A Blackstone deal in the runup to the financial crisis, its acquisition of Equity Office Properties Trust from Sam Zell in early 2007 was recognized at the time as a sign of a market peak. Is history about to repeat itself with Blackstone’s rental securitization?
Recall that this deal was launched with great fanfare as major banks salivated over the prospect of creating a whole new type of investment to satisfy the private equity industry’s need to cash out of its single family home land grab. Mind you, this is far from the only exit. One approach, which is much more straightforward, is to spin the company out that manages the properties as an IPO. Industry experts argue you need a portfolio of only 1000 homes to go to market. But only a few deals got done before the Fed’s renewed seriousness about the taper gave investors the jitters.*
Of course, PE firms can also exit by selling homes individually. But that is a slow process and does not sound as sexy or sophisticated. And there’s a practical reason to regard this way out as a last resort. Remember the management part? As you start liquidating the homes, you are spreading overheads over fewer and fewer homes. While some activities can be cut more or less pro-rata, others can’t be as readily dialed down.
So enter the Blackstone rental securitization of last October. It was a modest $479 million deal and was six times oversubscribed. Investors no doubt believed that the initial deal would have to be priced on very favorable terms to assure its success, given Wall Street’s eagerness to launch a new product type.
But there’s still the wee problem of fundamental risk. As Bloomberg tells us:
Rents collected on the collateral for the first U.S. rental-home securities declined by 7.6 percent from October to January, according to Morningstar Inc.
Payments declined as expiring leases and early tenant departures left residences backing the bonds of Blackstone (BX) Group LP’s Invitation Homes vacant, Becky Cao and Brian Alan, analysts at Morningstar’s credit-ratings unit, said in a report. While 8.3 percent of the properties were vacant or occupied by delinquent renters in January, renewals on 78.5 percent of leases that expired the prior month exceeded the analysts’ expected rate of 66.7 percent.
One of the big risk elements in this deal is that it was sold before anyone in the market has reached “stabilized rentals,” where the portfolio is mature enough that enough of the units have been through a lease expiration or two so that investors have an informed idea of what renewal rates look like.
Notice several things: when I first heard PE investors in this strategy describe their expectations two years ago, they were anticipating only one week of vacancy a year, which is less than 2%. They’ve clearly gotten more realistic. The transaction was marketed with a modeled vacancy rate of 8%, so the 8.3%, which included delinquencies, does not look bad relative to that.
But what the 7.6% fall indicates is that Blackstone is having to cut rents to get renewals. We’d predicted that. Private equity investors were salivating over how tight rental markets were, and somehow failed to factor in that their very conversion of formerly owner-occupied homes into rentals would increase supply and lead to more competitive conditions for tenants, which would show up in higher vacancy rates and/or falling (or at least not rising) rents. Now admittedly, real estate is local, so there are undoubtedly markets around the US that are still tight. But certain area were particularly popular with investors, like Las Vegas, Atlanta, and Phoenix. A city with underlying growth like Phoenix might have enough of an increase in population and incomes to weather the large-scale PE conversion. Others are more vulnerable.
The big test for Blackstone will be the first quarter, the peak period for rent renewals in this transaction.
Mind you, this blip hasn’t hurt the AAA investors. The AAA investors have 40% subordination, meaning 40% of the deal consists either of lower-rated tranches or other risk buffers. But as one might expect, the prices on the riskier tranches which are the first to take the hit if cash flow comes up short, fell after the Morningstar news was made public. And that alone could prove fatal to this type of deal.
As we discussed in ECONNED, dealers do not want to wind up stuck with the riskiest inventory from securitizations, so the ability to sell these deals is constrained by the ability to place the more speculative tranches. For subprime mortgage backed securities, the way to escape these limits was to create CDOs, which became a Ponzi (the risky tranches of CDOs were similarly unwanted and were sold to other CDOs). We’ve discussed other risks to these deals, such as localities imposing tougher conditions on absentee landlords and regulators taking an interest in the servicing of rental properties. So the jury remains out as to whether this deal was the beachhead for a new product category, or whether investors were foolish to be buying what Blackstone was selling.
* Mind you, that does not mean that IPOs could not necessarily have been launched, but not at the prices the PE firms wanted.