What Would a Rental Meltdown Look Like?

Not to heft blame on any particular entity for the housing collapse (well, in this article anyway), but one of the instruments that allowed the bubble to run so high in the first place was the Collateralized Debt Obligation.  The CDO, as it is known, combined separate tranches (levels of security risk) of mortgages into a single security, allowing investors to pick their risk tolerance and be paid in order of defined risk.  In essence, the investors in higher tranches got (and get, if you invest today) paid before the lower tranches – so if cash flows stop, CDOs become an expensive game of musical chairs.

…Which brings us to today’s clever new financial instrument.  What if you took the payment ordering and splitting prowess of CDOs for home purchasers and extended it to renters?  That’s right – rental CDOs!  What could possibly go wrong?

Why the Need?

The reason rental CDOs are even being floated goes by a lot of names – ‘inventory overhang’, ‘shadow inventory’, etc.  Basically, the idea is that a whole lot of houses that were foreclosed upon during the aftermath of the real estate bubble still haven’t been released to market.  That means there are large numbers of foreclosed properties which are slowly being sold by banks and mortgage insurers (and reinsurers), which if released all at once might tank the market a second time.  Enter Rental CDOs – by creating an investment which bundles rental payments into tranches paralleling its mortgage cousin, you have a brand new shiny instrument to raise money for hedge funds and investment banks to purchase homes for rentals.  Here’s how it would work:

  1. Bank, hedge fund, large asset manager of some type owns/purchases homes
  2. Homes are rented out
  3. CDO is created with tranches based on creditworthiness/rating of renters
  4. Money from CDO used to buy more houses to rent
  5. Rinse/repeat/profit

There You Go Again…

I mean, what could go wrong?  Well, for starters, renters have less net worth than homeowners.  Average rental leases are around a year while mortgages generally last 6-10 years.  And (sorry for the stale link, help me update it) renters have worse credit scores than homeowners.  The entire mess is one rating agency (ahem, 3) rubber stamp away from becoming a real mess.

As we saw a couple years ago, home prices don’t always increase.  This may come as a shock to some people, such as my peers in the Bay Area, but rents can theoretically do the same thing.  Just like with mortgages, if rent prices start to head south or buildings start going without renters, you’ll see entire tranches of rental CDOs miss payments.  Correlation increases in a downturn!

Of course, renting and owning are the only two realistic ways to live (I know, let me hear about you living in a tent commune in the comments).  The truly interesting (scary?) scenario would be a situation where home prices and rents fell together.

So, in my eyes, a rental CDO is an interesting asset class – but one of those things which might have massive repercussions 10 years down the line.  I’ll probably be steering clear.  How about you?

Would you be interested in investing in a rental CDO?  Can you imagine a rental meltdown?  Do you think these CDOs could reduce the inventory overhang?

 

Comments

  1. greg says

    this essentially seems to say “if people underestimate risk, they stand to lose a lot of money” … o_O

  2. freeby50 says

    How is this significantly different than what a REIT does? REITs get loans and sell shares based on rental income.

    • says

      Rental REITs don’t have tranches of debt – it would be comparable to if you had a bunch of different Rental REITs with declining quality (defined by in-the-dark ratings agencies) and mixed them up into one asset.

      If you squint enough it’s like 2005 all over again!

  3. says

    Great post. I’m a personal home owner but my sister is a renter and always has been. Yes, she has less net worth than me, but she always brings up the argument of how much it costs to get something fixed.
    As a home owner if my roof leaks the cost is on me and as a rental, if a roof leaks it’s on her. It’s a great argument, but I would like calling my home, my home.

    • says

      On the flip side, her maintenance (or lack thereof…) is priced into rent. If people think that, as a renter, they don’t pay for the convenience of someone else fixing things or property tax… I’ve got news for them. Landlording isn’t charity, heh.

      Glad you enjoyed it!

  4. JT says

    A rental CDO is an interesting idea. I wouldn’t be interested in it, though.

    I’m not entirely convinced that CDOs are the problem – I mean, really, they’re just index funds! The CDO-squared should have been even safer, since it was more diversified.

    I’m trolling.

    I think the market would be better off with single family home REITs of differing quality. I’d love to see real estate investors shake in their boots as their real estate investments have some kind of benchmark for market value. About time real estate catches up with equity investors who have to deal with seeing the market value blasted on every website and television news network.

  5. says

    I think the biggest room for error takes place in Step 3 — “CDO is created with tranches based on creditworthiness/rating of renters.”

    The CDO should be created based on not only the creditworthiness/rating of renters, but also the ‘margin of error’ within the rent-to-expense ratio on the underlying home. Simply stated, the larger the gap between the operating expense and the current annual rental income, the bigger the safety margin. You can cushion a decline in rent, even a substantial one, and stay in the black.

    It should also take into account the underlying trends in the area. Is the underlying home in an area with declining population? Or an area with new investments?

    Plenty of variables play into the safety/risk rating of a rental investment. I wonder how skilled the CDO-creators are at understanding these variables.

    • says

      From the “rater” side, I think you’ve just started to scratch the surface. Note that renters are also more transient than buyers – buyers might refinance every few years and move every 6, but renters may be in a place for as short as they can find a contract. With no mortgage hlding them in place your guess is as good as mine.

      Of course, I imagine that a rental CDO of equivalent quality to a buyer CDO would have some risk premium built in. I just see big banks bullying the raters and making the rental CDO appear safer than it is.

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