Close

This page had been redirected to a new URL, please update any bookmarks.

Font Size: A A A

Real Estate Research

June 11, 2014

Signs Point to Slow but Steady Construction Growth

After bottoming out in early 2011 and following an upward trend for two years, national new house sales on a seasonally adjusted basis have been essentially flat since January 2013 and are at a pace about half that of 2000–01. Over the past month, speeches by Fed Chair Janet Yellen and Reserve Bank presidents John Williams, William Dudley, and Charles Plosser have included references to a slowing housing sector in the face of strong fundamentals as a source of economic uncertainty. They mentioned many reasons for the slow pace of housing´s recovery, including difficulties in increasing housing supply (that is, construction).

In the Southeast, we hear from our housing contacts that it remains difficult to acquire construction financing and that funding of land acquisition and development projects is extremely difficult. In the most recent Southeast Housing Market Poll, most builders continued to report that the amount of available construction and development finance fell short of demand (see the chart). Concern regarding the lack of readily available construction financing is not unique to the Southeast and may be part of the reason for the recent slowing in the housing sector. Fortunately, it appears that construction financing may in fact be getting a bit more accessible.

How Available Do You Perceive Construction

A key input to construction is the availability of financing. We explored construction lending trends in a few of our posts last year (here and here). The most recent bank lending data indicate several reasons to believe that banks continue to return to construction and development as a line of business.

Aggregate bank construction and development lending remains well below its 2008 peak (see the table). That said, more than half of the banks with a construction business line are expanding their single-family residential construction lending. Interestingly, the median March 2013 year-over-year growth rate in residential construction lending was positive, yet aggregate 1–4 family construction loans fell from March 2012 to March 2013, which means that lots of smaller lenders were growing. The good news is that the March level of 1–4 family construction loans increased in 2014 for the first time since the recession ended.

Bank Call Reports

Although banks appear to be lending for residential construction (the "vertical" part of homebuilding), we cannot say the same for lot development (the "horizontal" portion). The data is a bit less clear on this front because lending for raw land and land development is lumped together with loans for all construction that is not for 1–4 family structures. Aggregate lending for "other construction, all land development and other land" increased year over year, but the median growth rate was negative. That is, more banks are pulling back from this activity than are growing, but the ones that are growing are the ones with larger volumes. Considering that lenders have viewed multifamily construction favorably, it is more likely that the growth in lending is attributable to multifamily loans rather than to lot acquisition and development.

The Fed presidents I mentioned in the first paragraph were optimistic about housing in large part because population growth and household formation both point to an inevitable increase in housing demand. The evidence from bank construction lending supports this idea that growth will continue, but it also suggests that the recovery will continue at its slow and steady pace.

Photo of Carl HudsonBy Carl Hudson, Director, Center for Real Estate Analytics in the Atlanta Fed´s research department


June 11, 2014 in Credit conditions , Housing demand | Permalink | Comments ( 0 )

May 16, 2014

Are Single-Family Rental Securitizations Here to Stay?

In the fall of 2013, private equity firm Blackstone LP issued the first single-family rental (SFR) securitization: Invitation Homes 2013-SFR 1. In March, Colony Capital released another SFR securitization. The Invitation Homes 2013-SFR 1 was backed by 3,207 single-family rental homes concentrated in Arizona, California, Florida, Georgia, and Illinois. Deutsche Bank arranged the deal. There are a variety of estimates of the size of institutional investors’ activity in the SFR market, but with numbers like 90,000 to 150,000 homes and 15 to 20 billion dollars invested, most agree that we can expect more securitizations like these in the future. So what exactly is this new asset class, and how did it obtain its strong credit rating?

In this post, we look at how the structure of the Invitation Homes SFR emerged and compare it to more familiar commercial mortgage-backed security (CMBS) and residential mortgage-backed security (RMBS) classes to better understand the triple-A rating. We also consider some factors that could determine whether the SFR security class will stick around.

(For a nice discussion about the entry of institution investors into the rental market, read this second-quarter 2013 EconSouth article.)

