The Role of Investors in Acquiring Foreclosed Properties in Low and Moderate Income Neighborhoods

by Chris Herbert
Research Director

In the fall of 2011 the What Works Collaborative convened a meeting of researchers, policy makers, and practitioners to help frame a research agenda to inform policy making on issues related to housing finance over the next several years. Among the issues discussed at the convening was the challenge of obtaining mortgage financing in lower‐income neighborhoods heavily impacted by the foreclosure crisis. At the time, the foreclosure crisis had yet to show signs of abating even as the main federal initiative to address the impact of concentrated foreclosures on communities across the country, the Neighborhood Stabilization Program (NSP), was beginning to wind down. Participants noted that while the NSP had been plagued by problems that had stymied efforts to expend program funding, private investors had emerged in markets around the country as a significant source of demand for foreclosed properties in heavily impacted neighborhoods, with the volume of financial investment made through private channels easily dwarfing those made with NSP backing. Yet, while it was clear that private investors were playing a substantial role in absorbing foreclosed properties and directing substantial capital into these areas, there was little systematic information available about the scale of investor activity, who the investors were, what strategies they were pursuing with the properties they acquired, or what the consequences would be for these neighborhoods of this substantial increase in investor activity.

To address this void, the What Works Collaborative funded a series of case studies in four market areas across the country representing a range of market conditions. In each market, the researchers focused on the activities of investors in acquiring foreclosed properties in low‐ and moderate‐income neighborhoods in the metropolitan area core county. The purpose of the research was to identify in each area the extent to which foreclosed properties were being acquired by investors, what scale investors were operating at, the strategies that investors were pursuing with these properties, whether they were engaging in rehabilitation of these properties, and ultimately what impact their activities were likely to have on the surrounding community. To address these issues the case studies combined quantitative analysis of available data on transactions involving foreclosed properties with qualitative information gathered through interviews with government officials, nonprofit organizations, investors, real estate agents, lenders, and other informed observers.  These are the four case studies, as well as a summary and synthesis of findings from the report series:

• The Role of Investors in Acquiring Foreclosed Properties in Low- and Moderate-Income Neighborhoods: A Review of Findings from Four Case Studies (Christopher Herbert, Irene Lew, and Rocio Sanchez-Moyano)
   
• Investors and Housing Markets in Las Vegas: A Case Study (Allan Mallach)
   
• The Role of Investors in The One-To-Three Family REO Market: The Case of Cleveland (Frank Ford, April Hirsh, et al.)
   
• The Role of Investors in Acquiring Foreclosed Properties in Boston (Christopher Herbert, Laurie Lambie-Hanson, Irene Lew, and Rocio Sanchez-Moyano)
   
• The Role of Investors in the Single-Family Market in Distressed Neighborhoods: The Case of Atlanta (Dan Immergluck)
  
  

Strategies for Achieving Scale in the Residential Remodeling Industry

by Abbe Will
Research Analyst

Since its inception nearly twenty years ago, the Remodeling Futures Program of the Joint Center for Housing Studies has been investigating trends in contractor size, concentration, performance, and survivorship to better understand the evolving structure of contractors serving the residential remodeling market. Unlike the national homebuilding industry, which saw significant achievements of scale and consolidation in recent decades, the professional remodeling industry continues to be highly fragmented, where the vast majority of remodeling companies are relatively small, single-location businesses that likely will not experience any significant growth over the course of the business’s life-cycle. Two thirds of remodelers are self-employed, and fully half of payroll establishments have total revenues of under $250,000. Yet our research suggests that there are significant benefits to be gained through larger scale businesses.

The evidence for the benefits of scale in the remodeling industry is compelling. Comparing the revenue growth of larger-scale remodeling companies to the industry as a whole shows that larger-scale remodelers benefit from significantly stronger revenue growth. Where the average revenue of all residential remodeling contractors increased less than 18% in inflation-adjusted terms during the last industry upturn from 2002-2007, larger-scale firms with annual revenues of approximately $1 million or more increased their average revenue by over 30% during the same period. Additionally, larger-scale remodeling contractors benefit from higher revenues per employee, which implies that they enjoy greater labor productivity (Figure 1). While an admittedly crude measure of efficiency and productivity, the trend is obvious that larger remodeling businesses are seeing a benefit of scale.

Source: Unpublished tabulations of the 2007 Economic Census of Construction, U.S. Census Bureau.

Furthermore, there is evidence that larger-scale remodeling firms suffer significantly lower failure rates across the rocky business cycle (Figure 2). Remodelers with estimated receipts of $1 million or more during the last industry upturn in 2003–04 had a failure rate of only 2.7% that year, and their failure rate remained essentially unchanged during the cyclical downturn in 2009-10. These low and stable failure rates for the largest remodelers are in stark contrast to the roughly 20% failure rates of smaller remodeling businesses. With the efficiency gains that come along with achieving scale economies, larger remodeling companies seem much better equipped to ride out the volatile business cycles in the remodeling industry.

Source: JCHS estimates using U.S. Census Bureau tabulations of the 1989-2010 Business Information Tracking Series.

