Securitization: Ain’t nothing going on but the rent

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Rental income from repossessed housing is the next big thing in securitization. It will also be the acid test of what, if anything, the market has learned over the last five years.

When the Blackstone Group sold its inaugural securitization backed by rents from foreclosed properties at the end of last year it was hailed as a revolution in US housing finance. The concept is simple: large institutional buyers purchase properties out of foreclosure and rent them out themselves. This rental income then provides just the kind of steady, predictable revenue stream that screams out to be securitized.

Blackstone has been at the forefront of this process for some time. The firm has spent $7.5 billion building up a portfolio of 40,000 foreclosed single-family homes in Arizona, California, Florida, Georgia and Illinois.

In total, institutional investors, including firms such as Colony Capital and American Homes 4 Rent, have snapped up 200,000 foreclosed properties in the past two years and are now queuing up to follow Blackstone’s lead. Some observers have predicted that single-family rental bond deals could become a $20 billion a year business for the banks.

Blackstone’s deal, a $479 million securitization backed by rental payments from 3,207 of its properties, was arranged by Deutsche Bank, JPMorgan and Credit Suisse. It received a rapturous reception last November, being oversubscribed six times and pricing at a mere 115 basis points over Libor for the triple-A notes. American Homes 4 Rent is expected to bring a similar trade in the first quarter of this year through JPMorgan, Goldman Sachs and Wells Fargo.

If there was one lesson to be learned from the sub-prime mortgage crisis it was that securitized bonds are only as good as the assets that are backing them. Or, put more succinctly: crap in, crap out.

The quality of the rental streams backing these bonds is therefore of crucial importance. When Morningstar, whose credit rating unit rated the deal, recently released a review of its performance from October to January it revealed that rental collections were down by 7.6%, meaning that 8.3% of properties are vacant or occupied by delinquent tenants.

A certain level of vacancy is to be expected – and indeed the renewal of leases for properties in the pool was higher than expected at 78.5%.

But the concern with this deal is that net cashflow relative to the size of borrowing is high: the loan-to-cost ratio is 88% and it had a debt coverage ratio of just 1.68 times at launch. The loan-to-value ratio is lower at 75%, but has been determined using "broker price opinions" of the value of the property.

It doesn’t take a genius to figure out that those opinions might be on the high side given that these properties are located in areas where values have been driven upwards because of the bid for property by the likes of Blackstone itself.

The last thing that the securitization market needs is another housing-related snafu. Any new attempts to apply the technique to residential real estate must be, well, safe as houses – for all the obvious reasons. The market needs to watch that vacancy figure like a hawk before rushing headlong down another route to disaster.