Please note that much of the information that follows is based on reports from the rating agencies:

Commercial or residential—or both?
This product took a long time to come to market. For nearly two years, the industry discussed how to structure this new security class. Discussions in 2012 and 2013 about the rating and pricing of an SFR security focused on three gray areas. The first was housing market risk. Would housing markets, and the underlying value of investor-owned homes, appreciate on a market-wide basis?

The second was property management risk. Could scattered-site, single-family homes be managed cost-effectively? And with a lack of historical data for scattered-site, single-family rentals, how could credit rating agencies predict vacancy rates, maintenance costs, and income streams with any precision?

Finally, there was confusion about how to structure an SFR securitization and what tensions and risks would exist in that structure. There was also some uncertainty about whether an SFR securitization would be more like CMBS or RMBS. Like RMBSs, the underlying assets of SFRs are single-family homes. And many risks—for example, home price depreciation and household income—are the same as in the homeownership market (Joseph Hu 2011). But like CMBSs, the borrower is a corporation, not a homeowner, and the cash flow comes from rental, not mortgage, payments. That means the payments come from highly variable net operating income, which is sensitive to vacancy rates, market rents, and maintenance costs unlike the fixed-income streams of mortgages, which are sensitive to repayment and default risk but otherwise fairly predictable. Also like CMBSs, the sponsor of the SFR deal would be responsible for maintenance, meaning they might have to keep some cash on hand.

Equity pledges or first-priority mortgages?
These issues influenced the structure of the security. High maintenance costs associated with the rental properties created a nontrivial conflict. Ideally, in a security, assets are owned by a tax-neutral, special-purpose vehicle (SPV), with assets and liabilities perfectly matched. However, retaining cash flows for maintenance jeopardizes that tax-neutral status. Early discussions favored a structure in which the borrower, not the SPV, would retain ownership of the properties and instead of mortgages, equity pledges would collateralize the securitization. While these equity pledges might be preferable for maintaining properties and would be less transaction-intensive than issuing individual mortgages, equity pledges would create a weaker claim than first-priority mortgages for investors in the event of default. Further, equity pledges were not deemed to be as bankruptcy-remote as mortgages. All this meant equity pledges could be vulnerable to material consolidation in the event the sponsor were to become bankrupt or if the sponsor were to mismanage the properties, either selling them or borrowing further and creating competing liens on the properties (Matthew Clark 2013). For this reason, Moody’s and Kroll stated that they would cap securitizations using equity pledges at Baa or A.



Ultimately, the Invitation Homes/Blackstone SFR security used first-priority mortgages, not equity pledges, and secured a triple-A rating. In structure, the security is probably more like CMBS than RMBS. Deutsche Bank compared the instrument to CMBS, and the ratings agencies also leaned this way—Kroll and Moody’s compared the security to CMBS on the forms where they express their expectations for representations and warranties. Aspects of the transaction itself suggest that it is more like a CMBS deal than an RMBS one. For instance, the special servicer, Situs Holdings LLC, specializes in CMBS (not RMBS) workouts. Still, the security remains a hybrid. Kroll used a CMBS model to determine the probability of default and an RMBS model to determine severity, working on the assumption that the income-based approach typically used in valuating CMBSs would not be appropriate for pricing the sales of single-family homes in a distressed housing market. Similarly, Morningstar used both Cap Ex and HPI stress tests to generate ratings of the various tranches, feeling that both an income/expense approach and a sales approach to valuation were appropriate.

The structure of the securitization reflects a priority for enhancing an investor’s ability to take ownership and sell the homes in the event of a default, rather than other structures which might have prioritized management of homes to enhance rental income. Moody’s did not base its rating on an evaluation of the income streams from the properties, because the agency did not feel it had the ability to evaluate with certainty vacancy rates, maintenance costs, and other key factors. Instead, it based its rating on the strength of investor claims on the homes in the event of default, and estimated sales prices of the underlying properties assuming a distressed housing market. Another factor in the triple-A credit rating is that the security is overcollateralized. That is, the value of the collateral ($638M) is well above the value of the loans ($479M)—Invitation Homes took a 25 percent advance rate on these homes.

