Silver lining in Fannie’s REO auction

Fannie Mae sold its first pool of real estate owned properties (REOs) to Pacifica, a California based real estate investment company, to let as rentals. The 699 Florida homes sold for $78 million — 96% of their estimated value. This is approximately $111,600 on average for each property.

This deal is a joint venture between Fannie Mae and Pacifica. Fannie financed the majority of Pacifica’s purchase price on an appreciation participation rate of return for Fannie. This requires Pacifica repay the “loan” with net rental income generated leasing the properties to tenants, and on sales after three years of renting the units, splitting the net proceeds 50/50.

After the three year rental period, Pacifica may exercise its right to sell. Similar sales from Fannie’s inventory of 2,500 REOs are planned in six different states, including California.

Essentially, the buyer has been retained by Fannie to manage the properties as rentals for three years, then sell them and split any profits.

However, the concept of selling REOs to real estate investment trusts (REITs) at a discount is a bad idea in most situations. This case is an exception since it theoretically allows Fannie to get the inventory off its books with the least amount of work possible. It also allows it to avoid dealing with multiple listing service (MLS) agents who would otherwise move the properties. Consider this as a way of moving the bad inventory with the good.

REIT’s goal for single family residence (SFR) transactions is to produce quick and juicy profits for its investors; for SFRs this means flipping properties by reselling them as soon as possible at a higher price — the perpetual game of real estate hot potato. Management of SFR inventory is a very, very inefficient way to own income producing real estate.  Thus, REITs will only purchase the properties if they are guaranteed a huge spread between the properties’ current fair market value (FMV) and the reduced price Fannie is receiving in this “garbage disposal” event.

Although this bet may yield a significant return on investment (ROI) for REIT investors, it is not a gift to the housing market at the MLS level, which will suffer a loss of properties from its resale market. Further, it feeds a rise in home prices, buoyed by this massively disruptive speculator intrusion. The only person who gains from flipping homes is the investor (and affiliate providers of real estate services if they can get in on the deal, such as property managers) — future buyers reap the consequences of inflated home prices that follow.

However, the terms of Fannie Mae’s recent sale anticipate and circumvent some of these adverse results.

The investors buying into these pools of homes are required to rent them out for aminimum of three years following the transaction. No quick selling here. Thus, many of the disruptive results of flipping (doubled-down home sales and distorted prices) are avoided for at least the next three years while the public benefits by the filling of vacant properties with tenants.

Home pricing will rise temporarily as the mandatory rental of these properties reduces MLS inventory of SFRs that would otherwise flow into the MLS as part of the homeownership and resale market.  However, the rental market will benefit from the increased number of rental units, providing much-needed housing at a competitive rent for families currently ineligible for homeownership, such as those who were recently foreclosed or lack employment.

Vacant REOs are universally detrimental, whether held by lenders or by speculators, intent on eventually selling them to homebuyers at a profit. The properties physically deteriorate without maintenance, continually depreciating and dragging down their value and the value of neighboring properties in turn. Whole neighborhoods hurt.

The best market solution for vacant REOs is to sell them to end user owner-occupants. However, the still-lagging jobs market has left us with insufficient buyers possessing the downpayment and attendant strength of credit needed for a home loan, meaning the supply of REOs currently greatly outpaces end-user demand.

Since finding a creditworthy homebuyer to fill each of these properties is not currently a viable option, selling them to buy-to-let investors is the next best thing. The buy-to-let investor will hold the property for the long-term, using it as steady source of income and not promptly returning it to the MLS. The three-year safeguard against quick flipping will allow demand to grow before these properties actually hit the market for eventual resale, and preserve property value at the same time.

Bulking up investors may not be the best case scenario, but it isn’t the worst either.

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