Private Equity's Foreclosure Binge (& Purge)

by: Michael L. Boyer

As favorable news from the housing sector trickles in, there still may be room for housing bears in one real estate trade. Private equity funds, such as Blackstone (NYSE:BX), Och Ziff (NYSE:OZM), and KKR (NYSE:KKR) have been channeling billions into residential foreclosures according to a Bloomberg Businessweek article. Even sovereign wealth funds have gotten in on the action, such as the Alaska Permanent Fund, as explained in this Juneau Empire piece.

The general strategy is simple: buy houses cheap and in bulk; repair as needed; rent them for positive cash flow; then sell as prices rise. Some firms, as reported by the New York Times, are trying to make the process very efficient---like an assembly line.

Theoretically, the plan makes sense. Even legendary investor Warren Buffett quipped he'd buy a house if he was "handy". However, a single mystery foreclosure can create enough uncertainty for an episode of reality television. So buying a few hundred can definitely lead to some uncertain investment returns for a variety of reasons.

Some open questions remain about the soundness of the bulk buying of foreclosures:

1) Scalability: Single-family homes simply do not lend themselves well to large-scale rental investments. There is mass customization, both by the various builders and the previous homeowners, and each property can be so unique in its challenges that it represents a complex small-scale turn-around. In addition to the property, the people side of the business equation--the dynamic between renters, property managers and neighbors--can add another layer of complexity in single family homes.

2) Unproven Housing Strategy: Strategists may have extrapolated from false premises. Since Levittown, investors have learned new housing can be profitably constructed on a large scale. And many REITs have proven adept at multifamily housing on a regional and national scale. But both new and multifamily are very different from bulk distressed property purchases of existing homes. But the strategy blends the large scale rental model with the marketability and liquidity of the single family home. It is, as of yet, a largely unproven hybrid strategy strain. Investors can see this strategy in the IPO crucible with the inchoate Silver Bay Realty Trust, and ultimately the proof will be in the demand for shares and the performance of a firm in such a venture.

3) Mass Customization Frustration: Large-scale foreclosure purchases can confound the process of repairing, maintaining and managing properties at scale for several reasons. First, they are not in the same location--like multifamily projects or even new subdivisions. Second, anyone who has strolled through a neighborhood, knows the dictum--"all property is unique" is very true. Bulk foreclosures will result in a maze of styles and plans--homeowners deliberately customize a home's interior and exterior, creating a dizzying array of exterior and interior landscapes. Just standardizing paints colors and door locks could be overwhelming when you multiply it by a thousand doors and ten thousand walls. And that just gets you in the door.

4) Condos- A No Go: Condos or homes in close proximity in an association may offer uniformity, but these would also present problems for the strategy. A firm opting for some type of condo, townhouse, or cooperative, etc. would find these often require extra management costs, association or board issues, and uncontrollable dues/fees increases; there may even be restrictions on rentals or sales (pets, smoking, etc). While condos may offer more uniformity and proximity, these reduce the strategic advantages of controlling costs (unless the firm can acquire a majority of units, but then financing issues arise with a lack of owner occupants).

5) Geography Conundrum: One of the most problematic flaws of the widescale bulk foreclosure strategy is geographical. That is, the more diversified investors seek to be, the more they decrease their economies of scale and increase their management challenges. Investors in large scale purchases want to be diversified (i.e., not at the mercy of any one local economy or housing market). Local markets could be based on a single industry or sector (e.g., plant, military base, government, oil/gas). So investors will wisely spread their property purchases across multiple cities and states (and the states hit hardest by the foreclosure crisis have been popular locations of purchases--CA, AZ, NV,FL). Yet as they diversify geographically, these firms simultaneously decrease their ability to tightly manage properties in a geographic area. This can require more managers, more travel, new vendors, contractors, even facing new landlord tenant laws and regulations, different types of housing and unknown rental markets. Many landlords don't like having rental properties on the other side of town--much less spread across several states. It makes maintenance, oversight and repairs too onerous. Yet firms buying hundreds or thousands of properties face a harsh irony: as they diversify across markets, they potentially lose the power of scale.

