Explaining Southern California's economy

The Fed's solution to the housing crisis: Rent!

Real Estate Brokers Lead Bus Tour Of Foreclosed Homes In Vegas Area

Ethan Miller/Getty Images

Well, this is interesting. The Federal Reserve has produced a white paper that tackles the Very Big Problem of the ongoing housing crisis and submitted it to Congress. It's a veritable treasure trove of clear-eyed analysis about why the housing market is still in such rotten shape. But beyond that, it offers a suite of equally clear-eyed ways to fix the problem.

One of these is particularly intriguing: taking foreclosed properties and, instead of trying to sell them to new homeowners — which requires mortgage financing which isn't now widely available to any but the most creditworthy borrowers — turning them into rentals. And who will do the renting? Real estate investors are the secret sauce (just a bit of translation: "REO" means "real estate owned," i.e. foreclosures):

To date, REO holders have avoided selling properties in bulk to third-party investors because the recoveries that REO holders receive on such sales are generally lower than the corresponding recoveries on sales to owner occupants. Investors considering such bulk-sale transactions tend to demand a higher risk premium than owner occupants and thus will purchase only at lower prices. Investors in such transactions also might have more difficulty obtaining debt financing than owner occupants.  Although mortgage products are available for individual one- to four-family houses and for multifamily properties (albeit currently at tight terms), no mortgage products currently exist for a portfolio of single-family homes. [My emphasis] In addition, REO holders must absorb the costs of assembling inventory for bulk sale — that is, holding properties off the market until enough properties have been assembled to cover the fixed costs of a rental program. Until the inventory is assembled, the REO holder receives no revenue from the property but incurs direct financing costs; carrying costs such as taxes, utilities, and maintenance expenses; and the continued depreciation of the property.

An REO-to-rental program that relies on sales to third-party investors will be more viable if this cost-pricing differential can be narrowed. REO holders will likely get better pricing on these sales if the program is designed to be attractive to a wide variety of investors. Selling to third-party investors via competitive auction processes may also improve the loss recoveries.

This is, to put is bluntly, an incredibly good idea. The goal is to create financing — mortgages — that can be applied to a grouping of single-family homes. For the sake of argument, let's make it a nice round number: ten homes, all in roughly the same geographical area. To keep the numbers nice and round, let's say all those homes sold originally for $400,000 but are now foreclosed and only worth $200,000. That's $2 million worth of homes. (I'm taking out various ancillary and transactional costs to keep the example simple.) 

The Fed's idea is to create a mortgage product, backed by the government, that would enable an investor to finance that $2 million, in the same way that he can now finance a multi-family apartment building.

The investor would then rent these properties in a rental market that's beginning to show strength, according to the Fed (no surprise there, given how many people have been foreclosed and need a place to live but can't obtain another mortgage). 

This would take foreclosed properties off the owner-occupant market, allowing the supply-demand ratio to return to something resembling historic norms and enabling the housing market to recover to pre-crisis price levels.

What the Fed is, I think, calling for here is the creation of a new, government-subsidized mortgage product — the REO-to-rental bulk mortgage — that will be attractive both to the institutions holding the REOs and to the investors who want to buy them and rent them.

My very informal discussions with real estate investors suggests that they're eager to grab foreclosed properties right now and either rent or sell them, often after investing money in fixing them up. The challenge is in the financing. The Fed's proposal wouldn't just fix that problem — it would open up a whole new investment opportunity. 

It might just deserve a chance.

Follow Matthew DeBord and the DeBord Report on Twitter.

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