Investors in Blackstone (BX:US) Group LP’s debut sale of bonds backed by U.S. rental homes are agreeing to accept more risk than in traditional mortgage deals by at least two measures -- along with an unproven business.
Blackstone’s Invitation Homes borrowed more through yesterday’s deal relative to the value of the houses serving as collateral for the bonds than recent residential-mortgage securities, according to data from ratings companies. The cushion to cover interest payments is also smaller than in deals tied to apartment complexes. Monthly rent checks from 3,207 properties will be used to service the $479.1 million of debt.
Five years after defaults on home loans packaged into securities helped trigger the worst financial crisis since the Great Depression, Wall Street is turning to bundling assets into bonds to help institutions buy and rent out properties. The transaction comes after Federal Reserve stimulus to bolster credit markets contributed to property gains exceeding 40 percent in some regions where Blackstone has been investing from California to Florida.
“Given the rapid increase in prices in the areas in which the properties are concentrated, the amount of protection for bond investors doesn’t make one feel all that warm and fuzzy,” David Liu, co-manager of a $340 million securitized-asset fund run by New York-based TIG Advisors LLC, said last week, adding that he expected the offering to find buyers easily given the momentum in housing and other features of the debt.
The Blackstone deal heralds the latest use of securitization, an investment-banking strategy pioneered in the 1980s and later blamed for fueling the shoddy lending that contributed to more than $2 trillion in losses at the world’s largest financial institutions. Bonds can be created out of everything from mortgages and auto loans to resort timeshare interests, television-broadcast rights and drug sales.
The market for rental-home securities may grow as large as $900 billion, assuming 15 percent of annual home purchases are conducted by investors and 35 percent of those and existing rental-home owners turn to the market for financing, according to Keefe Bruyette & Woods Inc. Banks have been the main source of financing for new property landlords such as Colony Capital LLC and Blackstone, which has spent $7.5 billion on about 40,000 houses.
Deutsche Bank AG (DB:US), the lender to Invitation Homes that structured the deal, and other underwriters marketed six separate classes of the Blackstone bonds, according to reports from Moody’s Investors Service, Kroll Bond Rating Agency and Morningstar Inc. (MORN:US) As with other securitizations, some of the bonds are designed to have less default risk because they stand in line for losses after other notes.
Fitch Ratings disagreed with rivals that any rental-home securities should get top ratings now, citing in part the “limited track record” of big institutions in the business and incomplete historical data on how rents, vacancies and other considerations can vary over economic cycles.
Christine Anderson, a spokeswoman for New York-based Blackstone, the world’s largest private-equity firm, declined to comment on the deal, as did Amanda Williams, a spokeswoman for Deutsche Bank.
A top-rated $278.7 million class yields 115 basis points, or 1.15 percentage points, more than the London interbank offered rate, according to people with knowledge of the transaction. It was earlier offered at about 120 basis points. A $41.5 million portion rated BB by Kroll priced at 365 basis points, down from about 400.
The levels are about the same or less than similar existing types of securities, said other people, who asked not to be named because the pricing details aren’t public. The AAA class of a transaction tied to two hotels near Florida’s Walt Disney World was sold yesterday at spread of 105 basis points and the BB- portion at 350. Credit Suisse Group AG underwrote a sale of AAA securities tied to junk-rated corporate loans yesterday at 140 and a BB class at 500. Freddie Mac last week sold the BBB-class of a multifamily deal at 400 and yesterday issued unrated single-family notes at 425 that share its risks tied to homeowner defaults.
The underlying loan in the Blackstone deal has a floating rate and an initial maturity of two years. Along with potential default risks, investors need to grapple with the borrower being able to repay the debt after 12 months or extend the maturity for a year as many as three times under certain conditions, said Bryan Whalen, a managing director at TCW Group Inc., which oversees about $130 billion from Los Angeles.
“That’s a lot of optionality you’re giving to Blackstone” and if bondholders can’t be paid off through a refinancing or home sales at the end of five years, they may need to wait even longer for the return of their principal, Whalen said.
Axonic Capital LLC, a $2 billion structured-credit asset manager based in New York, was considering buying the riskiest class offering the highest yields, said Chief Investment Officer Clayton DeGiacinto. He said the rental-home industry can be successful and the bonds offer enough protection for investors.
“We also operate a portfolio of single family homes and understand the risks and rewards of the business well,” DeGiacinto said. “We are in the midst of a paradigm shift in the way that this country finances housing and this deal is part of that change.”
Moody’s, Kroll and Morningstar are assigning top rankings to 58 percent of the securities and investment grades to as much as 91 percent. The firms said in reports last week that the planned rankings are appropriate based on how the classes carry greater loss protection than similarly rated assets.
The 42 percent for the AAA portions in the Blackstone deal compares with about 30 percent for new commercial-mortgage bonds and 6 percent to 9 percent typically for prime home-loan deals since the crisis. Subprime residential transactions before housing collapsed often had 20 percent to 25 percent credit enhancement.
After accounting for the borrower’s equity in the properties, the Blackstone AAA securities could get paid off if the homes get sold for just 43 percent of their current values, making Kroll’s rating “sufficiently conservative,” Glenn Costello, an analyst at the firm, said in a telephone interview.
