Throughout the financial crisis beginning in 2008, many mortgagors defaulted on their loans and, if unable to modify them, suffered the misfortune of losing their homes. As a result, a substantial number of single family residential real properties have been acquired by mortgage loan servicers in the foreclosure process as "real estate owned" property, commonly referred to as "REO."1 In addition, fewer new home purchasers are able to meet the downpayment and credit requirements to acquire these properties due to tighter underwriting standards. As a result, for the first time in American history, owners of REO, investors, and the federal government are evaluating strategies for the disposition and acquisition of single family REO in bulk with the objective of managing such REO as rental properties on a national basis.
On February 1, 2012, President Obama, as part of an overall plan to assist responsible homeowners and help heal the housing market, announced a pilot plan for the US Federal Housing Finance Agency (the "FHFA") to sell REO currently held by Fannie Mae for transition into rental housing as a way to help stabilize neighborhoods and improve home prices. The pilot plan was based on responses to an earlier August 2011 request for information about formulating such a program. The REO subject to the pilot plan was acquired by Fannie Mae in connection with defaulted loans included in pools which were insured by Fannie Mae.2 Additional REO held by Freddie Mac and the Department of Housing and Urban Development may be sold later in the program. This is the first step for the FHFA and the Administration to develop a "smart national program" to help manage REO. This announcement is a major development in the secondary market for REO.
The following discussion provides details on the Administration's proposal and identifies some of the legal issues related to investing in single family REO on a bulk basis, financing such purchases, and managing the rental process. As investors will discover, there are both opportunities and potential pitfalls.
The Administration Proposal
The program developed by the FHFA in conjunction with the Treasury Department, Department of Housing and Urban Development, Federal Deposit Insurance Corporation, Federal Reserve, Fannie Mae and Freddie Mac is the first step of the FHFA's REO initiative to target the hardest hit metropolitan areas. During the pilot phase, Fannie Mae will offer for sale pools of various types of assets, including rental properties, vacant properties and non-performing loans. The program will allow qualified investors to purchase the assets with the requirement to rent foreclosed properties for a specified number of years. The purpose of the pilot phase is to examine investor interest in various types of assets, how investors can maximize the participation of experienced local firms and organizations to provide the services and support needed to ensure community stabilization, the types of structures and/or financing that improves returns to the sellers, as well as home values in impacted areas, and the process by which investors are qualified for and ultimately participate in the sales transactions.
At this time it is uncertain what structures will be utilized during the pilot phase of the program. Joint venture transactions may be used whereby investors would purchase a controlling equity interest in a newly formed investment vehicle created to hold multiple assets with the bidders responsible for the management and servicing of the assets. This process would be familiar to those bidders that have participated in structured sales conducted by the Federal Deposit Insurance Corporation.
Any investors desiring to participate in the pilot program are required to submit a pre-qualification request form published by the FHFA. Based on submission of the form, Fannie Mae will determine whether a party is qualified to bid. Elements of the pre-qualification request require a bidder to certify as to matters with respect to itself, its affiliates and owners, including (i) organizational structure, (ii) experience, (iii) confidentiality and (iv) the source of funds used for the acquisition. The bidders will also be required to acknowledge that (i) transactions will essentially be completed without any representations and warranties being made by Fannie Mae and (ii) if any investment would be considered a "security", no filing with the Securities and Exchange Commission is contemplated.
With respect to the organizational structure of a bidder, the pre-qualification form identifies only certain types of institutions or individuals that would be acceptable bidders and any potential bidder is required to satisfy at least one of those criteria. The limited options available to bidders are generally as follows: (i) a not-for-profit organization, unit of a local government or state agency, (ii) a bank, broker dealer or registered investment company, (iii) a trust with total assets in excess of $5,000,000 that was not formed for the purpose of acquiring specific assets from Fannie Mae and whose decisions are directed by a person with experience in the necessary matters, (iv) a natural person with a net worth in excess of $1,000,000, (v) a business entity all of whose equity owners meet one of the criteria of clauses (i) - (iv), and (vi) a natural person with an individual net income in excess of $200,000 in each of the two most recent years. These limited options may limit the pool of potential investors by excluding certain private equity firms or hedge funds from becoming qualified bidders. Further, bidders are only eligible to participate in sales where they have the required knowledge and experience. A bidder must certify that (i) it is in the business of buying, originating, selling, developing or managing loans and/or real estate, as applicable, or otherwise deals in the ordinary course of its business in loans and/or real estate, as applicable, and (ii) if it will be responsible, either directly or indirectly, for providing for the asset management, property management, and servicing of the loans and/or real estate, as applicable, then it will do so through use of an infrastructure that has the demonstrated experience, capability, and technical expertise required to manage the loans and/or real estate.
