Possible Large-Scale, REO-to-Rental Policy Described in Federal Reserve White Paper

There are about 60 metropolitan areas with at least 250 REO properties currently for sale by the GSEs and FHA--the scale that the Federal Reserve says could be large enough to realize efficiency gains in an REO-to-rental strategy. Atlanta has the largest number of REO properties for sale by these institutions with about 5,000 units. The next-largest inventories are in the metropolitan areas of Chicago; Detroit; Phoenix; Riverside, California; and Los Angeles, each of which have between 2,000 and 3,000 units. A similar number of REOs are held by non-GSE lenders and servicers.  And four times the current supply of REO is backlogged in a “shadow” inventory.

A recently released Federal Reserve white paper on the current state of the U.S. housing market and related policy considerations outlines a possible REO-to-rental policy as a way to reduce the supply of current and future REO – before it can do further damage to the market by depressing values and affecting quality of life in neighborhoods.

Although the paper also addresses the tightened (possibly over-tightened) credit market for new buyers, and the low response to current loan-modification programs as significant barriers to housing recovery, the authors predict that neither of these situations is likely to “unwind” in the near future.

A large-scale REO-to-rental strategy with GSEs could take a number of forms: the REO holder could rent the properties directly, sell the properties to a third-party investor who would rent the properties, or enter into a joint venture with such an investor. The investor could be a for-profit investor or a nonprofit.

To date, REO holders have avoided selling properties in bulk to third-party investors because the prices that REO holders receive on such sales are generally lower than the corresponding prices on sales to owner occupants. Several solutions to closing the gap are proffered in the paper: 

• Design the program to be attractive to a wide variety of investors.
• Sell to third-party investors via competitive auction processes.
• Provide investors with debt financing - such financing is largely unavailable now, thus limiting the number of potential investors.
• Minimize the amount of time that a vacant property lingers in REO inventory before being rented to reduce disposition costs to the REO holder
• Include properties that are already rented.
• Auction to investors the rights to acquire, in a given neighborhood, a future stream of properties that meet certain standards instead of auctioning the rights to current REO holdings.
• Encourage deed-for-lease programs, which circumvent the REO process entirely by combining a deed-in-lieu of foreclosure--whereby the borrower returns the property to the lender--with a rent-back arrangement in which the borrower remains in the home and pays market rent to the lender.

The paper also acknowledges the impact such a program could have on neighborhoods if rental properties are poorly managed. Suggested remedies include allowing investors to bid on properties only after demonstrating some experience with property management and commitment to rehabilitation of properties, engaging experienced nonprofit organizations with established ties to the community as rental managers, or giving investors an incentive to provide appropriate property management by deferring some of their compensation until they meet standards.

Two million vacant homes were on the market in the last quarter, about 25% of them REO.  More than four times that many are somewhere in the foreclosure process. Twelve million homeowners are underwater in their mortgages and will remain so until the housing market recovers. Meanwhile, the market for rental housing across the nation has recently strengthened somewhat. Rents have increased in the past year, and the national vacancy rate on multifamily rental properties has dropped noticeably from its peak in late 2009.

It seems reasonable to assume that the scale of this problem will not be addressed in the current environment by relying on owner-occupant sales alone.  What do you think about the prospect of moving a few hundred thousand REOs per year into the rental market?  Which would be considered worse in the neighborhoods you work in: vacant properties for sale in a slow, glutted market or several/many formerly owner-occupied homes converted to rental for a few years?  Could your nonprofit build capacity to own and manage 250 or more scattered site rental properties?  Would you want to?

We’d love to hear your reactions.  The full white paper can be downloaded here.