Kroll estimates sustainable cash flows from the properties after expenses -- and adjustments for items such as probable vacancies -- are 27 percent more than the loan’s initial costs. That’s “much lower” than the average of 50 percent for mortgages on apartment buildings securitized in 2013, the firm said in a report.
Moody’s said the net cash flows relative to the size of the borrowing is “very low” compared with apartment deals. Future expenses may also be bigger, the ratings company said.
“Because each home has unique features, appliances, and building materials, the renovation, maintenance, and marketing may be more demanding than in a typical multifamily setting,” Moody’s said in its report.
The estimated value of the homes in the deal represents 75 percent of the debt’s balances. The ratio is based on the opinions of real estate brokers, rather than the licensed appraisers who are more reliable and traditionally used for residential mortgage-backed securities deals, according to Moody’s.
Invitation Homes bought the houses for $444.7 million, and with repairs and refurbishments spent $542.8 million, compared with the collateral’s $638.8 million valuation.
The highest average loan-to-value ratio for home loans serving as collateral for bonds without government backing since the crisis was the 69.7 percent in PennyMac Mortgage Investment Trust (PMT:US)’s September sale, according to Kroll.
One of the key risks of the Blackstone deal is its “heavy geographic concentration,” Bank of America Corp. analysts led by Chris Flanagan in New York wrote in a Nov. 1 report.
The breakdown includes 34 percent from the Phoenix area, 17 percent from the Riverside-San Bernardino-Ontario region in southern California and the rest from other parts of the state, as well as Florida, Georgia and Illinois.
“While additional diversification would be preferable in most RMBS deals, property management would become challenging if properties were too widespread,” the Bank of America analysts wrote.
Along with the Fed’s $85 billion of monthly bond buying that’s reduced mortgage rates, investors including Blackstone have helped drive property-value gains in the regions. Prices in Phoenix have soared 41 percent from a bottom in 2011, according to an S&P/Case-Shiller index.
When it’s time to repay the debt, rental-home owners may be unable to refinance or sell the bond collateral in bulk and flood the markets, Fitch analysts Suzanne Mistretta,Dan Chambers and Rui Pereira in New York wrote in a statement last month.
The transactions can also be “highly vulnerable to unknown variables” including property taxes, restrictions from homeowner associations and actions by local governments, they said.
Moody’s considered how much could be recovered in property sales under stressful conditions, including rental-home operators turning into sellers at the same time, said Stefanos Arethas, an analyst in New York. The flood of foreclosures during the recent housing slump has offered good information on how bad local markets can get in such an environment, he said.
“We have the data to guide us,” he said yesterday in a telephone interview.
Moody’s also made adjustments to potential losses on the collateral based on a variety of features of the deals, including a lower amount of property insurance against windstorms than found in typical commercial-mortgage transactions, according to its analysts.
While the Blackstone deal is the first of its kind, about 7 percent of the roughly $850 billion of mortgages acquired last year by Fannie Mae were to smaller property investors, according to a company presentation. The guarantor, which sells home-loan securities bolstered by its government backing, limits landlords to loans on a maximum of 10 properties, while the cap for rival Freddie Mac is four.
Investment properties have also represented a slice of the collateral for the $12.5 billion of mortgage securities without government backing sold this year. In the non-agency deals, the loans get mixed with those on borrowers’ own homes and vacation properties.
Just before the credit bubble began to collapse in 2007, the amount of investor mortgages held by non-agency securities peaked at $188.4 billion based on issuer disclosures, or 8.1 percent of the collateral, according to data compiled by JPMorgan Chase & Co. (JPM:US)
Prime mortgages have been 60 percent more likely to default when taken out by a property investor rather than a resident, because borrowers are either engaging in house flipping or relying on potentially risky income from external sources, according to Fitch’s methodology for rating traditional home-loan securities.
Unlike those investor mortgages, the Blackstone debt and others deals modeled on it would benefit from a single loan tied to multiple properties. With the structure “excess cash flow from one property can augment another’s cash flow to meet debt service requirements,” Moody’s said.
The deal’s covenants can allow individual properties to be sold, for between 105 percent and 120 percent of their allocated share of the total loan, according to information in the Kroll report, a release of liens that may leave the worst properties backing the remaining securities.
The largest danger may be that Blackstone will be allowed to sell the Invitation Homes business or take it public before the securities mature, said TCW’s Whalen, who described the deal as “well-structured and really well thought in terms of the way they put it together” in general.
“Even if can you get comfortable with a business that’s fairly new, you’ll be subject to the performance and disposition strategy of a company other than Blackstone,” he said. While many of the notes carry substantial loss cushions, “the further down you go” in buying bonds with less protection, “the more subject you are going be to that big risk.”
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. decreased, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, declining 1.3 basis points to a mid-price of 73.2 basis points as of 12:38 p.m. in New York, according to prices compiled by Bloomberg.
The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
A gauge of the health of U.S. financial conditions fell from a record high. The Bloomberg U.S. Financial Conditions Index, which combines everything from money-market rates to yields on government and corporate bonds to volatility in equities, decreased 0.02 to 1.68. The measure reached 1.70 yesterday, the highest level in data dating back to January 1994.
Bonds of Statoil ASA (STO:US) are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.4 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Norway’s largest energy company raised $4 billion yesterday in a five-part offering.
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