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Monday, December 23, 2013 12:11 PM

Wall Street Is My Landlord; Blackstone's Home Rental Bonds Yet Another Sign of Renewed Credit Bubble

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Blackstone Group LP, the world's largest private equity firm, became the largest owner of rental homes in the U.S. , acquiring 41,000 homes in the past two years. In October, Blackstone offered the first-ever "rental-home-backed" security on Wall Street. The bond is backed by just a fraction — 3,207 — of the rental properties owned by Blackstone. Monthly rent checks from the properties will be used to service the $479.1 million security.

See Bloomberg's Blackstone’s Big Bet on Rental Homes for a giant infographic.

Inquiring minds may also be interested in a related Bloomberg article, Wall Street Is My Landlord.

Let's focus on the credit aspect of what's in the Blackstone/Deutsche "Invitation Homes", first-ever rent-based bond offering. Here is a snip from the gigantic infographic in the first link above.

Invitation Homes Bond Offering

What do investors get for their money?

A Bond Credit Rating Table courtesy of Wikipedia will help explain.

Moody'sS&PFitchRating Description
Aa1AA+AA+High grade
A1A+A-1A+F1Upper medium grade
Baa1BBB+BBB+Lower medium grade
Ba1Not primeBB+BBB+BNon-Investment Grade Speculative
B1B+B+Highly Speculative
Caa1CCC+CCCCCSubstantial Risks
Caa2CCCExtremely Speculative
Caa3CCC-Default Imminent with Little Prospect for Recovery
CD/DDD/In Default

Whether or not one really believes the Aaa tranche truly deserves that rating, all those investors get is a coupon rate of 1.314%.

Those buying the class "D" offering, rated Baa2, get a "lower medium grade" bond, two steps above junk (again assuming the class really deserves that rating).  Those investors get a 2.314% return.

Classes E and F, both "unrated" are highly likely to be pure garbage in my estimation. 

Blackstone Lures Investors to Home-Rental Bonds

Feel warm and fuzzy with these bonds?

If so please consider Blackstone Lures Investors to Home-Rental Bonds.
Investors in Blackstone (BX) Group LP’s debut sale of bonds backed by U.S. rental homes are agreeing to accept more risk than in traditional mortgage deals by at least two measures -- along with an unproven business.

Blackstone’s Invitation Homes borrowed more through yesterday’s deal relative to the value of the houses serving as collateral for the bonds than recent residential-mortgage securities, according to data from ratings companies. The cushion to cover interest payments is also smaller than in deals tied to apartment complexes. Monthly rent checks from 3,207 properties will be used to service the $479.1 million of debt.

“Given the rapid increase in prices in the areas in which the properties are concentrated, the amount of protection for bond investors doesn’t make one feel all that warm and fuzzy,” David Liu, co-manager of a $340 million securitized-asset fund run by New York-based TIG Advisors LLC, said last week, adding that he expected the offering to find buyers easily given the momentum in housing and other features of the debt.

Fitch Ratings disagreed with rivals that any rental-home securities should get top ratings now, citing in part the “limited track record” of big institutions in the business and incomplete historical data on how rents, vacancies and other considerations can vary over economic cycles.

Along with potential default risks, investors need to grapple with the borrower being able to repay the debt after 12 months or extend the maturity for a year as many as three times under certain conditions, said Bryan Whalen, a managing director at TCW Group Inc., which oversees about $130 billion from Los Angeles.

“That’s a lot of optionality you’re giving to Blackstone” and if bondholders can’t be paid off through a refinancing or home sales at the end of five years, they may need to wait even longer for the return of their principal, Whalen said.

The estimated value of the homes in the deal represents 75 percent of the debt’s balances. The ratio is based on the opinions of real estate brokers, rather than the licensed appraisers who are more reliable and traditionally used for residential mortgage-backed securities deals, according to Moody’s.

One of the key risks of the Blackstone deal is its “heavy geographic concentration,” Bank of America Corp. analysts led by Chris Flanagan in New York wrote in a Nov. 1 report.

The breakdown includes 34 percent from the Phoenix area, 17 percent from the Riverside-San Bernardino-Ontario region in southern California and the rest from other parts of the state, as well as Florida, Georgia and Illinois.

When it’s time to repay the debt, rental-home owners may be unable to refinance or sell the bond collateral in bulk and flood the markets, Fitch analysts Suzanne Mistretta,Dan Chambers and Rui Pereira in New York wrote in a statement last month.

The transactions can also be “highly vulnerable to unknown variables” including property taxes, restrictions from homeowner associations and actions by local governments, they said.

Deal Covenants

The deal’s covenants can allow individual properties to be sold, for between 105 percent and 120 percent of their allocated share of the total loan, according to information in the Kroll report, a release of liens that may leave the worst properties backing the remaining securities.

The largest danger may be that Blackstone will be allowed to sell the Invitation Homes business or take it public before the securities mature, said TCW’s Whalen, who described the deal as “well-structured and really well thought in terms of the way they put it together” in general. 
13-Point Deal Summary

  1. Moody's rates 42% of the deal as Aaa Prime, Fitch rates none of it AAA prime. Whom do you believe? I believe Fitch.
  2. 18.27 percent of the deal is not rated at all, and highly likely pure garbage.
  3. Cushion to cover interest payments is smaller than in deals tied to apartment complexes
  4. Collateral for the bonds lower than recent residential-mortgage securities
  5. No track record for these securities
  6. Regional risk - properties concentrated in Phoenix and California
  7. Transactions “highly vulnerable to unknown variables” including property taxes, restrictions from homeowner associations and actions by local governments
  8. When it’s time to repay the debt, rental-home owners may be unable to refinance or sell the bond collateral 
  9. The offering is loaded with default risk, normal repair risk, renter damage risk
  10. Estimated current value of homes includes rapid price appreciation (brought on by Blackstone snapping up foreclosed houses en masse)
  11. Home value estimates made by real estate brokers, not licensed appraisers
  12. Individual properties can be sold, leaving garbage in the loan portfolio
  13. Blackstone allowed to sell the Invitation Homes business or take it public before the securities mature
Biggest Risk

What the biggest risk? Whalen says "The largest danger may be that Blackstone will be allowed to sell the Invitation Homes business or take it public before the securities mature".

I disagree. I think the biggest deal-based risk is that individual properties can be sold over time, leaving increasing amounts of garbage in the loan portfolio. That thought alone makes me suspicious as to how Blackstone picked properties to go into this pool in the first place.

Final Thoughts

Without a doubt, Blackstone picked individual properties carefully, and every property placed in the pool was to maximize value for Blackstone, not investors. That is to be expected, but Blackstone went steps further, nearly to the point of detailing how investors are likely to be gored by this deal.

Investors chasing this deal for paltry returns are picking up pennies in front of a steamroller. This is the way it is at the peak of every credit bubble.

The only surprising thing is how quickly investors were willing to repeat their last mistake.

Mike "Mish" Shedlock

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