Will they last?
Some negative commentary has surfaced in the five months since the Invitation Homes offering. And S&P has come out strongly against the triple-A rating, arguing that without historical performance data there is too much uncertainty about income streams. Recent appraisals noted that several tranches were trading below par, and that rents had declined 7.6 percent due to increasing vacancy rates. Firms that had hoped to make margin by “pushing rent” or increasing rents every year are now talking about keeping rents stable in order to minimize turnover and the associated vacancy rates. So with all of these issues, how much staying power does the SFR securitization structure really have? To the extent that these transactions are driven primarily by the value of the underlying collateral and not by rental income, they begin to resemble trades that will decline as home prices approach normal levels. Indeed, many SFR investors and managers say they ultimately intend to sell single-family rentals back into the owner-occupied market either 1) when maintenance costs begin to outweigh the potential of the asset’s income stream or 2) it appears that, in the medium term, home prices and mortgage markets have recovered—and thus the opportunity for this market to exist disappears.

Other commentators suggests otherwise: this asset class will grow, possibly driven by fundamental demographic shifts such as increasing labor mobility and shifting preferences for rentals. These attributes, combined with stagnant wages and tight mortgage markets, suggest increased demand for single-family rentals. They may also suggest that SFR securitization represents a new normal.

Photo of Deborah ShawBy Elora Raymond, graduate research assistant, Center for Real Estate Analytics in the Atlanta Fed's research department, and doctoral student, School of City and Regional Planning at Georgia Institute of Technology

 

May 16, 2014 in Housing demand , Rental homes , Securitization | Permalink | Comments ( 0 )

April 25, 2014

Two Views of the Involvement of Credit Rating Agencies in the Mortgage Crisis

A lot of people have blamed credit rating agencies (CRAs) for helping to cause the mortgage crisis. The report of the Financial Crisis Inquiry Commission (FCIC) labelled CRAs as "key enablers of the crisis," because the exploding mortgage-backed bonds that caused so much trouble could not have been sold without stamps of approval from the CRAs. Commentators often link CRA failings to the fact that they are paid by the issuers of the securities they rate, with the implication that CRAs are thus given incentive to award good ratings to securities that do not deserve them. Indeed, two recent articles by academic economists on this topic come to the same conclusion: financial markets would work better if we scrapped the issuer-pays model in favor of some other way to pay CRAs for their evaluations. But the two articles disagree on why this is so, and understanding the source of this disagreement sheds some harsh light on claims that CRAs should be even partly blamed for the financial crisis in the first place.

Grade inflation in the student-pays model
The first article is a Wall Street Journal op-ed piece by Princeton economist Alan Blinder. Blinder likens the awarding of credit ratings to mortgage-backed securities to his own awarding of letter grades to his Princeton students. "Suppose I proposed to grade my students by a 'student pays' model," Blinder suggests. Such a setup would encourage him to give easy As in hopes of attracting more students and higher pay, and the information in the grades would suffer as a result. "Yet that description comes pretty close to mimicking the way we pay rating agencies," Blinder writes. "Looking back, is it any wonder that so many securities were blessed with undeserved triple-A ratings?"

One interpretation of Blinder's analogy is that college grading works better than securities rating because universities have not adopted the student-pays model. That argument will seem curious to many college instructors, because this model approximates their own compensation arrangements pretty well. Students may not write checks to professors, but they (or their parents) write checks to colleges, who then pay the professors. Instructors whose grades are overly harsh in relation to other courses are likely to see their class sizes dwindle, to the dismay of department chairs facing hard budget constraints. Even if an instructor has no problem attracting students, she may not want grading disparities among courses to distort student decisions on what to study, so she might ease up in her own grading as well. Given the incentives of professors, it is not surprising that grade inflation is debated at many universities, even the very best ones. A December 2013 article in Harvard University's student newspaper, the Crimson, described a faculty meeting at which a professor bemoaned the fact that the most frequently awarded grade at Harvard College is an A-minus. A university dean corrected him: "The median grade in Harvard College is indeed an A-minus," the dean is quoted as saying. "The most frequently awarded grade in Harvard College is actually a straight A." (Disclosure: Harvard's grading policy is of personal interest to two authors of this blog post, who teach intermediate macroeconomics courses there in their spare time.)

