Are Rental-Backed Securities the Next Big Thing? (KKR, BX, OZM, TWO)

There has been a lot of investment buying of foreclosed and distressed US houses, and one of the questions that always comes up is how an essentially local business can be managed on a national scale without driving up operating costs. One answer to that question appears to be securitizing single-family rental payments and then offering the securities for sale, in much the same manner as other real-estate-backed securities are offered.

Fitch Ratings, however, may have thrown some sand in the gears yesterday with its report on the risks of rental securitizations. Fitch’s report reveals some of the key concerns it has related to the rental securities. Chief among these concerns the “limited performance data for the sector and individual property management firms.” These limitations could force the agency to cap its ratings on rental-backed securities:

Historical data for market rents, rent roll histories, vacancy rates, and supply and demand are also limited. Although some firms have a few years’ operating history, most do not have a proven track record managing in a down cycle, outside their footprint, or on a large-scale basis. This concern is further heightened by ambitious growth strategies by regional operators looking to expand their portfolios rapidly over the near term, which will make it unlikely that Fitch will consider high investment-grade ratings for initial SFR transactions.

Some of the firms that have been testing the waters here include The Blackstone Group LP (NYSE: BX), Kohlberg Kravis Roberts & Co. (NYSE: KKR), Och-Ziff Capital Management Group LLC (NYSE: OZM), and Two Harbors Investment Corp. (NYSE: TWO), all of which have acquired blocks of distressed properties and very likely have no interest in actively managing them as rentals.

Instead, the firms would like to package the rental payments into securities and spread the risk around.

Fitch’s reluctance to issue top ratings to the securities could limit their attractiveness to investors. The ratings agency says it will rate the rental securities on four key factors:

• Management expertise and continuity
• Durability of cash flow
• Stability of value
• Liquidity sufficiency and structural considerations

Just as an example, here are some things Fitch would consider regarding the structure of the securities:

Unlike [commercial mortgage backed securities] or [residential backed mortgage securities], it is not clear how the security interest in the [single-family rental] collateral will be perfected (or whether the transaction will be secured) and what rights investors or servicers will have regarding [single-family rental] assets on the default or underperformance of the transaction. Similarly, operating strategies have not clearly stated how SFR debt will be repaid.

The Fitch report is available here.

Paul Ausick