U.S. housing has been on a slow, sometimes rocky road to recovery over the past couple of years. But it remains in fragile health, vulnerable to tight credit conditions, rising mortgage costs, falling affordability or new economic downdrafts. And now we have another sign that this crucial sector could be headed for renewed trouble: Wall Street's financial engineers are coming.
Major property investors such as Blackstone Group are finding ways to monetize their holdings, such as bringing real estate initial public offerings to market at a clip not seen since the early days of the bubble nearly a decade ago. But Blackstone, the world's biggest private equity player in the property game, has also figured out an intriguing way to cash in on its huge stash of distressed single-family houses, many of them bought out of foreclosure at a cost of more than $7-billion (U.S.).
With the help of the derivatives pros at Deutsche Bank, it has devised a security backed by the rental income stream from the tenants ensconced in those houses. This new product should offer a higher yield than typical mortgage-backed securities, and appeal strongly to yield-hungry fund managers running out of opportunities in overcrowded alternative assets like infrastructure.
Most of the rentals in the offering are in a handful of large urban centres in California, Arizona, Florida and Georgia, according to a report in International Financing Review, thus avoiding the hardest-hit cities of the Northeast and Midwest.
The $479-million worth of notes are backed by a loan cobbled together by Deutsche Bank and collateralized by 3,207 houses owned by Blackstone's residential rental investment vehicle, Invitation Homes. This neat device has secured a coveted triple-A rating for a large chunk of the offering, which would never have been attainable for the rental stream alone. Still, Fitch Ratings says such securities should not be rated higher than the edge of investment grade because of the risks. After all, rental bonds have no track record yet.
Nevertheless, there are plenty more deals waiting in the wings if this proves a success. Invitation Homes itself has assembled a portfolio of about 40,000 houses acquired at dirt-cheap prices and is adding more, at the rate of about $100-million worth every week. Blackstone is expected to take the unit public next year if the IPO market remains strong.
Competitors will also be keeping a close watch on the market reception for the bonds. Housing vultures have snapped up about 150,000 distressed homes in the past 18 months and turned them into rentals, says bank watcher Keefe Bruyette & Woods. In some markets, these big buyers provide much of the real estate action. Large funds, including Blackstone, accounted for nearly one-quarter of houses acquired in the Atlanta area between last May and July.
There is no shortage of supply. Speculators are trolling through recovering markets as well as foreclosure-wracked cities like Philadelphia, New Orleans and bankrupt Detroit, looking for both residential and commercial real estate. Detroit alone has 78,000 vacant properties, many of which face demolition.
The bottom line is that if there's a way to package dross and peddle it as pure investor gold, Wall Street's derivatives pros will find it, and they can still count on at least one or two rating agencies to give them a helping hand. But when a major financial player like Blackstone decides to cut other investors in on a good thing, rather than keep all the profits for itself, that ought to be a signal that the housing market isn't out of the woods yet.