Rational employers, rational investors
If the student-pays model leads to grade inflation, then don't we have even more ammunition that the bad incentives inherent in the investor-pays model for CRAs is partly responsible for the mortgage crisis? Not necessarily. For bad CRA incentives to have caused the crisis, two things must be true: one, the incentives must have caused inflated ratings, and two, the investors had to believe the inflated ratings. The second step in this causal chain is open to question. If the investors knew that the issuer-pays model gave incent to the rating agencies to inflate ratings, then rational investors would have taken that information into account when making investment decisions.

The college-grading analogy is again useful here. Consider an employer who is thinking about hiring a recent graduate who received a B-minus in a course that is highly relevant to what the firm does. How should the employer use this information? One option would be for the employer to look up how the student's official university documents define a B-minus—the documents are likely to define a grade in the B range as indicating a better-than-average understanding of the material. But a rational employer who knows the incentives facing American professors would also know that instructors are given cause to inflate grades. The firm could thus surmise that an applicant on the border between a B and a C may actually have a lower-than-average mastery of the subject. In the same way, rational mortgage investors who knew that CRAs had incentive to inflate ratings would have taken those ratings with a grain of salt when evaluating mortgage-backed investments.

Investor rationality plays a prominent role in a second recent piece on CRA incentives, a formal paper by the economists Anil Kashyap and Natalia Kovrijnykh (KK). Because this article is part of the academic economics literature, the authors adopt the fundamental assumption that all actors in the model are rational. As we might expect from our analogy of the job applicant, the rationality assumption makes a big difference when analyzing CRA payment regimes. Consider a situation in which CRAs are paid by the issues of securities, as they are today. Further assume that CRAs receive more money for good ratings than for bad ones. Rational investors in the KK model would realize the ratings are likely to be inflated under this set of incentives and would deflate the ratings accordingly. But if the CRAs are unable to fool investors who know both the CRAs' preferences and their opportunities, then the CRAs might as well tell the truth. KK therefore constrain their attention to equilibria where rating agencies are always truthful.

The revelation principle
In assuming truth-telling, KK are following a long tradition in the modeling of imperfect information. In fact, the assumption that actors with private information tell the truth shows up so often in models of imperfect information that it has a special name: the revelation principle. This principle is useful for modelers because it allows them to focus on equilibria in which the agent with private information has no reason to lie. To be clear, in this situation, the revelation principle does not mean that rating agencies never lie. Rather, it states that any equilibrium in which rating agencies lie is equivalent to one in which they tell the truth. The lying doesn't affect the actions of investors who know the incentives and opportunities of the CRAs, just as inflation of our B-minus student's grade does not lead the employer into an inappropriate hire. Because lying does not encourage agents to take inappropriate actions, it can safely be ignored when thinking through the fundamental aspects of the problem.

The appropriateness of the revelation principle in this context hinges on the ability of mortgage investors to analyze CRA incentives and opportunities and thereby back out the truth. Is this realistic? Ironically, the critics of CRAs provide evidence in support of this view. When Barney Frank alleged that CRA incentives led them to inflate ratings, he was doing exactly the sort of reverse engineering that lies behind the revelation principle. And if legislators could figure out that rating agencies had distorted incentives, why couldn't investors, who were putting up their own money? Indeed, investors should have had much better information about agency incentives than Barney Frank. It turns out that financial intermediaries lost enormous sums on the mortgage-related securities that they purchased and held on their balance sheets (more details on this in the next post). At the same time, they were also large issuers of these securities. Who would know better about the potential for corruption of rating agencies than the financial intermediaries that supposedly corrupted them?

