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A 10-Year Perspective on the Golden Goose Egg of the Financial Crisis
Editor's note: This select print feature originally appeared in the May 2016 issue of DS News.
By Jim Leath
Anyone in real estate during the aftermath of the mid-2000s financial crash would likely agree that the real estate owned (REO) market was a bright light in real estate during the high default environment. Just look at what was happening: The boom of opportunistic construction starts across markets was squashed out by the reality that potential buyers had limited cash on hand or financing options to purchase those properties. Simultaneously, homeowners across the country found it difficult to pay down their mortgages.
REO, foreclosures, and short-sales have always been around, but the environment nearly a decade ago, when aged REO inventories skyrocketed and prices dropped, led to dramatic growth and opportunity in what was typically a sleepier real estate sector – one that always served a purpose, but largely existed under the radar.
As the REO market adjusted to new levels of inventory, business models on Wall Street shifted to take advantage of the opportunity within the high default environment, which gave way to the rather nascent but thriving sector of the single-family rental market. Wall Street investors were the first to see the enormous potential that the market conditions provided. Household investment firms, like Blackstone, parlayed the strong REO inventory into a profitable real estate play. According to a 2013 Wall Street Journal report, “Blackstone Group LP [became] the biggest U.S. investor in single-family rental homes by spending more than $1 billion since the start of 2012 to acquire more than 6,500 foreclosed houses in eight metropolitan areas.” As of 2015, it held 50,000 houses, nationwide.
The New Frontier of REO
While the single-family rental market is one area that will continue to provide opportunity in the REO marketplace, the question remains: What’s next for the banks, servicers, and investors who touch the REO sector nearly a decade past its high?
California was and continues to be the key state for REO, along with Arizona and Florida. Below state markets, at the city level, we continue to see the same names as 10 years ago, such as Atlanta and Dallas. These regional market opportunities are one aspect of REO that has largely been untouched by the years. Those aforementioned areas continue to provide the most opportunity to investors, indicating that they will continue to play there—for now. Looking forward, while there are a number of factors at play for what drives REO in a market, a good rule of thumb is where there is a boom, there is also the potential of a bust. Arizona is a prime example of that basic economic tenet at work.
The biggest macro factor affecting the REO sector today is that aged REO property inventory is declining. However, the high volume the sector experienced in recent years was unprecedented and, in fact, asset management servicing firms, banks and investors had to adapt to address the upward shift. What we’ve seen recently is a normalizing of inventory levels.
In the peak years, there was a wealth of, for example, 180 day past due accounts on the books or older. This became the norm in terms of aged properties. As the number and length of aged properties repositions, dwindles and largely goes away, new property types in earlier stages of their lifecycles have become increasingly popular among investors looking to build out their portfolios.
Second to the impact of inventory changes is the advent of online auction platforms. To put it bluntly, ten years ago they didn’t exist. Now, they not only exist, but they are playing a major role in how, when and where investors are looking and bidding on properties.
Additionally, they’ve opened the market up to non-traditional investors to begin to evaluate or even participate in the process. From a consumer perspective, the innovation in online auction platforms, coupled with the notoriety the boom led to, has to a large extent led to REO becoming a more mainstream and accessible part of the real estate sector.
However, for realtors and agents, the online auction platform has been a notable disruptor. But it doesn’t have to be all or nothing. In fact, the most well-rounded online auction platforms will be realtor-friendly and find ways to capitalize on their value and complement the online auction offering.
In such a changed marketplace, examining what’s happening today in REO asset management, banking and investing 10 years post its rise is an importance retrospective to explore.
The servicing market has changed dramatically since the recession, becoming incredibly efficient as a result of having to respond to and effectively manage the extraordinary period of volume. As we emerge into a more stable REO environment, asset management servicing firms are in a better position than ever to deal with REO assets. However, given the change in opportunity and inventory levels, servicing professionals must remain educated about the changes occurring in the marketplace so that their organizations have the necessary knowledge to maximize returns.
Emerging Trend: Outsourcing
In order to operate in this new normal, servicing firms need to regularly review their expenses and ask critical business questions: What is the price in fixed costs to the company to do this work vs. what it would cost them to outsource it? At some point those lines cross, and when they do, it may make “good” business sense to pass the baton.
Now that servicers aren’t simply reacting to the high inventory environment, they should slow down to speed up – i.e., they should spend the time re-examining how REO fits into their business structure. If it’s not falling into a critical core competency, that may be a trigger for outsourcing.
The first thing that servicing firms should consider is the compliance-oriented environment that we live in when outsourcing. In such a highly regulated mortgage and banking industry, where servicers are being held responsible for what vendors are doing, they could end up spending a lot of money on the oversight and monitoring of multiple vendors.
In an outsourced business model, consider minimizing providers and maximizing the single vendor approach for title management, property valuations, inspections, auctions and realtor services.
Revival vs. Disposal
For many years, REO assets that took up the majority of an asset manager’s portfolio were significantly time-worn. As the market moves upstream and portfolios are rounded out with more viable assets, coupled with the opportunity provided by contingency financing, asset managers should evaluate returns on renovations. That’s something that is certainly coming of age. Looking forward, this could be one aspect of the REO market that picks up speed and captures increasing interest from the broad spectrum of industry professionals on both the servicing side and among investors.
Banking in REO in 2016
Banks are being pushed by Wall Street to get better numbers, and the way to do that is by reducing expenses, which comes directly from shedding costs. REO is a good place to do that—especially because of the dwindling inventory.
Similar to servicing firms, the major decision playing out at many banks today is whether to manage REO themselves, outsource it, or shed the category altogether.
During the recession, every lender had to contend with REO, many very reluctantly. However, as volume declines, banks and other financial services companies now have the flexibility to decide whether to stay in the business, and if so, how best to manage it.
One of the prevalent trends is the rise of the non-bank lender holding REO. Some banks are shedding portfolios and asset managers and nonbanks are picking them up because they are more committed to the REO business and the focus and resources that it requires. This consolidation of the customer base is leading to more methodical procurement and vendor management teams that are asking challenging questions about liability and recourse before selecting a partner – a notable shift from only a couple of years ago when having the capacity to support a lender was the primary decision making factor.
Investing REO in 2016
The findings align with the movement in the market. New investors, such as traditional home buyers, flippers and mom and pop investors, are now competing for space in the marketplace, while aged inventory declines. These “new” investors may have been eyeing REO for years, but faced certain barriers to entry that are now lifting. This is largely occurring because the 100 percent all cash model is being offset by the availability of contingency financing. Additionally, as the assets become more viable, sellers are now open to accepting different financing options because they want to get the right buyers into the properties vs. driving transactions that result in liquidation.
Technology and easy access to market data will be a critical driver of the market moving forward for both large-scale investors and new ones. REO participants across the board will be able to make smarter purchasing decisions by analyzing potential property cash flow, post renovation projections, or analytics on an occupied property to determine the right offer price in relation to the potential ROI. Additionally, technological innovation in the online auction marketplace has created opportunity for geographical portfolio diversification, which will be increasingly important in a more competitive marketplace. It’s the difference between making an offer on the courthouse steps or placing a bid on a property in Florida while sitting in DC.
In a post default environment with shrinking inventory, the REO marketplace is evolving to exist and flourish in this new normal, where new breeds of investors, technology and information will not only change the sector but bring it into its next iteration.