Rental-Backed Securities Pose Modest Threat

Jody Shenn of Bloomberg recently reported that the private-equity firm Blackstone recently debuted bonds backed by rental properties. David Dayen thinks this is a terrible idea. Matthew Klein says, "what, me worry?"

Dayen is worried about the parallels between rental-backed securities and mortgage-backed securities. He writes:

You’ll remember that mortgage-backed securities were bestowed triple-A ratings during the housing bubble, and that this spurred massive purchases, fueling demand for more and more home loans to create more securities. You can see the same thing happening in the rental market if these securities catch on. In fact, while the most attractive foreclosed properties have already been snapped up, homebuilders are constructing new properties specifically for single-family rentals. Some analysts are concerned that this gold rush will create a new housing bubble in the communities where Wall Street firms are purchasing homes.

 Klein disagrees and says:

Where Dayen goes wrong is assuming that these securities will help fuel another bubble and crisis, or breed “absentee slumlords.” The less exciting reality is that the rental market for single-family homes will probably remain a niche business that will be profitable for some people and make little difference to the rest of us.

Klein argues that the systemic risks of rental-backed securities are small because the size of the rental securitization market is small and is likely to remain small:

When the strategy first developed in 2011, investors could buy and renovate thousands of foreclosed homes on the cheap and rent them out for after-tax yields of as much as 8 percent. At the same time, they could position themselves to benefit from any rebound in housing prices. That made single-family houses attractive to investors hunting for returns of as much as 25 percent. But then places such as Phoenix became saturated with investor capital, house prices soared and yields fell. Investors moved on to Atlanta. As the housing market recovers, the opportunities for big gains will diminish.

Matthew Klein makes a good point here. The logic behind the housing bubble was that mortgage-backed securities remained profitable so long as housing prices continued to rise. The logic behind rental-backed securities seems to be the opposite: that rental-backed securities remain profitable so long as you can purchase rental properties while housing prices are depressed. Rising housing prices will, instead of reinforcing an asset bubble, serve as a check on any sort of bubble formation.

However, I'm not entirely convinced by Klein that rental-backed securities pose little threat. First, despite their AAA rating, these rental-backed securities are still quite risky - much more risky than mortgage-backed securities. Part of the logic that explained why mortgage-backed securities were less risky than individual mortgages was that the mortgages that made up the securities were geographically diverse. That's not the case with rental-backed securities. Blackstone's rental-backed securities are geographically concentrated. And they have to be to make property management feasible. One bad stroke of economic luck in the West could wipe out these securities.

Second, even though the size of the rental market is relatively small, it's possible that the market could gain disproportionate importance in the financial sector. Just as we saw during the MBS bubble, financial instruments such as synthetic CDOs and credit default swaps can magnify relatively small losses in the real economy. Furthermore, much of the money behind Blackstone's deal came from a 2 year loan with a floating rate. If the Fed overreacts to a future sign of inflationary pressure, it's possible that Blackstone could be hit with a double-whammy in the form of higher interest payments and lower revenue from rental properties. In need of liquidity, Blackstone would be forced into the tough situation of selling geographically concentrated properties in a higher interest rate environment. If the losses - possibly magnified by credit default swaps and synthetic assets - are large enough, there could be big trouble in the financial markets.

Not to say that this is likely, though. But it is possible. And it's unclear whether the advantages of rental-backed securities outweigh these risks. On one hand, there will be greater stability in the rental market of a city during a city-specific economic downturn. On the other hand, the rental and housing markets of one city can possibly be affected by the rental and housing markets of another, distant city. And in specific cities, firms like Blackstone could, as Dayen notes, gain a disproportionately large slice of market power. Which is why I would rate my level of concern with rental-backed securities as cautiously neutral to mildly pessimistic.