Yield-hungry investors have been snapping up single family rental securitizations, with recent deals heavily oversubscribed. Buyers have been comforted by raging agency reviews that give the top tranches AAA grades, based on loss cushions that these scorekeepers treat as generous (a dissenting view comes from Standard & Poors, which stated that the “operational infancy” of these rental securitizations made them ineligible for a triple A rating).
However, investors appear to be overlooking a risk component that can deliver large-scale losses. We’ll call it trigger risk.
Recall that private equity firms hoovered up houses out of foreclosure in hard-hit Sunbelt states, buying the properties with cash. The fact that they did not use leverage at the time of purchase, however, did not mean that these financiers were going to let an opportunity to use other people’s money go by.
These securitizations have a mortgage. Singular. For instance, see this section of the transaction summary from Kroll’s New Issue Report on a Blackstone Group Invitation Homes offering, Invitation Homes 2014-SFR2:
IH 2014-SFR2 is backed by a non-recourse first-lien mortgage loan originated by German American Capital Corporation (the lender). The loan will have a principal balance of $719.9 million as of the cut-off date and will close simultaneously with the securitization. The loan is secured by the borrower’s fee simple interest in 3,749 single-family residential properties.
The floating rate loan will require interest-only payments and have a two-year term with three 12-month extension options. The borrower will be required to enter into an interest rate cap agreement with a third-party provider. The agreement will be pledged as additional collateral for the loan. As such, should the loan be extended, a replacement interest rate cap agreement would need to be obtained to cover the extended loan term.
So effectively, this loan is a bullet with a maximum term of five years. This is short compared to commercial mortgage backed securitizations, in which the underlying loans on the properties have terms of seven or ten years. And CMBS have mortgages on each property (typically 20 to 100 in a deal) so some of the properties having trouble refinancing would not impair the entire securitization. By contrast, these rental securitizations presuppose either a refinancing or a sale of the properties in a short period of time.
Kroll takes the position that they’ve stress-tested the risk with high default probabilities and severe home price declines. However, they appear to have overlooked the way that deteriorating credit quality can feed on itself. Reader MBS Guy writes:
I think I’ve figured out what these deals compare to: rather than cliff risk, I would call it “trigger risk”. I first heard the term used in connection with Enron. It is also what happened with Bear Stearns, the bond insurers and AIG – some credit weakening and modest downgrades, which trigger covenant or performance triggers, which set off a spiral that leads to further downgrades into bankruptcy. In Enron’s case, the downgrade below “A” set off a wave of internal covenants. In AIG’s case, the downgrade from AA triggered the requirement to post additional collateral, which weakened them financially, etc. spiral.
In theory, the downgrade or event tripping the initial trigger doesn’t seem so severe, but in practical reality, it sets off a series of events that blows the company up.
In the rental securitizations, it appears like there is plenty of enhancement and legal provisions to make everything work effectively. If collateral property values or rent yields aren’t high enough at the refi point, you just sell the portfolio. The reality is, if they have to sell the whole portfolio, they will trigger significant home value and rent yield declines, which will spiral down from there. This is especially true if the properties are concentrated, which of course they are – 78% of the properties are located in just 3 states, top 3 cities equals 36%.
This degree of geographic concentration is necessary from a property management perspective but increases the downside risk in the event of a forced unwind.
Consider what happens if a deal couldn’t be refinanced at a yield that “works” relative to the underlying rental yields and the homes need to be sold. They have tenants with leases in them. Who manages the properties with the securitization being dissolved. Even if the current property managers are in theory still in charge, how good a job will they do with their revenue stream disappearing? How good a job will they do while downsizing or closing shop?
Moreover, given the prospect of a bulk sale at a discount or large-scale individual home liquidation, investors won’t have a good handle on the value of the underlying collateral is. Mind you, unlike a CDO, there will almost certainly be value in the underlying properties, but investors are not too keen about uncertain outcomes and murky timing. For instance, one scenario is that if the special servicer can’t sell the homes, the bond holders would be forced to accept more extensions at a lower value.