Of course, if the KK model holds that rating agencies always tell the truth, then the model cannot rationalize arguments that CRAs helped cause the crisis by misleading investors. Indeed, the revelation principle makes it hard to rescue any story about untruthful CRAs. What if credit rating agencies had private information about their incentives, in addition to private information about their effort and the quality of the securities that they rated? Setting aside the fact that the issuer-pays model of credit ratings was common knowledge in the market, this change to the model has no effect on its outcome. Here again, the revelation principle would imply that CRAs truthfully reveal the private information about their incentives. For investors to be misled, they cannot simply be confused about incentives. Rather, they must believe that the CRAs' incentives were better aligned than they actually were. In our view, that is unlikely.

CRA payment arrangements
We began this post by noting that both of the recent articles on CRA incentives argued against the issuer-pays model. How can KK make this argument if investors in their model are not fooled? The reason involves some subtle implications of exactly how CRAs are paid in different states of the world. In all contracts in KK's issuer-pays regime, CRA pay is contingent on the outcome of the security. That means that if an AAA-rated security defaults, the CRA gets paid less than if the security pays off. To induce effort by the CRA, the spread between the payoffs must be large (that is, the CRA must be paid a lot more when the AAA security is successful compared to when it defaults). Because of limited liability, the CRA's compensation is bounded below by zero when a bond defaults—that is, investors can't demand payment from the CRAs in the default state—so high-powered incentives, which require high average pay, imply that compensation to the CRA in the good state has to be very high. As a result, paying the CRA for high effort can be prohibitively expensive for the issuer, causing the issuer to settle for low-powered incentives instead and thus receiving low effort from the CRA. Even in the low-effort equilibrium, however, CRAs increase the information set of investors and are socially useful.

Going farther, KK show that having the investor rather than the issuer pay the CRA solves the limited-liability problem and thereby raises social welfare. Particularly surprising about this finding is that the investor-pays model is not only good for society, but it is also good for the CRAs! The reason once again involves the revelation principle. In equilibrium, everyone knows both the amount and usefulness of the effort expended by the CRAs in evaluating securities. The larger the CRA's social benefit, the more the CRA gets paid. If KK's model is accurate, then CRAs themselves may lead the way to a better social outcome by encouraging the adoption of the investor-pays model.

While KK's paper includes many specific lessons about potential CRA payment arrangements, the bottom line to emerge from a comparison of the Blinder op-ed and the KK model involves their differing assumptions regarding investor rationality. The KK model illustrates how the revelation principle, which follows from investor rationality, works against the argument that CRAs helped cause the crisis by misleading investors. As long as investors understand the basic structure of the market, then standard models of asymmetric information—of which the KK model is an example— do not predict that investors will experience large and unexpected losses.

You can read the Harvard Crimson article on the magazine's website.

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston,

 

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, and

 

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston

April 25, 2014 in Mortgage crisis , Subprime MBS , Subprime mortgages | Permalink | Comments ( 0 )

March 27, 2014

Limiting Property Tax Assessments to Slow Gentrification

A recent New York Times article on gentrification discussed a number of cities—including Boston, Philadelphia, and Washington, D.C.—that are planning to freeze property tax assessments for long-time homeowners in gentrifying neighborhoods. The concern is that rising house prices will also raise property assessments, forcing low-income residents to move to escape the greater tax burden and thereby accelerating the pace of gentrification. Although the desire to protect existing residents from gentrification appears to be new, laws capping assessment growth for all property or all primary homes ("homesteads") have been around since Californians passed Proposition 13 in 1978. After California, a number of additional states passed laws limiting how quickly an individual property's assessed value could increase. The bulk of these laws passed in the early eighties to the mid-nineties, and advocates for the law were concerned, at least in part, with limiting the size of local government. If this tax backlash of the previous decades is uncorrelated with more recent gentrification pressures, this may be a good test of statewide assessments caps.

