Everybody wants credit for doing something about the housing crisis. Right now the government is hoping to convert hundreds of thousands of foreclosures owned by Fannie Mae and Freddie Mac into rentals.
Why isn’t this already happening? Or is it? I worry that we’re about to repeat earlier mistakes and create expensive market distortions that don’t produce much fundamental good.
Let me catch you up on the news. Earlier this month, the Obama administration asked private investors for ideas on turning the agencies’ stock of foreclosed homes, or REOs, into rentals. The White House had officials from the Federal Housing Finance Agency (the body charged with overseeing Fannie and Freddie), the Department of Housing and Urban Development, and the Treasury Department jointly issue an official request for ideas on how to move nearly 250,000 unsold repossessed homes it acquired through foreclosure from the for-sale market to the rental market. According to the press release, the hope is that pooling these REOs would reduce credit losses for Fannie and Freddie and stabilize neighborhoods as a result.
On the surface, it sounds great. We could help the housing market by getting rid of some of the foreclosure inventory while creating rental options for a lot of homeowners who are being displaced by foreclosure.
But what, precisely, is the market impediment that we’re trying to fix here? Yes, we have a very large supply of foreclosed homes courtesy of a wrenching, multi-year housing recession. And home prices are still falling. But the flip side of the horrible purchase market is a booming rental market. Rental supply is reportedly as tight now as it was prior to the recession, and effective rents are estimated to rise 4% this year. Likewise, the foreclosure epidemic is converting lots of homeowners into renters, thus increasing rental demand.
Investors smell a distinct opportunity here: the chance to buy an asset cheaply and rent it out dearly. About 30% of the purchases of existing homes this year have been going to all-cash buyers, the bulk of whom are real estate investors. For the most part, these have been small, private investors buying properties one by one with the intention of leasing them out.
This natural market dynamic does seem to be making some headway. In the second quarter, Fannie sold more REO properties than it acquired. That means its REO backlog has finally started to subside. In fact, the combined inventory of REOs owned by Fannie, Freddie and the Federal Housing Administration (FHA) declined at the end of the first quarter compared to the previous quarter.
Granted, part of the reason that REO sales are finally outpacing REO acquisitions is the slowdown in the foreclosure process. So it is likely that inventory levels will start to rise again once the foreclosure pace ramps back up. But the point still holds that Fannie, Freddie and the FHA are disposing of REOs at a record pace.
This is what a market-clearing process looks like. Rental demand may soon outpace supply, which will bid up rent prices. This, in turn, will create the incentives for even more investors to snap up cheap foreclosures and convert them to rentals. It’s painful for people who lose homes along the way. It’s not always pretty or fast for the rest of us. But it is natural.
Can the government help speed along this process? Maybe. But the first order is definitely making sure that we don’t do the market any further harm. For example, any plan in which the government-sponsored enterprises (GSE) retain ownership of the homes while renting them out just seems nonsensical. These homes will presumably have to be ultimately sold, so continued direct ownership perpetuates shadow inventory which undermines buyer confidence in price stability. The rentals will also directly compete with private investors who bought distressed properties in hopes of capitalizing on strong rental demand. Instead these investors would be thrown into competition with the GSEs.
What about increasing the pace of REO sales? We could try either to spur more bulk sales to large private investors or to figure out ways to increase the pace of sales to small investors. Some bulk sales of REOs are already occurring, often arranged by the Federal Deposit Insurance Corporation (FDIC) after it takes over the assets of failed banks. But two issues arise here: the deep discounting that accompanies them and the question of how the houses are later absorbed by the marketplace.
The discounts can be steep. In a bulk REO sale, it’s often the case that neither the seller nor the buyer really want to do due diligence on all the homes in an enormous, sprawling collection. There’s no time to understand how much refurbishment each home might need, whether it’s currently occupied or not, and how much each home might fetch on the market. So the buyers propose a hefty discount for the whole lot, hoping that they’ll luck into more screaming deals than stinkers in the exchange. Suffice it to say, this probably won’t maximize the return on Fannie and Freddie’s REO portfolio.
But the second issue—how the market absorbs the bulk sales—is even thornier. Who’s going to be on the buy side of these bulk deals, and what do they intend to do with the homes? Are there private entities out there now that are able to purchase, then manage, rental properties on the scale being considered? The GSEs are currently selling about 30,000 to 50,000 REOs per month. Converting all of those to rentals would equate to creating a new company the size of some of the largest property management companies in the country every three months. Can you name a private company that is willing and ready to manage those homes now? Very simply, it doesn’t exist.
Okay, so what if, instead, private funds buy their deeply discounted REOs from the government in bulk, then flip them to individual homeowners or smaller investors? Oops. That’s exactly what the GSEs are doing today. Except now the private funds will be capturing the difference between the REO bulk purchase price and the ultimate market price. They’d be siphoning lucre that would otherwise have gone to the GSEs—and ultimately to us, the taxpayers.
What’s left? There’s the option of making it easier for the small private investors who would like to buy or are already buying REOs and converting the homes into rentals. I’ll admit this idea has a nice American ring to it. It’s decentralized and democratic. A lot of the property management of single-family rental housing is already being done by individual investors, and perhaps there are ways of making it easier for these types of people to do a bit more. A number of options for doing this involve credit accessibility for such investors, and I promise I’ll explore some of these in an upcoming piece.
For now, let’s approach plans to juice the rental conversion process through government assistance with some caution. Remember how we got into this housing mess? Part of it was easier access to mortgage credit during the housing boom, which prompted millions of people to buy homes when that may not have been the most economically rational long-term choice for them. Well, pushing rental conversion above what the market is doing now may have unintended consequences down the road as well. Just to state one obvious possible consequence, subsidizing rentals may increase investor demand for foreclosures but at the cost of weaker homebuyer demand for foreclosures. Thus, we may make it less attractive to buy foreclosures to live in when one can rent a foreclosure for less.
While I can’t fault anybody for sincerely scouring the land for new ideas that might not have been considered already, I don’t think you have to be a hardened cynic to suspect that a healthy portion of the motivation for this call to action is political. The housing market is still hurting, and this rental-conversion plan gives the impression that the government is doing something. The genesis for this idea can be traced to early July, when President Barack Obama complained that the government’s previous efforts to prop up housing were “not enough. So we’re going back to the drawing board.”
We need to learn from the failure of those previous efforts. The federal homebuyer tax credits did prop up demand when they were in effect, but the program was expensive and the hangover effect was palpable. Once the credits expired, we saw home values take a nosedive across the country, with Zillow’s Q1 Real Estate Market Report showing some of the most dramatic declines since the start of the housing recession.
While we aren’t out of the woods yet by any means in terms of the housing recession, the market has improved somewhat relative to the post-tax credit period. In Q2, 94 of the 154 markets covered in Zillow’s reports showed home value appreciation. Importantly, this progress is organic, fueled by historically high housing affordability and private investors moving in to convert cheap foreclosures into cheap rentals. It would be a shame to derail this organic momentum, just to give the appearance of action.