Finally, with respect to the pre-qualification form, bidders should recognize that no changes will be accepted by Fannie Mae to alter the form and any edits submitted with the form will be disregarded.
General Issues Related to Acquiring REO
REO is fundamentally nothing more than residential real estate and, with some differences discussed below, purchasing it for rental purposes is in most ways no different from an individual buying a home as a primary residence. It differs substantially, however, from purchasing residential mortgage loans, even those loans where the property is actively being foreclosed upon. For example, rather than receiving an assignment of an existing mortgage note and mortgage, the purchaser instead receives a deed. In addition, an investor will have to evaluate the extent and scope of due diligence it will perform on the portfolio, which may be difficult and expensive for a large pool. An investor in REO is generally purchasing the property on an "as is" basis and thus not receiving any representations from the seller about the physical condition of the property. Furthermore, because the occupant of REO prior to foreclosure may not have taken care of the house as well as an occupant motivated to sell for the highest price possible. As a result, the property condition may be significantly worse than for a traditional residential sale and may even be unknown as access to particular homes may not be possible at the time value determinations need to be made. An investor in REO should also consider the costs and benefits of obtaining title insurance.
An investor in REO will also need to consider issues pertaining to the adequacy of title to the REO. Typically, when a valid foreclosure is completed, the borrower's equitable right of redemption ends. In approximately half of the states, however, the borrower also has a statutory right of redemption—that is, the borrower has an additional period of time post-foreclosure to pay the redemption price (typically the foreclosure sale price) and retain (or in some instances, take back) the property. The statutory time period varies by state but can range from six months to over a year. Therefore, an investor acquiring REO during this redemption period faces the possibility that its title to the property can be divested by the exercise of this right.3
Another title issue an investor in REO must consider is the validity of the foreclosure sale itself. All states mandate procedures by which a foreclosing lender must follow in order to foreclose on property. Any lender that has not followed these requirements might be subject to borrower challenges, not just during the foreclosure proceedings but possibly even after the foreclosure sale was completed. This again creates a possible cloud on the investor's title to the REO.
Title insurance might be able to insure against these kinds of title risks. Any investor in REO, therefore, is well-advised to investigate whether title insurance companies are willing to insure against these risks and, if so, to seriously consider the benefits (and, of course, the costs) of purchasing title insurance.
Investment Vehicles for Acquiring REO and Related Tax Issues
Any individual or entity (including private equity funds, hedge funds, REITs, banking or other financial institutions and corporations) may acquire REO. Ownership, maintenance and disposition of REO, however, present special tax concerns for non-U.S. investors and U.S. tax-exempt investors (including non-US investors and U.S. tax-exempt investors investing in the REO indirectly through private equity funds, hedge funds and REITs). If an investment in REO is improperly structured, non-U.S. investors and U.S. tax-exempt investors may be required to file U.S. federal income tax returns, and non-U.S. investors may be subject to effective U.S. federal income tax rates approaching 54.5% (35% for U.S. tax-exempt investors). While there is no "silver bullet" that resolves all tax concerns facing non-U.S. investors and U.S. tax-exempt investors investing in REO, several structuring innovations in the marketplace may mitigate those concerns which are most important to those investors.
One such structure involves the use of a real estate investment trust ("REIT"). A REIT may invest in REO, whereas a real estate mortgage investment conduit ("REMIC") may not. A REIT which invests solely in residential property would be an equity REIT, similar to most REITs which invest in commercial property. One benefit from using a REIT to invest in REO is that a REIT avoids the 35% U.S. federal income tax imposed on U.S. corporations, assuming that the REIT distributes its taxable income annually. An additional benefit from using a REIT to invest in REO is that the disposition of shares in a "domestically-controlled" REIT (i.e., a REIT, more than 50% of which is owned by U.S. persons) does not trigger U.S. federal income tax liability or U.S. federal income tax return filing obligations to the REIT's non-U.S. investors.
