A New REO Dilemma: SFR Rentals Vs. MDU Rentals

Written by Paul Hayman
on August 11, 2010 No Comments
Categories : Required Reading

REQUIRED READING: Over the past two years, much of the industry's – as well as the government's – attention has focused on defaults in the single-family residence (SFR) sector, and for good reason. Hundreds, or even thousands, of SFRs are continuing to go into foreclosure every day. According to a recent RealtyTrac study, bank repossessions (i.e., real estate owned properties (REOs)) hit a record monthly high in April, with a total of 92,432 properties repossessed by lenders during the month.

To alleviate this strain on the industry, it often becomes more attractive for lenders, servicers and investors to rent SFRs to generate money and keep neighborhoods stable. This approach, while sound, has caused a new dilemma to take root: The increase in SFR rentals is beginning to compete directly with multi-dwelling unit (MDU) rentals, driving down MDU rents and depressing cashflow. For this reason, an alarming number of MDU investors are now electing to choose strategic default, thereby adding more MDU assets to the portfolios of institutional lenders, which are now becoming reluctant landlords of hundreds of multifamily building properties.

According to Real Capital Analytics, defaults on apartment-building mortgages held by U.S. banks climbed to a record 4.6% in the first quarter – almost twice the level from a year earlier – as more borrowers failed to repay debt approved near the market peak. In addition, defaults on multifamily mortgages rose to 4.4% in the fourth quarter from 2.4% during the same period in 2009.

The fact that the SFR and MDU markets have become intertwined and interrelated can no longer be ignored. As SFR defaults continue apace and the housing market remains stuck in neutral, SFR lenders will continue to rent these units rather than have them remain unoccupied. While this strategy makes sense, it will cause SFR properties to compete directly with MDU rentals and further depress the MDU rental market, escalating MDU defaults.Â

Until there is a sustained turnaround in the economy that slows the SFR default rate and allows banks to sell down their SFR inventory, MDUs will remain highly undesirable assets. Can there be a balance between the SFR and MDU markets? Can there be a symbiotic relationship? Or, can the industry simply create a system that supports each sector and produces a positive outcome for lenders and investors of all properties?Â

Untangling SFRs and MDUs

To date, the federal government has not offered much assistance for investors in multifamily properties. Institutional holders of multifamily REO units have traditionally looked at the disposition of these properties the same way they view SFR units – "empty and sell."

While this provides immediate relief for the lender responsible for the foreclosed property, it offers no long-term benefit or upside for the economy, investor, renter or neighborhood. In fact, it perpetuates the current challenge we have: increasing numbers of rental vacancies ultimately suffocating the market and causing a downward spiral for property holders of both types.

So, what should SFR and MDU investors do when faced with the challenge of having to fill rental vacancies and sell properties to avoid defaults?

Well, there's good news: According to the National Association of Realtors (NAR), SFR home sales are on the rise, and there are signs that multifamily rental properties will begin to see reductions in vacancies and modest increases in rent.Â

According to NAR, single-family home sales rose 7.4% to a seasonally adjusted annual rate of 5.05 million in April from a pace of 4.7 million in March, and are 20.5% above the 4.19 million level recorded in April 2009. The median existing single-family home price was $173,400 in April – up 4.5% from a year ago.

In addition, single-family median prices rose in 18 out of 20 metropolitan statistical areas reported in April from a year ago; six of the areas experienced double-digit increases. In data recently reported for the first quarter, 91 out of 152 metros saw price gains.

As far as multifamily rental properties, NAR predicts that the multifamily vacancy rate will decline from 7.3% as of the first quarter of the year to 6.3% in the first quarter of next. In addition, NAR predicts that 145,600 multifamily rental units will be absorbed this year, and in 2011, that number will grow to 214,500.

Furthermore, multifamily rents will gain some ground by 2011. According to NAR, average rents in 2010 may slip 1.5% and then recover 1.2% in 2011.

With that said, there will be variations of turnaround nationwide, per city. According to a recent report by Standard & Poor's (S&P), Phoenix will be one of the first cities to rebound, and New York could be one of the last.

With the S&P report suggesting REO inventory could take 34 months, on average, to liquidate nationally, it is clearly not a time to sell, and the market remains a buyer's market. Smart investors in areas not expecting a quick turnaround could benefit significantly from a lease-and-hold strategy. As the economy turns around, SFRs will sell. As the SFR rental inventory is depleted, tenants will increasingly be driven back to renting in MDUs, increasing MDU cashflow and making them more valuable assets for potential buyers. In fact, chances are good that investors will be able to sell these assets at a profit.

Now that there's an understanding of the market and the potential for upside in holding onto SFR and MDU rental assets, this still leaves the question of how lenders can successfully manage their instant landlord status and whether the potential reward is worth the risk.

The increasing number of MDU strategic defaults and the need to stabilize and improve the SFR market have created a new market reality that requires a new skill set on the part of servicers. Rather than add more vacancies to the growing list of foreclosed properties, SFR and MDU investors need to seek alternative ways to more effectively and efficiently rent, manage and market their rental units.

One reason for this new reality is that renter satisfaction is essential. A rented property is more than a building or a house – it is a family's home. A tenant who is happy is more likely to take care of the property, leading to greater resale potential. A happy renter is more apt to make timely payments, providing lenders with potential cash-generation opportunities. Most importantly, a happy tenant has greater potential to be the ultimate buyer, turning the REO property into a profit.

While banks and servicers can undertake the responsibilities of property management, traditionally, it hasn't been their core competency. And with the influx of rental properties, this job can become time-consuming and resource-draining. Lenders need to remain focused on managing their portfolios to increase long-term cash value rather than spend their time on property management.

Stabilization and upward movement of the housing market through the sale of tenant-occupied SFR REO units – as well as the ability to properly hold, maintain and finally sell cash-generating REO MDUs – are closely related. The key is to identify the right assets for a lease-and-hold strategy and contain that portfolio as a separate class.

As SFR sales increase and the inventory of inexpensive SFR rentals decreases, renting MDUs becomes more attractive, ultimately increasing cashflow and driving up the value of these properties. Successful execution of both SFR and MDU rental strategies, of course, depends heavily upon happy, cooperative tenants.

Paul Hayman is president of TenantAccess, an Austin, Texas-based property management company. He can be reached at phayman@tenantaccess.com.

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