Investors buy non-performing loans to foreclose and obtain rental properties

Investors buy delinquent mortgages from lenders with plans to foreclose, boot out the mortgage squatters, and convert the property to rentals. This strategy may cause an increase in foreclosures nationwide.

REO-to-rental investment hedge funds exhausted the supply of homes they could acquire at auction or on the MLS for the prices they need to make the investment profitable. Desperate for more homes to add to their portfolios, investors turn to lenders to buy the non-performing loans on their books so these investors can foreclose on the delinquent borrower and obtain a rental property. This new strategy may cause a dramatic increase in the number of foreclosures.

I didn’t see this coming. Like most industry observers, I assumed that once house prices rose above levels where rentals provided reasonable cashflow returns, most seasoned professional investors would simply stop buying — and many have stopped, but the latest development is an innovative way of obtaining even more inventory at prices that make their business model work.

Souring Mortgage Debt May Be the Next Big Thing

By Reuben Brewer, February 15, 2014

Hedge funds were among the first to institutionalize the single-family housing space by buying up swaths of distressed properties. Now that good deals are harder to find, they’ve switched to buying soured mortgage debt. …

When the housing bubble burst, institutional investors quickly rushed in to buy up homes at fire-sale prices. The foundation for REITs like American Homes 4 Rent, Silver Bay Realty, and American Residential Properties were built during that period. Put together, these companies now own around 30,000 properties in key markets throughout the United States.

However, in the third quarter all three noted that they were slowing their purchase pace or shifting purchasing tactics in response to changing market dynamics. In other words, the opportunity that brought these REITs into existence is going away. This brings with it big questions about how these companies will continue growing.

In the post Bold California housing market predictions for 2014, I noted “The biggest demand cohort in 2013 was investors, many paying all-cash. With house prices 20% higher or more, these investors will not be nearly as active in 2014. In fact, I predict one of the big housing stories of 2014 will be just how dramatically and abruptly these investors pull back.” Prices no longer make sense for their business model, so they will stop buying houses.

But that doesn’t mean there isn’t opportunity in the housing market. Hedge funds have started to buy soured mortgage debt as a way to continue making money off of the housing bust.

Silver Bay, American Homes 4 Rent, and American Residential all have a pretty simple business model. Buying homes and renting them out is easy to get your head around and works well within the REIT structure. And as long as they don’t get overburdened with debt, they’ll be running fairly low risk operations backed by hard assets. You, as an investor, should get a steady stream of dividend payments along the way.

Many people either don’t like this business model or don’t understand it; critics claim this business will fail without considering the obvious: these are low-risk operations backed by hard assets. With no debt, the risk is minimal, and as long as the operators don’t obtain more debt than their cashflow can service, this will remain a low-risk operation.

The hedge fund push into buying bad mortgage debt is far more aggressive. There are all sorts of problems with the model of acquiring homes by foreclosing on delinquent homeowners. For example, according to RealtyTrac, it took an average of 564 days to complete a foreclosure in 2013. That’s a lot of time and legal headache.

Long foreclosure timelines are not a reason to avoid buying the bad debt. Remember, lenders don’t want to foreclose on these borrowers; the main reason foreclosure timelines are so long is because it serves lender’s interests to kick the can. The foreclosure process in some judicial foreclosure states is broken, but by and large, the main reason timelines are long is because lenders are not in a hurry — REO-to-rental hedge funds will be.

And don’t forget that foreclosed homes often need extensive repairs and updating before they can be rented out.

So what? These hedge funds formed to buy foreclosed homes. They know the problems, and they were designed to deal with them. I can’t believe this was listed as an objection.

Still, with home prices heading higher, the best way to build a portfolio of cheap homes may be taking on the extra risk of buying delinquent debt.

And this is exactly why this may become a popular acquisition method this year.

How will this impact the housing market?

This acquisition strategy, if it becomes widespread, will almost certainly increase the number and pace of foreclosures; however, none of those foreclosures will make their way to the MLS as for-sale inventory. There will be no flood of supply causing house prices to go down because all of this inventory will be held by the investment company for some period of time. Depending on how fast they boot out the delinquent mortgage squatters, some markets might get flooded with rentals, but assuming the squatters had jobs, they will also be adding renters to the demand pool.

If hedge funds start turning away from purchasing off the MLS, and apparently they are, then it will mean less competing bids on properties. Ordinary buyers will finally have the chance to obtain properties without competition from all-cash investors. Of course, the only reason this is true is because prices are so high that hedge funds won’t pay it, but for those who want a family home, they would be fighting against a hedge fund to obtain a house.

The uptick in foreclosures, if it does happen, will wet the appetite of realtors and homebuyers hoping to find more inventory, and housing bears will predict an imminent decline, but since these foreclosures will largely be gobbled up by the hedge fund with the non-performing note, it won’t have the price impact many are hoping for. For those waiting to see delinquent mortgage squatters get the boot, this new strategy is exactly what they are hoping for.

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[idx-listing mlsnumber=”PW14033733″]

301 EADINGTON Ave Fullerton, CA 92833

$399,900 …….. Asking Price
$430,000 ………. Purchase Price
7/7/2004 ………. Purchase Date

($30,100) ………. Gross Gain (Loss)
($31,992) ………… Commissions and Costs at 8%
($62,092) ………. Net Gain (Loss)
-7.0% ………. Gross Percent Change
-14.4% ………. Net Percent Change
-0.7% ………… Annual Appreciation

Cost of Home Ownership
$399,900 …….. Asking Price
$13,997 ………… 3.5% Down FHA Financing
4.27% …………. Mortgage Interest Rate
30 ……………… Number of Years
$385,904 …….. Mortgage
$107,108 ………. Income Requirement

$1,903 ………… Monthly Mortgage Payment
$347 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$83 ………… Homeowners Insurance at 0.25%
$434 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$2,767 ………. Monthly Cash Outlays

($425) ………. Tax Savings
($530) ………. Principal Amortization
$22 ………….. Opportunity Cost of Down Payment
$120 ………….. Maintenance and Replacement Reserves
$1,954 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$5,499 ………… Furnishing and Move-In Costs at 1% + $1,500
$5,499 ………… Closing Costs at 1% + $1,500
$3,859 ………… Interest Points at 1%
$13,997 ………… Down Payment
$28,854 ………. Total Cash Costs
$29,900 ………. Emergency Cash Reserves
$58,754 ………. Total Savings Needed
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