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Posted by on Apr 16, 2012 in Bailout, Remodel Projects, Thinking of Buying? | 4 comments | Print Print

REO-To-Rental Analysis

Key points to whether the REO-to-rental plan is attractive enough for investors, from HW:

Any long-term REO-to-rental strategy will need to adopt extensive refurbishment plans in order to resell the assets.  Further, much of the foreclosed property that financial institutions would look to bulk-sell is currently in need of repair.

Morgan Stanley analysts say that nearly 95% of distressed homes are in no shape to rent out, in some key markets. Only a tiny fraction of these properties are less than a decade old, they add.

“The importance of getting construction — or specifically, re-construction or rehabilitation — right cannot be overstated,” according to a report from lead author Oliver Chang, sent to Morgan Stanley clients. “The quality and cost of rehabilitation can continue to benefit or haunt the asset far past the initial completion of work. For example, shoddy plumbing or other infrastructure work can result in significantly higher maintenance costs over time, and can also affect eventual exit pricing.”

Chang and his team point out that these complexities predicate that REO-to-rental investors should not look for a quick buck and place bets that housing prices will recover so that the property can be sold for a much higher price.

“Therefore, we believe it is critical that the rehabilitation work be done such that the workers are incentivized to minimize long-term costs, not just short-term expenses,” the report states.

Chris Clothier, a partner in Memphis Invest, said his turn-key real estate investment firm follows a renovate strategy.  The firm acquires, renovates, sells and manages REO rental properties for private investors in the Memphis and Dallas markets. It spends an average of $78,000 to acquire each REO and puts an average of $16,300 into renovations.

The company works with about 400 investors, generally smaller investors with portfolios of several homes, not hundreds.

Clothier declined to seek bid approval on the Federal Housing Finance Agency’s upcoming pilot bulk REO-to-rental program because he prefers to keep a tight control on the location and condition of the REOs he buys, investing only in well-known established neighborhoods. Buying properties one-off allows that control, he said, whereas the FHFA pilot likely will require bulk investors to accept some undesirable properties.

Morgan Stanley estimates that renovations will cost about 25% of the purchase price and provide an internal rate of return of about 8.2%. See cashflow model assumption below.

Chang and his team sent the report just as sources said the FHFA pushed the vetting process back to May for prospective bidders on Fannie Mae REO. For Morgan Stanley, bidders will not be qualified unless they can prove scalability of their operations.

“Our premise is simple: if an operator can handle the acquisition of 20 homes per week (about 1,000 per year) right now, what would happen if they were delivered 400 empty, distressed homes in one week?” they ask.

Moody’s Investors Service believes rental markets are generally balanced. Further, market fundamental may tend toward working out on their own.

“It is unclear how many additional purchases the federal program can generate,” said Celia Chen, a senior director at Moody’s Analytics. “On their own, investors are already purchasing foreclosed and distressed properties in large and growing numbers. Tax incentives may be a more effective way of driving additional investor purchases.”


  1. I think investors would be extremely happy if they could get properties for $100K and rent then out at $1200+ per month. In a market like that it certainly makes sense to buy because cost of ownership would be <$800/month even in the worst case (high property tax, FHA financing, etc.) Sounds like investors are going to get a heck of a deal from Fannie Mae at the expense of the tax payers.


  2. All of these properties should go to retail sale so they maximize the return to the taxpayers. There simply are not enough Fannie and Freddie owned properties in most markets to be the least bit disruptive. Let the small investor buy and rehab them. Sell the war zone stuff to whoever wants it or give it to the local jurisdictions if it isn’t saleable. The bulk REO to rental plan will never work, especially if the IRR is only 8.2 percent for that level of risk.


  3. Agreed.

    I think when these invstors start seeing what they are being pitched, they will have major second thoughts – especially those who are already successful with doing onesy, twosy on their terms.

    The gov might throw them a couple of plums, but don’t you think the bulk of the bulk will be junk?

    Why bulk-sale the nice ones when you can retail them?


  4. I know of a few groups of very smart, experienced, well capitalized guys who have already accumulated many thousands of units. The proforma shown here is close but the return is lower then those I have seen (low double digit). Also don’t forget that the managment fees are paid to their own in-house operations which turn an addtional profit. The business model is to turn a nice operating profit while waiting for the end-game of capital appreciation cash out. Obviously based on the numbers this isn’t going to play out in large numbers in CA, or at all in San Diego.



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