The housing crash created a lot of problems. Millions of families lost their assets. Neighborhoods emptied out as homes went into foreclosure. The rest of the economy went into a tailspin.
Investment funds had a problem too: They largely lost the market for residential mortgage-backed securities that had provided such excellent yields in the early 2000s, and with the Federal Reserve keeping interest rates low, there aren't a whole lot of obvious sources of income. For the past three or four years, they've been hunting for new places to park their money that could generate substantial returns. Lucky for them, the crash brought about by those very securities had also created an opportunity: Not mortgage payments on homes that a buyer would eventually own outright, but rent checks that a tenant would keep sending forever.
Here's how. In the wake of the collapse, private equity firms and real estate investment trusts have bought up a total of about 200,000 homes, worth $20 billion, and rented them out. Now, the biggest of those buyers -- Blackstone, which has spent $7 billion on 40,000 properties -- has figured out a way to sell bonds backed by that rental revenue stream that can be sold off to other investors, creating a $479 million fund for the acquisition of even more rental properties (it's a little more complicated than that, but that's the gist). So not only are you sending a check to a faraway Wall Street firm, but that money is ultimately split between hundreds of other people who've bought into the pool.
Banks have been doing this quietly for about a year now. But Blackstone's offering did something that early observers didn't think was possible: Got an AAA rating from the ratings agencies, which opens up the vehicle to a much wider range of investors.
Now, there is an argument in favor of this arrangement. As William Cohan wrote in September's Atlantic, the backers of this scheme -- including mega-investor Sam Zell, and the man who created mortgage-backed securities in the first place, Lewis Ranieri, -- claim it will "professionalize" the burgeoning rental market, renovating homes that small-time landlords in low-income communities would rather just let rot.
Whether or not Blackstone, Hyperion, and other big investors succeed, what they are doing is in fact a classic example of the role that risk capital is supposed to play in broken markets: to make bets that others are fearful of making, and to profit from them if things work out. Invitation Homes is injecting money directly into troubled local economies, not only through its purchases but also through the $500 million the company has spent, at places such as Home Depot and Lowe’s, to renovate the houses it’s buying. And if it really does provide a growing rental population with better options and better service, that will also serve a nation still recovering from the excesses of the past decade.
The Huffington Post found some evidence to suggest that renting from a hedge fund isn't all that it's cracked up to be, but there's really no way to compare that experience with renting from landlords.
Still, whenever financial "innovations" hit the market, it's always smart to game out what might go wrong. Critics of the plan see two major risks.
The first problem is similar to what the housing market encountered with mortgage-backed securities. When the lender doesn't actually plan to own your loan, it's disincentivized to make sure you can actually pay it back. That's why so many silly mortgages were issued in the early 2000s, creating a bubble that could only burst.
Regulators have since made rules requiring lenders to make sure borrowers actually have the ability to repay. In the rent securitization scenario, though, it's up to Wall Street to make sure renters in foreclosure-stricken neighborhoods all over the country can actually make their payments on time. They can always evict people if they fail to do so, but that takes time and lowers returns. And even though Blackstone figures it can just liquidate properties if rents get too depressed, ratings agency Fitch worries that might be easier said than done, and would destabilize any housing market where a large sell-off occurred in a short span of time.
The second problem is one of distorting the market further away from homeownership toward rentals. While it's true that, pre-crisis, America probably had an artificially inflated homeownership rate -- at around 70 percent -- the pendulum has since swung the other way. Between a third and a half of home sales are all-cash offers, mostly from investors, easily beating out buyers who have to go through the additional hassle of getting a loan. Securitizing the resulting rental stream will free up more money for all-cash offers that typically win out against buyers who have to go through the hassle of getting a mortgage.
Robert Hockett, the Cornell Law professor who's advanced a plan to seize securitized mortgages through eminent domain, envisions a kind of dystopia that might arise from tipping the balance so far toward investors.
"If things are such that homeowners can't buy back their own homes cheaper, or refinance, but strangers can buy them on the cheap and rent them back to their [former] owners, that strikes me as somewhat unfair," Hockett says. "We don't want to become a landlord-tenant culture, a sharecropper society. It's kind of like medieval Europe, where a few large financial institutions own everything, and we just rent from them."
Looked at another way, though, the problem isn't with institutional owners having lots of access to credit -- it's regular homebuyers having too little, with banks being extremely cautious about who they lend to.
"It's not like the institutional financing is what's driving the trend," says Chris Mayer, research director for the Paul Milstein Center for Real Estate at Columbia Business School. "What's really driving the trend is how tight credit is for homebuyers. If we wanted to help them, we could help them much more easily by opening the credit box."
Mayer also isn't worried about the new rental securities creating systemic risk, since the institutional property portfolios aren't highly leveraged, like homebuyers were during the housing bubble. Plus, he points out, it's possible that creating a cheaper source of credit for rental investment might make renting less expensive.
"Institutional owners in general are likely to have deeper pockets, and if they can lower their financing costs, they're going to charge lower rents," he says (which may be true, as long as any one investor doesn't own enough of the homes in a given market to artificially drive rents up). "What we're creating is investors lowering the cost of capital, so why isn't that good for consumers?"
Ultimately, a lot of this debate is fueled by memories of what happened the last time Wall Street came up with a clever trick to make boatloads of money off real estate by slicing up the value of a home and selling it off in bite-sized pieces. And yes, as with the pre-bubble innovations, it's hard to predict exactly how things might go wrong.
But when you strip out the eerie similarities, there are structural differences between this new instrument and the old ones that could make it safer, and create more of the rental housing that America desperately needs.