Remember, if interest rates rise, the collateral will be under water, since the leases are effectively fixed rate, while the interest rates float. Again from MBG Guy:
I think the ratings on the deals don’t come close to properly valuing the administrative risk of a portfolio sale. I am fairly certain the investors have no clue either. The parties involved will almost certainly fail at managing the process, which hasn’t been properly valued either. There would likely be total disarray and a huge tranche warfare issue – the AAA bond holders are fairly well protected and would want to push for sale of the properties (or refi of the loan on bad terms) as quickly as possible because they’ll still be made whole or close to it (40% protection or so). Subordinated bond holders, who typically end up with much more control in the deals, will want the opposite.
And keep in mind that the quality of these rental securitizations keeps getting lower and lower. The Kroll summary shows that the quality of the collateral in the latest Blackstone deal is considerably below market norms for what many consider to be the most important metric, namely. – debt service coverage (emphasis ours):
The issuer debt service coverage (DSC) and KBRA debt service coverage (KDSC) for the underlying loan are 2.30x and 1.77x at current LIBOR (0.25%), respectively. The issuer’s DSC and the KDSC at the interest rate cap strike are much lower at 1.22x and 0.94x, which is significantly below the KDSCs of typical multi-family properties in KBRA rated Freddie Mac K-series and CMBS transactions over the last year, which have averaged at approximately 1.43x. Lower DSCs increase the probability of default during the loan term, particularly if cash flows come under stress, all else being equal.
Worse, debt yields have dropped relative to earlier deals by Blackstone and other issuers. The first Invitation deal came to market at a 6.4% debt yield, while the current one is at only 5.2%. The American Homes 4 Rent transaction was 7.9% and Silver Bay’s were at 6.2% and 5.7%.
Remember lower rental yields allow investors to bid more for properties. For the inaugural Invitation Homes rental securitization, the average property price was $199,000. Using the 6.4% rental yield for the portfolio, that results in an average annual rent, net of vacancies, of $12,736. If you apply the rental yield of their most recent deal, 5.2%, to that $12,736 average rental stream, you get a an average home price of $244,923. Voila! A 23% increase!
Notice that these rental securitization exits on riskier and riskier terms have allowed institutional investors to keep bidding up home prices. Even so, these private equity buyers have pulled back from the market and demand the small-scale investors who haven’t yet gotten the memo will presumably dry up soon in the markets that were inflated by the private equity rental bid.
MBS Guy concludes:
If Michael Lewis were writing this up, he would say that this is a case of the rating agencies just assuming property values will increase indefinitely into the future. A more accurate way of describing it would be to say that the business of institutional buying and securitization permits the normal market dynamics to be obscured so that people on the ground – either as individual property investors or renters, or as bond investors – can’t get a full picture of what is happening. Typically, economists and similar types miss it, as well.
The home purchase and rental market, in aggregate, depends on some degree of rationality to keep a check on prices. When institutional investors come along using warehouse facilities and securitization, they introduce a whole new structure for pricing – one that depends on a different set of metrics (and typically benefits from much more leverage and misdirected investors).
In theory, bond investors (and rating agencies, lol) should be imposing price discipline on the rental securitization issuer. But they are making comparisons to a very different set of metrics. In this case, bond investors are driven by a mad hunt for yield and are comparing this to junk bonds, probably, and seeing value. They are also not knowledgeable enough about the dynamics of the underlying rental market to gauge whether prices are accurate or not (in this way, securitization creates a sort of poorly informed rental investor with way too much money in their pockets, who think they are experts in the field).
As I’m writing this, I’m realizing that this is exactly the way I described what happened to the MBS market – the credit derivatives folks came in to the market in 2003-4 with an entirely new set of metrics for the pricing of MBS sub bonds, which drove the pricing and standards of the underlying mortgages, which none of the traditional MBS people could understand. We all thought that the market would have to correct, but it lasted much longer than we thought possible. There are signs that the rental market is correcting already in formerly hot markets like Phoenix. I don’t know whether the market as a whole for these deals will cool soon or not, though. I’d bet they won’t.
Yves here. And as we learned the hard way in the toxic phase of mortgage securitization, which was driven by the perverse effects of credit derivatives, the longer the unnatural dynamics persist, the more painful the eventual day of reckoning.