Rental securitizations: the next ratings blunder?
The nascent market for single-family rental (SFR) securitizations has given investors nearly $5bn of issuance so far, and yet another new issuer, Progress Residential, brought its first deal this month. Many of these real-estate owned (REO) properties were bundled into triple-A products in the run-up to the 2008 financial crisis — and investors could be left holding the bag again if history repeats itself.
Progress Residential marks the tenth SFR issue. All ten issues so far have been assigned triple-A ratings by Moody’s Investors Service, Kroll Bond Rating Agency and Morningstar, because of a hybrid, CMBS-style structure that securitizes the originator's interest payments on a first-lien loan. The first-lien loans in SFR deals, however, must be refinanced before notes mature for originators to make good on principal payments.
If an SFR issuer defaults on the deal’s collateral, then a special servicer can step in and liquidate properties until the bond’s final disposition date and make good on the securitization’s principal. The role of a first-lien loan as collateral on SFR notes provides certainty that investors will recover principal in a default scenario.
Betting the house
An investment in SFR ABS could be interpreted as a bet on the US housing sector, given that the value of the notes depends on the issuer’s ability to refinance or sell homes in its portfolio.
Freddie Mac deputy chief economist Leonard Kiefer thinks that bet is a good one. Because single-family housing sales have been low compared to population demographics, there is a lot of pent-up demand for housing among would-be buyers who delayed purchases during the economic recession, he says.
“The downside risk is we’re already five years out of the great recession, and in the next 10 years the odds of the US entering into another recession are pretty high,” Kiefer says.
The risk of another recession is too high to ignore for Jorge Newbery, founder and CEO of American Homeowner Preservation, a former not-for-profit enterprise which purchases defaulted mortgages with the goal of keeping people in their homes.
Newbery says recent home price appreciation has been inflated by REO-to-rental buyers, and he expects unemployment, low wages and looming interest rate rises to weigh down the housing recovery. SFR ABS issuers would be “lucky to sell [REO properties] for the price they bought them,” he says.
An MBS investor in New York — who wished to remain anonymous — is similarly pessimistic about the asset class: “Single-family rental securitizations are untested. We don’t know what the conditions for refinancing will be in five years’ time. And it’s not like multifamily housing where there are economies of scale to managing properties — it is much harder to manage a portfolio of properties in a suburban area.”
Raters square up
That risk of sponsors not refinancing the first-lien loans backing SFR deals is the main gripe of Fitch Ratings, which recently issued a friendly (or perhaps combative) reminder to investors (and perhaps other ratings agencies) in early September that “loans with balloon payments will default at maturity if not refinanced".
Fitch has capped all SFR securitizations at single-A because of “cash flow leverage, refinance risk and dependence on property liquidation for debt repayment".
Fitch notes that the first SFR, from Blackstone's Invitation Homes, carried a break-even interest rate on collateral of 4%. Recent issues Silver Bay Realty 2014-1, American Residential Properties 2014-SFR-1 and Invitation Homes 2014-SFR2 offered debt yields of approximately 5%, compared to 9% for Freddie Mac K Series transactions, according to the ratings agency.
“Given the leverage on SFR transactions, it is unlikely a secured lender would refinance the current debt, absent significant improvement in property cash flow,” says the Fitch report. “Fitch also believes that debt repayment predicated on foreclosure and liquidation is contrary to sponsor plans to build SFR portfolios, and is inconsistent with high investment grade ratings.”
But while SFR ABS require refinancing akin to CMBS transactions, they also experience benefits from their hybrid structure.
All SFR deals to date include provisions allowing a special servicer to liquidate mortgages on certificate holders’ behalf during a multi-year window until a final distribution date following an issuer’s default. Moody’s, Kroll and Morningstar cite the special servicer’s role as one of the justifications for assigning triple-A ratings to SFR securitizations.
“Do we really think [special servicers] are going to go and do a fire sale of [mortgages] for which they are getting a fee business, with their reputation on the line? No,” says Moody’s RMBS Analyst Navneet Agarwal.
One thing supporting that argument is the number of market participants that invest in mortgages. Kroll points to the government sponsored enterprises Fannie Mae and Freddie Mac, as well as banks, speciality finance companies and the bond market as viable options to refinance the mortgage-backed loan collateral in SFR deals before the notes mature.
“RMBS is a much more liquid market, with a lot more history of what single-family home prices are and how they trade under normal and stressed economic environments,” one of Kroll's analysts told GlobalCapital.
Like Fitch, Standard & Poor’s has not logged any ratings business from SFR issuers. S&P says the asset class is too new and unproven to garner a triple-A rating.
While the basic structure of all SFR ABS issues has been based on the collateralization of a single first-lien loan, with rental payments forwarded to noteholders, there are some differences.
Four of the deals include amortization of 1% per year, whereas the other five deals to have settled do not. All but one of the issues mature in five years and include a floating interest rate — American Homes 4 Rent’s September issue, valued at $513.3m, matures in 10 years and includes a fixed loan interest rate of 4.166%.
The majority of homes underlying SFR issues to date are located in California, Arizona, Florida, Georgia, Texas, Illinois and North Carolina.