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Investors Get Creative with Hot Rental Market

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Remember mortgage-backed securities?

Big banks and investment houses pooled mortgages of all types and sold them off to investors, who then traded them all over the place, pumping so much liquidity into the mortgage market that brokers were basically giving mortgages away?

And then remember when all those mortgages went bad because people couldn’t pay them, and so those securities went bad, and that brought down the whole national economy?

What if I told you investors were now looking at another housing-related security…this time backed by rent.

It’s no secret that investors have been inhaling foreclosed properties at a breakneck pace, trying to cash in on an increasingly hot rental market. They have been buying properties alone and in bulk, and some are even creating REITs of these properties in order to raise capital to buy more. But enough is never enough, and with such a huge supply of distressed homes (5.57 million loans either delinquent or in the foreclosure process, according to a new report from Lender Processing Services and many more already repossessed by lenders and the government), it should come as no surprise the investors are getting ever more creative.

The latest proposal is for a new security backed by pools of previously foreclosed rental properties. It would be similar to the MBS model, but instead of mortgage payments providing the cash flow to investors, the monthly rents would. Standard and Poors has already been approached to rate these potential new securities.

“There is clearly an opportunity, lots of REO [bank-owned] properties coming into the market over the next few years,” explains S&P’s Vandana Sharma. “What is the best way to finance them? So the next thing is to say, how do you assemble a pool with some geographic diversity, how do you take homes from different markets, so how do you put that pool together?”

The properties could be owned by banks, investors, or even the federal government. But while the rental stream coming through these securities sounds simple enough, the fact that these are rental properties presents complications, specifically in property management. Unlike buying a security that pools mortgages, the owners of these securities would have to factor in the costs of the property’s upkeep and management of tenants.

“There's also the cost of painting and re-leasing the homes, periodically setting the market rents, so there's a very active property management aspect to it and a capability, and then there's the question of what pays the investors back? Is it the lease payment from the rents they collect or is it the sale of these properties, so that's really the next phase of analysis for this opportunity.” adds Sharma.

S&P is running some possible scenarios, one in which investors would first get rental income but then could also get a cut if the property were to be sold when the overall housing market recovers. Investors are already interested, especially given the fact that these days good yield is hard to find.

“We’re now in a world where yield means everything, and anything that throws off yield gets a look,” says Steve Duffy, Managing Director at Moss Adams Capital.

Still, investors are far more cautious today than they once were.

“From an investor standpoint, what we're looking for is more transparency,” says Blackrock Vice-Chairman Barbara Novick. “So whether it's REO or performing loans, whatever the underlying assets are, what we really need in the new world is a better, clearer understanding of what's in that pool when it's first issued and then how is that pool performing over time.”

Investors would want to know not only if the tenants are paying on time, but if there might be any credit issues in the prospective pool, because it’s the individual renters who are going to determine how the credit quality looks.

The risks of such securities go beyond just the renter making a monthly payment. There is also the question of what happens when the overall housing market recovers, and more renters turn to buying, thereby driving rents, and potential investor returns, down. There are also unanswered questions about the government’s role in all this, especially since they could participate given how many foreclosed homes Fannie Mae, Freddie Mac and the FHA hold on their books.

“We have questions about: will the government have restrictions about when properties are sold, does the government put restrictions on how much you can raise rents, do you have any other requirements for money that the property managers must put aside for reserves or other things, and so there are a lot more technical questions that we would have as credit analysts,” concludes S&P’s Sharma.

- Realty Check producer Stephanie Dhue contributed to this story

Questions? Comments? RealtyCheck@cnbc.com And follow me on Twitter @Diana_Olick

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  • Diana Olick serves as CNBC's real estate correspondent as well as the editor of the Realty Check section on CNBC.com.

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