisis as an opportunity to buy cheap real estate from the banks who were desperate to sell them. Those individuals were taking the biggest risk and were the ones who finally put a floor on the panic selling, they also likely made an enormous return on their investment. However, the biggest cash buyers came much later.

     Blackstone, a private equity firm, has become the largest landlord. Beginning in 2012, Blackstone invested heavily in the hardest hit parts of the country like Arizona, Florida, Nevada, California and others. Blackstone purchased the homes with the intent to fix them up, rent them, and eventually sell them. Large buyers like Blackstone and American Homes for Rent began outbidding the original cash only buyers, which started driving home prices even higher. You can see from the chart on the right that home prices began rising when Blackstone founded its subsidiary (2012), Invitation Homes, to begin investing in single family homes. Blackstone is hoping to capitalize on the transition of homeowners to renters. The next chart on the right shows the vacancy rate for rentals, this lack of supply has led to an increase in rents. While private equity purchases of single-family homes are recorded as cash purchases, this does not mean that there is no leverage involved. Private equity firms pool money from various investors and borrow heavily to amplify their returns.

     One of the strangest developments (to me at least) is the sale of bonds that are backed by rental incomes from these properties. Investors such as pension funds and endowments buy these bonds and rental income is pooled to pay the investors. These bonds have a similar tranche structure as the mortgage backed securities that were involved in the subprime crisis. The A class bondholders are protected from missed payments and rent defaults while B-F class bondholders are less likely to receive payment in the event of a default. If these sound a lot like the mortgage securitizations that were involved in the last housing crisis that's because they are. In many cases, it is the same exact people who defaulted on their mortgages in 2008 who are now renting the home that they used to live in. Bloomberg has an excellent series of charts on the structure of these securities.

     These bonds are vulnerable to an increase in the supply of rental units. As rental prices increase, developers have responded by increasing construction of apartments. As more of these units come on to the market it should eventually begin to put downward pressure on single-family home rentals as well. If rental prices decline this will be harmful to the lower classes of rental-backed securities.
     
     The other question is what will happen when private equity begins to make its exit? Private equity firms are looking for much higher returns than what are generated from rental income, so they will likely want to make an exit eventually. In recent months, private equity firms have dramatically slowed their purchases of existing homes, especially in the markets with the strongest rebounds like Phoenix. According to a report by Arizona State University's W.P. Carey School of Business, “Demand has been weakening since July (2013), especially demand from investors. Second home buyers and
owner-occupiers have been less active too. January is usually the quietest month of the year for sales,
but this January was far weaker than January 2013 and 2012. Single family home sales dropped 19%
compared with December with Maricopa (Phoenix metro) County down 19%, while Pinal County fell 21%.” If investors were the driving force behind the surge in home prices since 2012, then either prices will continue to weaken unless traditional home buyers come back to the market in a major way.

     The key determinant in future home prices will likely have a lot to do with the direction of interest rates. If interest rates move lower then housing prices could continue to rise, but if expectations shift toward higher interest rates this could have a negative impact. However, if interest rates move higher in response to rising inflation, then homes as a real asset could be expected to keep up with the pace of inflation. In general, home prices seem to have become a more speculative endeavor due to the amount of leverage in the market. Leverage fell after 2008 but it seems to be back in full force which means we could be in for a bumpy ride.