The Federal Housing Finance Agency and mortgage finance giant Fannie Mae are set to conclude the auction of nearly 2,500 previously foreclosed homes (known as “real-estate-owned” properties) in Fannie’s inventory to entities that have committed to rent them out for a number of years. The call for bids is over and the results will be announced shortly.
The purpose of the pilot is to assess the viability of various aspects of the Rehab-to-Rent program, from pricing to sale to operation of the properties themselves. For a detailed discussion of Rehab-to-Rent, see our January 2012 paper, “Rehab-to-Rent Can Help Hard-Hit Communities and Our Economy.” As early advocates of converting foreclosed homes into affordable rentals, the Center for American Progress has been monitoring the pilot closely. At the top of our wish list for the pilot program is to include strong features that enable nonprofit community organizations to participate—most prominently via the use of joint ventures. These joint ventures would enable Fannie Mae and participating community organizations to share the risk and reward of rehabilitating and renting these properties.
Although rising property prices and tight capital make it hard for community organizations to buy foreclosed properties from Fannie Mae, their participation in this pilot and in the full Rehab-to-Rent program could have several positive effects for Fannie Mae as well as for the communities in which the properties are located. For Fannie, entering into joint ventures with community organizations may generate higher returns than with private buyers, as we detail below.
Rehab-to-Rent is also intended to increase the supply of rentals to help avoid a rental bubble, which is important to community organizations dedicated to boosting the supply of affordable housing. This can increase worker mobility by providing affordable options for those looking to move for a new job as well as increase household creation, which shrank to nearly zero during the Great Recession of 2007 to 2009, as younger Americans find housing options that finally permit them to set out and begin their own careers. (For more, see our paper).
The price of foreclosed homes sold individually at auction, however, is going up faster than expected. Without bulk property transfers like this pilot program, higher auction prices will mean that buyers will both expect to charge higher rents and will have to do so to cover their increased costs, perpetuating rising rents across the country. It also increases the chances that private buyers will not see sufficient returns to maintain a viable business, putting the quality of the resulting rentals at risk. This is why community organizations are so important to the pilot program.
How a joint venture works in Rehab-to-Rent
The classic joint venture model involves two parties: the equity (or “money”) partner and the operational partner. Here is a basic version of how it would operate in the Rehab-to-Rent pilot program. Fannie would contribute properties or a substantial portion of the equity in those properties. The joint venture partner would rehabilitate and retrofit the properties and then manage them on an ongoing basis. Fannie would receive a portion of the monthly rent as a fixed income stream and then receive a substantial portion of the eventual sale price of the property.
There are many variations on this structure. Terms could guarantee Fannie a return of equity or minimum monthly income stream, or the terms could offer the operational partner the chance to buy out the property from Fannie at a set price after the holding period. Importantly, the terms of joint ventures in the program permit community organizations such as nonprofit organizations to participate in bulk sales because they do not need to raise all the capital necessary to buy the homes. Instead, they just need access to a smaller pool of funds needed to rehabilitate and operate the properties.
But with less risk comes less reward. The operations partner has to share the rental income stream and generally has a small stake in an eventual sale because it has no equity in the property This generally makes joint ventures less attractive to private investors, but not so for community organizations and nonprofits whose required returns are lower. Table 1 offers a comparison of estimated bulk sales and joint ventures:
The estimates above are generous in several respects. First of all, a 20 percent discount is likely small. It is taken from the most recent discounts in the Federal Housing Administration’s so-called Section 601 distressed note sales, a benchmark. Discounts in earlier sales were significantly larger because the process was unknown and perceived to be riskier. The discount determines Fannie’s net loss in a sale; it correlates to losses one-to-one.
Sales in this pilot program also assume a “cash on cash” sale—that is, the value of the home assigned by Fannie to the home today will be the sale price after a five-year hold period. If the home value instead goes up, Fannie gains more in a joint venture; it gets nothing in a bulk sale because it holds no interest going forward.
Then there is the discount rate, which is used to determine the net present value of the foreclosed home. This rate is the federal discount rate available to Fannie, which is not that much higher than the cost of capital for private investors.
In short, the joint venture results in higher returns to Fannie but lower returns to the joint-venture partner—a fact that community organizations can easily stomach. It also requires less capital on behalf of the “buyer” to get involved—another plus for entities that cannot compete with the cash reserves of financial entities rushing into this space.
Secondary benefits of joint ventures: Still a sale, but with some control
Joint ventures offer an additional benefit to Fannie Mae: They may be considered as sales. Practically, the Federal Housing Finance Agency’s role is to wind down Fannie Mae and Freddie Mac, making any transaction in which Fannie retains an interest in the underlying properties less palatable. In a joint venture, Fannie and its operations partner create a joint venture—a separate entity—and transfer the properties to that entity. Fannie is swapping its interest in the houses for a minority interest in the entity.
The Federal Housing Administration did this in its Section 601 distressed note sales. This Department of Housing and Urban Development program permits the Federal Housing Administration to dispose of delinquent loans of the Federal Housing Administration by auctioning them into private-public joint ventures. Put simply, the agency determined that if it held a minority interest and did not control the assets in the resulting joint venture entity, it could consider the transfer a sale. Similarly, Fannie would not control the underlying assets except to set and monitor quality standards. It too may be able to consider these transfers a sale.
Even though the joint venture could be a sale for accounting purposes, it may still afford Fannie the “long tail” interest it needs to monitor whether landlords are holding up their end of the bargain. In an outright sale, Fannie would retain no interest in the properties, so its only recourse for a buyer’s noncompliance, such as failing to maintain habitable properties or to hold the underlying properties for rent, would be based on contract law. That is, Fannie would have to sue—a prospect that would take between months and years. If the property were sold to a third party in the meantime, it would only complicate matters.
A joint venture can be structured to require the approval of Fannie prior to the sale of any underlying properties within the Rehab-to-Rent program’s minimum holding period. That can prevent or more quickly nullify an impermissible sale.
For repeat offenders, the joint venture could even permit Fannie an option to take control of some or all of the joint venture’s assets. The majority interest would be canceled and all interest would vest in Fannie Mae once more, at which point it can dispose of the properties or take on a new joint venture partner.
Both joint ventures and bulk sales should exist
We recognize that joint ventures should not exclude outright sales of Fannie’s foreclosed-upon properties or that of other government-controlled housing entities’ foreclosed inventory. Rather, they should compete with sales as a “bid” for the properties, with the value of the bid being Fannie’s net present value on the transaction. We continue to believe this value should be adjusted to give credit to community groups and those committing to retrofitting properties, doing deeper property rehabilitation, and holding properties longer.
Beyond this, there is little difference between joint ventures and bulk sales. Assessment of properties’ quality, construction, geographic proximity, and price should be the same in both instances.
We believe joint ventures offer a competitive and sometimes superior choice to outright sales of Fannie’s foreclosed properties. They can do more for communities and return more to Fannie. And if Fannie really wants to test the viability of the Rehab-to-Rent program, we hope to see one or more joint ventures in the coming pilot.
Alon Cohen is a Consultant for the Center for American Progress on housing issues.