There are numerous tax considerations related to investing in REO by a REIT. One major consideration arises from the nature of the REIT as an investment vehicle. REITs are expected to "invest" and not "deal" in REO. A tax of 100% is imposed on REITs that derive gains from "prohibited transactions." A prohibited transaction generally refers to a sale or other disposition of property, including REO, that constitutes inventory or dealer property. There is a safe harbor that excludes up to seven sales a year from prohibited transaction status, which may require the packaging and sale of properties in bulk. To qualify for this safe harbor, a number of requirements must be met, including a requirement that the property being sold must have been held for two or more years. However, this safe harbor provides little or no comfort for a REIT seeking to reduce or reallocate its portfolio in the face of scarce liquidity, deteriorating credit quality, and disrupted capital markets.
Real property is not a security for purposes of the Investment Company Act of 1940, so private equity funds, hedge funds and REITs that invest solely in REO do not need to worry about registration.
Managing the Rental Process
Generally, the owner of multiple single family residences would retain a manager to manage the properties: to lease vacant homes, collect rents, enforce the leases, repair and maintain the properties and generally oversee the properties on behalf of the owner. Management agreements can be complex and frequently must take into account state and local law issues. Extensive diligence on the manager should be considered when acquiring REO in bulk in any particular state, and contracts should be in place before the purchase. Working with a law firm experienced in real estate law and conversant with local law and practice and the negotiation of management contracts is essential to the process.
Financing
Financing the acquisition of REO in bulk raises some issues which may be unfamiliar for investors who typically seek to finance the acquisition of mortgage loans. An investor in an REO could finance the acquisition through a mortgage loan, which would give the lender a direct interest in the property. Such a mortgage would be filed with the local recording office like any other mortgage. Obtaining individual mortgages may not be practical or cost effective for bulk acquisitions of REO given the costs associated with recording individual mortgages, mortgage taxes, and document preparation. However, it is possible in some jurisdictions that a blanket mortgage covering multiple individual properties may be obtained, which may reduce the cost.
Investors in REO may also seek financing through non-mortgage structures where the REO is transferred to a special purpose entity ("SPE"), and the financing is secured by the equity interest in the SPE. These structures would not give the lender a first lien on the property, but similar protections could be achieved, for example, by prohibiting the SPE from encumbering the REO in any way. If the lender views the rental income as a material consideration in extending credit, the lender would need to diligence the management agreements and the entire rental arrangement.
Securitization
Securitization can be used to assist with the acquisition process. Securitization of REO in "scratch-and-dent" or non-performing deals either as a small percentage of the deal or a large percentage has been done through a variety of structures. Additionally, when acquiring the REO or afterwards, mortgages with assignments of leases and rents could be recorded to secure notes sold to investors, effectively making the securitization investors the lenders, with the rents and the real property serving as the collateral. This structure has been used for commercial properties in "net-lease" transactions for many years.
Regulatory Issues
The activities associated with the rental of REO is may be a commercial activity. As a result appropriate commercial licenses could be required in the state where such activities would occur, unless an appropriate exemption is available. Renting of residential property is highly regulated, and an experienced and knowledgeable manager and local counsel is key in this regard. In addition, investors acquiring REO should confirm that local zoning ordinances permit the rental of these properties as part of their initial diligence.
Conclusion
Sellers, investors, lenders, or others interested in pursuing the new opportunities in the REO for rental market should consider the issues that we have outlined above. This market is new and while new markets mean new opportunities, there are pitfalls as well. We have no comment on the commercial feasibility of this market, given that it has not existed before on the large scale being currently proposed. However, with the significant balance of REO currently held by Fannie Mae and other similar parties, a market will certainly exist; these properties are not going away.
Footnotes
1. While the vast majority of the properties available are REO as a result of foreclosures, this alert technically covers all residential real estate available for sale and rental. We will refer to all of these properties as REO, however, as that appears to be the current market convention.
2. Pursuant to its Form 10-Q for the second quarter of 2011, as of June 30, 2011, Fannie Mae held 162,489 single family REO properties.
3. The vagaries involved in the various states' statutory rights of redemption rules are rich and nuanced, to the say the least. In addition, there can be federal pre-emption issues involved in certain instances as well. The purpose of this Client Alert is to merely highlight the possible issues relating to the statutory right of redemption. Any investor in REO should consult with local counsel in each applicable jurisdiction when assessing this risk.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
