Brian Hurley, Chief Executive Officer for Gradus Capital, Inc.
I manage two funds that are investing in different dimensions of the real estate recovery. The first is a residential real estate acquisition fund – very market specific in terms of geography. The second fund is investing in real estate transaction growth. We’re forming and acquiring real estate brokerages, title companies, escrow companies and other ancillary real estate service providers. In prior roles, I ran a large residential asset management firm and one of the largest title companies in California.
Q: Where is the Private Equity Market presently investing the majority of its funds?
A: There are a lot of interesting opportunities in the market, but I can tell you that the entire PE market has been looking at single family housing. There isn’t a single PE fund with more than $500m under management that hasn’t entered this space in some way. The securitization of residential investment is a new market, which has attracted a lot of attention and capital. None of the established players in the housing space saw this market coming. Residential real estate doesn’t have the built-in diversification that you have with multi-family, where investments can be amortized over many units. Residential is difficult for institutional capital to manage. The early pioneers – KKR, Waypoint, Blackstone, Colony – used their angel funds and seed funds to dabble in this area, and they are now pouring unbelievable amounts of capital into it.
Q: Are we transforming neighborhoods from owner-occupied areas into areas where everyone rents?
A: High-volume investor purchases of single family housing have definitely crowded out potential homebuyers, and that had led to some public policy issues. When it comes to neighborhood stabilization, our nation’s housing policy has always focused on owner-occupancy, so a declining homeownership rate feels troublesome. According to a recent Goldman Sachs report, in 2005, 30% of residential housing was held by investors. Today, that percentage has risen to 35%, with even stronger shifts in markets like Phoenix where the opportunities have been greatest.
Of course, as prices continue to go up, the yields that PE firms can offer investors are going down. Based on cap rates, a lot of funds are now around 5%, at which point you really begin to reconsider the risk profile because of the idiosyncratic asset challenges. The challenges with scattered site rental are big and require a lot of investment – field repair, plumbing, construction. Now some firms are seeking ways to cash out of their investments because they haven’t hit the yield targets they expected. Because they’ve built up apparatus to manage them, many people now believe that the exit strategy won’t be to release the assets to the owner-occupied market, but rather a conversion of the portfolios to a REIT, which enables investment managers to pull in pension fund and insurance companies as investors (because of illiquidity, pension funds generally can’t invest in PE, but can in a REIT). To grow their potential REIT holdings, we’re now seeing PE firm buying portfolios from one another.
Q: What is the likely role that municipalities will take as it becomes apparent that there’s more of a concentration of houses in PE firms?
A: In much the same way that the swift entry of institutional investors into residential housing took the default market by surprise, many cities and towns were completely unprepared for the changing ownership structure of their housing stock. There have always been single-family rental properties – the difference today includes both the scale of holdings and the often physical remoteness of the property owners. Think about the often burdensome processes required by most municipalities for a developer seeking to release hundreds of multi-family rental properties into a given market – then think about how equivalent holdings could be amassed in the single-family market without any registration, permits, applications, and so on. I think the first role that most municipalities will take, and that many have taken, is one of awareness: expect new processes for property registration, likely followed by one-time or registration annual fees. Thereafter, what we see will likely depend on the general condition of properties and on the aggressiveness of municipal regulators.
Q: How do municipalities engage with institutional asset holders and make them responsible homeowners?
A: The REO market taught us that it’s naïve to think that large-scare property owners can remain “below the radar” forever. Many banks and servicers were forced to accept responsibility for abandoned REO houses, for “green pools,” and for other physical property deficiencies as a result of municipal ordinances. Ultimately, if a town finds a correlation between sub-standard condition and PE ownership, regulation will follow, ordinances will be passed, and code violations will be issued. Whether in the form of fees for excessively long font lawns or through efforts to pursue eminent domain, the housing crisis drove a new wave of “municipal activism,” but many cities and towns are still struggling financially. As a result, there have been some successful partnerships between municipalities and community groups to identify code violations and monitor property condition. To the great extent that such groups are also interested in broader consequences of declining owner-occupancy, they have become strong municipal allies in the effort to promote “responsible homeownership” on the part of investors.
Q: How have different PE firms dealt with this issue, and how have these different processes affected private and public engagement in the PE policy debate?
A: Many municipalities are just becoming aware that one or two firms may own one or two thousand single-family units within their housing stock. As a result, to this point, there have been relatively few regulations for PE firms to deal with, and many PE firms have stayed very “low key,” even to the extent of grouping holdings in multiple sub-entities so as to avoid obvious ownership concentration. For PE firms that have built their portfolios for medium-term holds (versus “flippers”) there is actually alignment with many municipality objectives: municipalities are chiefly concerned with property condition and property management practices out of an obligation to protect the values and usability of surrounding homes. For investors who aim to ultimately sell houses and achieve appreciation, property condition and the stability of the surrounding neighborhood are also important. As a result, PE firms that are driving for scale and/or readying for a structural transformation of their holdings (e.g., to a REIT) seem to be moving toward rental practices that align with municipality objectives: they are selecting strong tenants, they are registering properties, they are monitoring and maintaining properties, and they are taking prompt corrective action through local service providers. If the market trend moves in this direction and away from some of the early patterns of investor disengagement, then the ensuing PE policy debate can be less of an indictment of poor rental management and more of a discussion about the ongoing need for single-family rental housing, the income and wealth challenges precluding consumer homeownership, and the achievement of positive social outcomes long correlated with high owner-occupancy rates amidst an increasing renter-share population.