A few years ago there were news reports that Fannie and Freddie would directly sell their inventory to large investors consisting of enormous blocks of single family residences in hundreds if not thousands per transaction.  In fact, there were a couple of pilot programs.  However, it seems like the hedge funds are purchasing REO’s and short sales listed on the market.  This has driven out the small investor due to the deeper pockets of these hedge funds.  Small investors might have hundreds of thousands while hedge funds have billions, it’s a David versus Goliath.  They will purchase homes at 5% to 7% over list if they really focused on deploying capital in a give a area. This drives up prices as evidenced by the huge run up in Phoenix last year.

This is unique in history, because traditional real estate investments have been industrial, commercial, retail, and multifamily types of properties.  Single family residences have been seen as a consumption item not an investment vehicle.  Typically an SFR purchase by a owner is for it’s use and enjoyment, except during the housing bubble due to easy and cheap credit at that time.  Valuations on home sales are done by comparable sales, not on projected incomes streams.  They are some transactions that are investor purchases and some conversions from a principal home to a rental.  However, the majority of the SFR buyers use it for their principal residence or vacation use.  Now, a large portion of homes that are purchased is for capital appreciation, cash flow, or both.

Hedge Funds Shrink Foreclosure Discounts

Written by: Steve Cook   Monday January 14, 2013n

Demand for foreclosures is so great and supplies are so low in some of the nation’s hottest foreclosure markets popular with investors that the price differences between REOs and full-price homes have virtually disappeared.

According to data from Home Value Forecast, during 2012 foreclosure discounts shriveled in some but not all of the markets suffering the greatest record foreclosure activity in past years. Foreclosure inventories have declined in these markers, largely due to residential real estate investors, both individual and hedge funds, who buy up foreclosed properties to convert into single family rentals. While full-price homes and short sales have appreciated slightly in these markets, REO prices have zoomed, a sign that investor demand-especially hedge funds who have been buying up thousands of REOs since the end of 2011-is driving the decline in foreclosure discounts.

A reason you have seen price appreciation is that banks have slowed the foreclosure process for it’s inventory.  It’s managing the slow release of it’s inventory so it won’t hurt home values if a flood of homes hit the market with few buyers.

Foreclosure discounts are critical to most investors’ business plans. To bring foreclosures up to market-ready or rent-ready status, investors spend a media of $7500 per property, or $9.2 billion per year according to a survey of investors by BiggerPockets.com and Memphis Invest. Should the foreclosure discount evaporate, it will be cheaper simply to purchase a full-price home that needs no repair.

Foreclosure discounts also have toxic effect home values. Their reduced values often are used by automatic valuation models and by appraisers in calculating comparable sales values for full-priced properties, resulting in lower appraised values.

I don’t think foreclosure discounts are a toxic affect. Really a market reaching it’s natural equilibrium.   It’s part of the business cycle we experience every 15 years or so.

In Las Vegas, the discount between full price homes and foreclosures was only was only 1 percent in the third quarter of 2012, and price differential between full-price properties are REOs has fallen to only $2000. Third quarter 2012 data from Home Value Forecast provides trend lines for REO, full-pricne and short sale prices, sales volume and time on market.. HVF provides insight into the current and future state of the U.S. housing market, and delivers 14 market snapshot graphs from the top 30 CBSAs. Home Value Forecast was created from a strategic partnership between Pro Teck Valuation Services and Collateral Analytics and uses numerous data sources including public records, local market MLS and general economic data.

Part of the problem in Las Vegas is that Nevada past very strict foreclosure laws and banks simply stopped foreclosing on homes.

The foreclosure discount in Phoenix has shrunk to about 5 percent. REO prices have risen to a median of $88,000 from $62,000 in January 2011, and today are only $6000 less than the median full-price home in the Phoenix market. At $70,000, short sales trail both REOs and full-price homes.

n Orlando, REO prices have been rising throughout 2012, but they still trail full-price homes by $17,000. The discount in the third quarter was still sizeable, about 21 percent, but down significantly from 33 percent in 2009. Tampa also saw in increase in REO prices at the same time that full-price homes rose, keeping the discount at about 32 percent.

Yet in Detroit, a major source of foreclosures but not a popular market for most inestors, the discount actually grew. REO prices in the third quarter were at the same level, $26,000, as they were in the third quarter of 2011, while full-price homes rose from $41,000 to $50,000.

Would you really want to purchase in Detroit, that’s a bad example.  However, other ones are excellent.

The massive amounts of money hedge funds are spending on foreclosures clearing impacting the real estate economy. Last year several dozen investment firms backed by $6 to 8 billion in private equity hedge funds announced plans to purchase between 40,000 and 80,000 previously foreclosed homes. In September investment bankers at Keefe Bruyette and Woods estimated the dollars raised so far may only trim 15 percent of the foreclosure supply and there is room for even more growth that could last for years.

Just last week Blackstone Group LP, the largest U.S. private real estate owner, accelerated purchases of single- family homes as prices jumped faster than it expected. According to Bloomberg, Blackstone has spent more than $2.5 billion on 16,000 homes to manage as rentals, deploying capital from the $13.3 billion fund it raised last year, said Jonathan Gray, global head of real estate for the world’s largest private equity firm. That’s up from $1 billion of homes owned in October, when Blackstone Chairman Stephen Schwarzman said the company was spending $100 million a week on houses.

I can’t see this situation being permanent.  Once single family residences become a consumption item again, the hedge funds will slowly get rid of their inventory can chase the new speculation that emerge in the future.  Remember appraisal valuations are produced by looking at comparable home sales not income streams.

“The market is moving much faster than anybody thought possible,” Gray said during an interview in Blackstone’s New York headquarters. “Housing is much stronger than people anticipated.”

Santa Monica-based Colony Capital LLC, last week raised at least $45 million to finance additional REO purchases. It has invested $355 million in the REO-to-rental business since July, according to regulatory filings.

Meanwhile, Colony, Blackstone, Waypoint Real Estate Group LLC and American Homes 4 Rent have reportedly converged on Atlanta in search of low-priced properties to buy and rent out, after helping drive prices up 34 percent in Phoenix from a year ago.

When federal reserve stops pushing down mortgage rates and the banks stop managing inventory this will all end.  The single family resident is the least efficient real estate investment that has the lowest rates of return.  They don’t have economies of scale like large commercial or multifamily buildings.  SFR’s for income and speculation has always been the small investor that wanted a extra income stream.