Using a data set of low-income central-city neighborhoods that Dan Hartley of the Cleveland Fed assembled from the 2000 census and the 2007 American Community Survey, we can look at the share of neighborhoods that gentrified in capped and uncapped states. Hartley shows that a central city moving from below-median-MSA house price to above-median house price is a good indicator of gentrification. Relying on the table of statewide assessment caps that Haveman and Sexton compiled, we identify 10 states and the District of Columbia (plus the city of New York) with the strictest limits. In these states, assessed value can increase only at the rate of inflation or by a fixed percentage ranging from 2 percent (California) to 10 percent (Texas). Table 1 presents the share of neighborhoods that gentrified in capped and uncapped states.

Table 1: Share of Neighborhoods that Gentrified between 2000 and 2007

Note that neighborhoods protected by assessment caps actually gentrified faster than those in states without them.

However, we might worry that the decision to impose statewide assessment caps was not random. In the case of Prop 13, rising home prices was certainly a factor in rising property taxes. It is possible that some underlying factor may drive statewide price up but also cause poor inner-city neighborhoods to appreciate faster than other homes in the metro area. One candidate is restrictive zoning laws that limit densification of already desirable neighborhoods. Such laws could both drive up aggregate house prices and push homebuyers into more marginal neighborhoods, causing them to appreciate relatively faster. However, assessment caps are only one possible response to rising property taxes. If voters wish to limit the growth in property taxes, they don't need capped assessments—they can restrict the growth in property tax revenues directly. At the same time, assessment caps that don't also cap the property tax rate don't actually constrain property taxes, but instead shift the tax burden from longtime owners to new buyers. In Table 2, we limit the sample to states that have a binding revenue growth cap or that jointly cap assessments and municipal tax rates. In this case, we assume that, conditional on imposing a tax expenditure limit, the decision to cap assessments rather than property tax revenue is random. We rely on the work by Hoyt, Coomes, and Biehl (2011) to identify various statewide tax expenditure limits.

Table 2: Share of Neighborhoods that Gentrified between 2000 and 2007 with some form of binding property tax limit

Limiting the sample to states that have chosen to constrain the property tax in some way, we still observe assessment caps seeming to accelerate gentrification rather than slow it. How can that be? One possibility is that because these are state-wide limits, the caps have reduced the turnover in more desirable neighborhoods, driving new homebuyers to marginal central-city neighborhoods. In that case, targeted assessment caps that apply only to currently low-priced neighborhoods could still be efficacious. On the other hand, the existence of an assessment cap may increase the long-run return from "pioneering" in a low-priced neighborhood.

So far, we have been using change in relative house prices as our definition of gentrification. However, advocates for assessment caps are plainly concerned about the ability of homeowners to stay in their home in the face of rising home values. While the in-migration of higher-income residents and house prices are highly correlated, we do not observe the duration of time that existing residents remain in their home. Unfortunately, there are few individual-level data sets with sufficiently granular geography to allow such an analysis. As an alternative, we can look at the change in median income of residents. This value is available at the census-tract level in the 2000 census and the 2007 American Community Survey. Table 3 presents change in median income for all census tracts and for gentrifying tracts with and without assessment caps. While median incomes rose in gentrifying neighborhoods (even as they declined nationally), they rose faster in tracts subject to an assessment cap. However, this difference is not statistically different from zero (p value 0.303).

Change in real income for gentrifying neighborhoods with and without assessment caps

Finally, assessment caps do nothing for renters, who may be impacted much more immediately by rising neighborhood quality than homeowners. It is possible that assessment caps could still allow a small share of long-time owners to stay, and the observed effects are just dominated by the movement of renters. If we had access to administrative data with finer geographic identifiers, we could look at whether neighborhoods that gentrified with assessment caps now exhibit more income or racial heterogeneity than neighborhoods without. However, looking only at aggregate data, property taxes do not appear to be a primary driver of neighborhood change, and concerns about gentrification do not appear to warrant interfering with the assessment process.

Photo of Chris CunninghamChris Cunningham, research economist and assistant policy adviser at the Federal Reserve Bank of Atlanta

March 27, 2014 in Housing demand , Housing prices | Permalink | Comments ( 0 )