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Rental vacancy rates in the United States dropped about 2 percentage points in the last two years.The number of households in rentals increased 4 percent, or 1.5 million, during the 12 months ending in March. homebuyer because 20 percent to 30 percent of deals with financing will fall through, Lichtenheld says. Two other factors barring potential owneroccupants from buying, he says, are the statistics used to evaluate the banks when selling off REOs. They are gross execution, or the percentage of the appraised value received through the sale, and the turnaround time for the sale. So banks can boost their ratings by accepting above-appraisal offers and agreeing to quick cash sales—neither of which includes typical sales to owner-occupiers, he says. Cash sales can take 30 days to close while sales that involve financing take 45 to 60 days. Even in markets where demand by rental investors drives up REO prices, the economics still work for the investors, Lichtenheld says. An example: The purchase price for a typical three-bedroom, two-bathroom, 1,400-square-foot house in Southern Arizona is $55 per square foot. Repairs cost $5 to $7 per square foot to make it rentable. The typical rental price for such a property comes to $7 to $8 per square foot, which means cash from the rent will offset the purchase price in seven to eight years, not including the benefits of the tax depreciation write-off, or cost recovery, Lichtenheld says. "This is a great market," he said. "The magical question is: At what point will the market improve?" Investors already enjoy decent returns without property appreciation, and those returns will become tremendous if appreciation is added. Because of the effect of investor demand on prices, in many markets, taking a flipping strategy, or a strategy of making only cosmetic repairs, is no longer viable, Lichtenheld says. Normally, spending $5,000 on painting, re-carpeting, and small repairs could help an investor recover two to three times that amount in resale value. "Those properties are too easy; they're not there anymore," he said. Now, investors will even reach down for a two-bedroom/one-bath home and install another bathroom—which requires more significant investment, time, and building permits—because the rent economics make it worthwhile, Lichtenheld says. The problem for would-be owner-occupant buyers is the glut of REO and in-default 58 properties that eventually must be released— estimated in some circles to be up to 6 million homes that must change hands in the next five years, Lichtenheld says. Potential homebuyers initially seemed excited about news of a recovery, but they were sidelined by the limited inventory and lack of houses at prices eligible for FHA financing, he says. And when the inventory is released, investors will like the even better deals they can get on good cash-flowing investments, but potential homebuyers will worry that another correction is coming and that it is a bad time to buy. How the property glut is released—steadily or in chunks—will be the key to moderating the impact on homebuyers, Litchtenheld says. For investors, figuring in a 10-year horizon for potential price appreciation is probably the safest assumption. "We don't know if we're at the bottom, but we know we're scraping along there," he said. Overcoming Obstacles The scale of the REO-to-rental space and how quickly it ramped up, presents a challenge for investors and service providers in the space, says Rick Sharga, EVP at Carrington Mortgage Holdings. Carrington announced a deal with Oaktree Capital Management in January to form funds that will invest up to $450 million in distressed single-family homes. The properties will be held for a relatively short time, at least three years, and then sold to capitalize on their appreciation in value. When the single-family rental space was small, it was dominated by mom-and-pop type landlords who bought only properties that were nearby, Sharga says. Now, investors and managers are collecting REO-to-rental properties across large regions of the U.S. Carrington, which counts itself as the largest rental partner of Fannie Mae, operates in more than 30 states. Two other issues for investors new to the single-family-home rental space include allocating adequate capital for ongoing maintenance and upkeep—building those costs into the revenue model—and understanding the behavior of renters in the space, Sharga says. Typically, in the past, single-family-home renters were expected to live in the properties for a short time as they used them as a steppingstone to buying, he says. But in the current economic and market conditions, that may not be the case, so behavior is less predictable. In addition to the foreclosure crisis, technology drives the development of the REO-torental market, says Colin Weil, co-founder and managing director of Waypoint Homes in Oakland, California. Waypoint, which formed in 2008, owns and manages more than 1,500 single-family rental homes in California and Arizona. Recent advances in cloud computing, mobile computing, and relational databases made it possible to develop sophisticated investing and management systems for single-family rentals that were impossible before because they were so complex and costly, Weil says. "Nobody's ever figured out how to scale it up," Weil said. "There's tremendous complexity." While the foreclosure crisis and the economics spurred the development of the market, "it was inevitable that the single-family rental industry would emerge," he said. "Our thesis is that this is not going to go away after the foreclosure crisis passes." Typical capital rates, the ratio of the property's net income to its capital cost, are about 6 percent for multifamily rental properties and 8 percent to 9 percent for single-family rental properties, not including leverage or the appreciation expected for REO properties, Weil says. Waypoint takes a buy-and-hold approach with its properties and raised several funds with high-net-worth investors before taking on the Columbia University endowment as its first institutional investor last year. Waypoint has $400 million under management from investors, leveraged to $1 billion, in its single-family-home rental investments. Key Considerations For any direct investor in REO-to-rental properties, due diligence should be a prime consideration, Clothier says. The investor should really understand the numbers, the goal of investing, and the end game planned. "Definitely do your homework; take nothing on faith, regardless of what you see; and meet the people you're dealing with," he said. "The cost of an airplane ticket and a short trip could save you a lot of money down the road." Investors should scout the company that will work with them on locating, buying, and managing the properties and make sure the company also invests in the local properties itself, Clothier says. The company should also have a long-term property management plan in place as well as be willing to talk about how it handled problems with clients in the past or addressed other negative situations.

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