Real estate securities return to Wall Street

Staff Writer
Columbus CEO

(c) 2013, The Washington Post.

The housing crash created a lot of problems. Millions of families lost their assets. Neighborhoods emptied out as homes went into foreclosure. The rest of the economy went into a tailspin.

Investment funds had a problem too: They largely lost the market for residential mortgage-backed securities that had provided such excellent yields in the early 2000s. And with the Federal Reserve keeping interest rates low, there aren't a whole lot of obvious sources of income.

For the past three or four years, the investors have been hunting for new places to park their money that could generate substantial returns. Lucky for them, the crash brought about by those very securities created an opportunity: not mortgage payments on homes that a buyer would eventually own outright, but rent checks that tenants would keep sending forever.

Here's how. After the collapse, private equity firms and real estate investment trusts have bought up about 200,000 homes, worth a total of $20 billion, and rented them out. Now, the biggest of those buyers — Blackstone, which has spent $7 billion on 40,000 properties — has figured out a way to sell bonds backed by that rental revenue stream to other investors, creating a $479 million fund for the acquisition of even more rental properties. (It's a little more complicated than that, but that's the gist.)

So renters are sending checks to faraway Wall Street firms, and that money is ultimately split between hundreds of people who've bought into the pool.

Banks have been doing this quietly for about a year. But Blackstone's offering did something that early observers didn't think was possible: It got a rating of AAA from the ratings agencies, which opens up the vehicle to a much wider range of investors.

There is an argument in favor of this arrangement. As William Cohan wrote in September's Atlantic magazine, the backers of this scheme — including super-investor Sam Zell and Lewis Ranieri, the man who created mortgage-backed securities in the first place — claim it will "professionalize" the burgeoning rental market, spurring the renovation of homes that small-time landlords in low-income communities would rather let rot.

Still, whenever financial "innovations" hit the market, it's smart to game out what might go wrong. Critics of the plan see two major risks.

The first problem is similar to what the housing market encountered with mortgage-backed securities. When the lender doesn't plan to own your loan, it has little incentive to make sure you can pay it back. That's why so many silly mortgages were issued in the early 2000s, creating a bubble that could only burst.

Regulators have since required lenders to make sure that borrowers have the ability to repay. In the rent-securitization scenario, though, it's up to Wall Street to make sure renters in foreclosure-stricken neighborhoods can make their payments on time.

The lenders can always evict people who don't pay, but that takes time and lowers returns. And even though Blackstone figures it can liquidate properties if rents get too depressed, ratings agency Fitch worries that selling could prove difficult and would destabilize any housing market where a large sell-off occurred in a short time.

The second problem is one of distorting the market further away from homeownership toward renting. While it's true that, pre-crisis, America probably had an artificially inflated homeownership rate at around 70 percent, the pendulum has swung the other way. Between a third and a half of home sales now are all-cash offers, mostly from investors who easily beat out buyers who have to go through the process of getting a loan. Securitizing the rental stream will free up even more money for all-cash offers.

Robert Hockett, a Cornell University law professor who has advanced a plan to seize securitized mortgages through eminent domain, envisions a kind of dystopia that might arise from tipping the balance so far toward investors.

"We don't want to become a landlord-tenant culture, a sharecropper society. It's kind of like medieval Europe, where a few large financial institutions own everything and we just rent from them," Hockett says.

Looked at another way, though, the problem isn't that institutional owners have lots of access to credit. It's that regular home buyers have too little, with banks being extremely cautious about to whom they lend.

"What's really driving the trend is how tight credit is for home buyers. If we wanted to help them, we could help them much more easily by opening the credit box," says Christopher Mayer, research director for the Paul Milstein Center for Real Estate at Columbia Business School.

Mayer isn't worried about the new rental securities creating systemic risk, because the institutional property portfolios aren't highly leveraged, as home buyers were during the housing bubble. Plus, he points out, it's possible that creating a cheaper source of credit for rental investment might make renting less expensive.

Ultimately, a lot of this debate is fueled by memories of what happened the last time Wall Street came up with a clever trick to make boatloads of money from real estate by slicing up the value of a home and selling it off in bite-size pieces. As with the pre-bubble innovations, it's hard to predict how things might go wrong.

But when you strip out the eerie similarities, there are structural differences between this new instrument and the old ones that could make it safer and create more of the rental housing that America desperately needs.