6) Agency Costs: Private equity firms face potentially high agency costs in this business model. There are numerous tasks involved in preparing the single family house and managing renters; moreover, finding incentivized generalists to perform these tasks may be challenging. Part of the secret recipe for Mom & Pop real estate ventures is that the enterprise rewards those able to do a myriad of minor jobs reasonably well, everything from cleaning nooks and crannies to touching up paint and showing units. With hundreds of common parts and wear points in an average home, it could take a cast of trades just to get a property in shape or turned over after a renter moves out. An absentee landlord might have to employ separate people from all sorts of specialties: cleaner/junk haulers, painters, dry-wall contractors, laborers, landscapers, handymen/women, plumbers, A/C maintenance, carpenters, appliance delivery/hook-ups, floor and countertop installers, etc. Then there is the customer service side of the transaction, and the necessary people skills to properly handle everything from initial screening to move out. It is doubtful that the private equity folks are going to roll up their sleeves to get a house ready to rent or screen potential tenants. So they have to find people to do these task and do them in a way that is cost efficient and in the best interest of the investors. Hence the partnership with the management firms, particularly as equity partners with aligned interests, will be key to success and quality control.

6) Rental versus Sale Condition: After a decade as a landlord, and having read and studied best selling real estate books by authors like Robert Irwin, Jay P. Decima and Leigh Robinson, I feel the understanding this concept is very important: rental versus sale condition. Most people know what a pristine house on the market looks like--new flooring, new paint, newer fixtures, countertops, surfaces, appliances, etc. It shines, shows well, and matches comparable properties in the area. It's move in ready and designed and staged to sell (like an "after" picture from an episode of an HGTV home improvement show).

What fewer people know about is the condition a property needs to be in to attract a suitable renter in a particular market. This generally means the units are clean and functional--but may be dated and show wear and tear--and offer comparable amenities to other rentals in the price range.

Misunderstanding this concept can be perilous. The goal of a rental is durability and functionality. The sale property must be aesthetically and cosmetically appealing. The delicate light fixture or high end designer flooring may offer bling for buyers, but renters would likely break the light and scratch the floor in the move in/out process.

However, it is not clear how this strategy will make this transition (from foreclosure to rental to sale property) and make it profitably. For example, all of the foreclosures that have been rehabilitated by private equity already--to be suitable for rentals--will likely need to be remodeled once again to be listed on the market (at least to get the best price in a competitive real estate market). Factors that make a property an ideal rental can make it a poor candidate for selling, and vice versa. Features that can add to sales appeal can detract from the property's value as a rental (think large yards, high end appliances or surfaces, elaborate landscaping, pools, etc.). What may attract some buyers can simply be a maintenance and cost headache in a rental. This difference in sale and rental condition could detract from profits and frustrate process of quickly reselling current rentals unless a highly knowledgeable incentivized manager is making the key decisions at every stage of the process.

7) Crowded Market with Many Players: Reports of foreclosure activity have been in the news for more than a year or two, with more players and more bulk buying. Along with private equity and individual investors, international players have piled billions into the US residential housing markets. Even large homebuilder are getting into the game. The wealth of buyers could increase the cost of foreclosures, and the additional multi-family construction could add competition in the rental market potentially decreasing the rents.

A true test of any business idea and strategy is its scalabilty. Often it is not the originator of an idea or concept that gets rewarded but those that can scale the idea profitably. And it is going to take some very talented execution and favorable market conditions to make the bulk foreclosures pay off.

In the meantime, this business model is resulting in other activity (along with the larger housing sector) that can benefit other companies. This strategy requires laying miles and miles of carpet and linoleum, painting thousands of walls, and replacing countless fixtures of all forms. So the better play may be to sell everything needed to turn that foreclosure down the street into a rental (or even pristine candidate for sale).

Private Equity Foreclosure Binge (& Purge) Picks

Regardless of whether the bulk buying of distressed properties pays off, the rehabbing and renting will no doubt continue to cost these new mega-landlords money. Some potential beneficiaries:

  • Paints: A previous article went through many of the usual suspects such as Sherwin Williams SHW , Valspar VAL, and PPG PPG.
  • Paint Plus: One can also get a nice paint player, plus other areas, with Masco MAS, a firm that also gets you into fixtures, cabinets, windows and more. And Berkshire Hathaway, BRK.B, of course, is at least a triple play with Benjamin Moore paint, Shaw Carpets, and Johns Manville insulation. RPM RPM is an ideal firm for popular coatings and caulks used in both rehabbing property for rental or sale.
  • Big Box Stops: Stores like Home Depot HD, Lowes LOW and Costco COST are go-to places for property managers to get everything from industrial size cleaning products, door mats, smoke detectors and more.
  • Yard & Perimeter: Scott's Miracle Grow SMG is a likely beneficiary for making the long forgotten foreclosure habitable. Here is a firm making grass and lawn solutions, weed killer, and popular rodent and insect control products, through brands like Ortho, Miracle Grow, etc. Unsuspecting renters may continue to need these products to evict the small, unwanted tenants of the once abandoned properties.

Disclosure: I am long MAS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I have interests in all of these companies through mutual funds, index funds and etfs