Housing News

Learning from Wall Street's Edge in Buying Fixer Uppers

The block purchases of single-family houses by institutional investors, which began during the housing and foreclosure crisis, was first credited with putting a floor under the housing market in 2010 through 2012. Since then, it has been blamed for keeping large numbers of homes off the market, leading to shortages and higher home prices. Some owners have been criticized as well for landlord abuses.

The Urban Institute has now published research on another aspect of institutional ownership of rental properties. UI says these findings should be considered a possible model rather than something to disparage.

UI analysts Laurie Goodman and Edward Golding say that most of the homes purchased by Wall Street investors as rentals need repair to enhance rentability and the institutional buyers have significant advantages not available to individuals in purchasing and improving them. The authors propose studying some of the methods these buyers use improve the competitiveness of individual homebuyers to benefit from buying and rehabilitating fixer uppers to live in.

Institutional buyers have expertise and can realize economies of scale when doing major work. Before purchasing a property, a company sends out an in-house team to inspect its structure and systems, prepare a budget, and weigh whether renovations will increase the property's rental value. After purchase they request bids from local venders, usually negotiating a volume discount and extended warranties for products commonly used in an upgrade such as appliances and HVAC systems. This expertise and cost advantage is factored into the purchase price of the property, giving investors an advantage when bidding to buy.

Even with the volume discounts, Goodman and Golding say investors put significant money into their properties. One of the biggest companies, Invitation Homes, spent $39,000 per home for up-front renovations last year, while American Homes spent $15,000 to $30,000.

The authors say a typical homeowner spends $6,300 during the first year after purchasing a home. They add, corporations' extensive experience, internal capacity, reliable vendor relationships, and discounts yield more cost-effective renovations than a homeowner could generally achieve for the same work.

Then there are the financial advantages institutional buyers have in this market. They typically pay cash (secured through capital markets) for purchase and repair then refinance later through the securitization market, lines of credit, or loans from a bank, insurance company, or other institutional investor. Thus, corporations can cover purchase, rehab, and financing costs separate from and not contingent on that financing.

In contrast, an owner-occupant usually needs a loan and standard purchase loans are not appropriate to this task because they are based on current rather than a post-improvement value. FHA's 203K program and Fannie Mae or Freddie Mac's renovation finance programs do base the loan amount on after-repair market value, but there are downsides to their use.

UI says that 2019 data provided through the Home Mortgage Disclosure Act shows that, of 4.437 million purchase loans originated that year, only 174,000 were rehab loans, with a lower number used for purchase, rather taken out by existing homeowners to finance major remodeling projects. These loans have a high denial rate. Among conventional loans, those for rehab have a turn-down rate of 36.3 percent compared to 9.1 percent for purchase loans and 14.9 percent for all mortgage loans. For FHA rehabs the denial rate is 28.8 percent rather than 12.9 percent for purchase and 19.6 percent for all loans. This means sellers are usually more reluctant to accept a buyer's offer that is contingent on these mortgages.

UI says these loan programs also have more limitations and are more expensive than regular mortgages. There are two forms of the FHA 203K loan. One is for smaller nonstructural projects costing up to $35,000. The second version covering major repairs requires the borrower hire a Department of Housing and Urban Development consultant to oversee the work.

The GSE programs, Fannie Mae's HomeStyle and Freddie Mac's CHOICERenovation, vest the risk of shoddy work or cost overruns with the lender, and give the GSE recourse against it. Although it's not required, many lenders hire contractor oversite to mitigate risk and may charge borrowers extra for this.

Recognizing that lender recourse can limit participation, on Monday Freddie Mac began to offer a new program for more limited improvement projects. It will cover additional funding of up to 15 percent of the purchase price in "high need" areas and 10 percent in other locations and does not require lender recourse.

The authors add that none of the renovation loans provide much flexibility once the scope of work is agreed on. The loan details are particularly difficult to navigate if a project grows or changes, as they so frequently to do.

Goodman and Golding say it is unlikely the playing field between investors and hopeful homeowners can be fully leveled, but it makes sense to understand how the former operate and explore whether adopting some of their techniques can bring expertise, scale, and financing opportunities to aspiring homeowners. Pilot programs could include direct government subsidies or government partnerships with home improvement companies or building supply companies. The successful pilots could be expanded to promote homeownership.

The authors add that we should be mindful that institutional investors play an important role in the market by improving the quality of the housing stock and increasing the supply of decent rental housing. "As long as they are not predatory, they are providing valuable upgrades to homes that need repair. It is important to have policies that promote both homeownership and the maintenance of a high-quality rental stock."