Although larger-scale remodeling firms enjoy significant benefits to scale, the industry has remained fragmented over time due to the many obstacles to gaining scale such as low barriers of entry, highly customized work, and difficulty attracting capital, to name a few. Understanding how remodeling companies are overcoming these major hurdles in their pursuit of scale economies should provide insights into how the industry is likely to continue evolving over the next several decades, as well as what opportunities exist for more widespread consolidation moving forward.

To this end, the Remodeling Futures Program has been conducting in-depth interviews with several dozen remodeling industry leaders including founders, presidents, and CEOs of larger-scale remodeling companies on the topic of benefits from scale and challenges and strategies for achieving scale. Key research questions for the project focus on exploring the major approaches used for gaining scale, challenges and opportunities unique to each type of strategy, and whether certain types of remodeling specialties or niches are more or less likely to attempt to establish a larger-scale or even national presence.

A key insight gained from these interviews is that successfully achieving scale in the remodeling industry has more typically occurred using strategies outside of the traditional model of organic expansion and acquisition. Common among remodeling companies that have been successful in establishing a larger-scale presence are strategies or approaches that involve strategic partnerships or arrangements, such as:

• Strategic Alliances: When expanding to new markets, building brand awareness and trust takes a significant investment of time and money, so securing strategic alliances or partnerships with long-standing, nationally known manufacturing and retail brands to sell, furnish, and install products and projects is very effective for gaining entry into new markets with instant name recognition and credibility with consumers, who, given the same quality and price, will choose the brand with which they are already most familiar. Strategic alliances ultimately provide a contractor with a high volume of quality leads in new markets. 

• Franchising: Franchising is a well-established scaling strategy in many industries that allows a business to quickly expand its brand recognition and reach without the challenges of managing each independently-owned and operated franchise location. Franchising in the remodeling industry seems to be more successful with single focus or specialty businesses, such as painting and insurance restoration services that are easier to standardize and streamline. 

• Outside Investment: Pursuing outside investment through private equity partnerships, for example, provides a company with an influx of working financial capital for expanding into new markets, developing additional lines of business or products, or restructuring operations or management to better foster growth. Though a highly effective way to scale a remodeling company toward a national presence, this strategy of securing outside investment has not been more common because investors are deterred by the relatively high-risk nature of such a volatile and fragmented industry.

Since the remodeling industry is so diverse, with business segments and market niches that cover the full spectrum from full-service and design/build firms to specialty replacements and handyman services, there is no one-size-fits-all approach to achieving scale. Companies often employ multiple business strategies and arrangements either consecutively or concurrently. Some of the biggest benefits of scale reported by industry leaders include improved buying power, lower costs, efficiency of centralized accounting and management, and improved use of technology systems, as well as geographic diversity (i.e., not being dependent on the economic strength of one market or region), greater ability to explore new business opportunities, greater consumer recognition and trust, and being able to provide growth opportunities to key team members. The many issues surrounding this topic of strategies, benefits and challenges of achieving scale in the residential remodeling industry will be explored in greater detail in an upcoming Joint Center working paper.

The Role of Investors in Acquiring Foreclosed Properties in Boston

by Irene Lew and Rocio Sanchez-Moyano
Research Assistants

In the fall of 2011, a meeting of researchers, policy makers, and practitioners convened by the What Works Collaborative highlighted the dearth of research examining the role of private investors in purchasing foreclosed properties in lower-income neighborhoods heavily impacted by the foreclosure crisis. To address this void, the collaborative funded a series of case studies in four market areas across the US that represented a range of market conditions: Atlanta, Boston, Cleveland, and Las Vegas. The case study for Boston, which was just released, focuses on the activity of investors in the city of Boston and other communities located in Suffolk County, Massachusetts.  (Note: the Atlanta case study was published earlier this year; Cleveland and Las Vegas are not yet published.)

The Boston study entailed an examination of data from The Warren Group, a third-party-vendor, on real estate transactions in Suffolk County from 2007 to 2012, as well as interviews with government officials, non-profit organizations, lenders, real estate brokers, and investors in foreclosed properties. Excluding government and nonprofit organizations, investors were identified in the transaction data either as those who had acquired more than one foreclosed property over the period or those who had purchased a foreclosed property under a corporate or legal name. Key findings from the report include:

• Investors accounted for a large share – 44 percent – of transactions between 2007 and 2012.
• In all, a total of 437 unique investors were identified.  Most of these investors can be classified as “mom and pop investors” who bought only one or two properties, but 33 investors each purchased 10 or more properties and accounted for more than 50 percent of all investor purchases. (Click table to enlarge.)
  
  

Note: Percentages do not sum to 100 due to rounding.

Source: Authors’ calculations of data from the Warren Group.

• While private investors operating on a national scale have received substantial media attention in the last year, in Suffolk County the largest investors had overwhelmingly local roots: 18 were based in Suffolk County and only two were headquartered out of state.
• Large investors were somewhat more likely to invest in highly distressed neighborhoods (35 percent of their foreclosure acquisitions, compared to 31 percent of the acquisitions of all foreclosure investors), and the majority of purchases were small multifamily buildings (2-4 units) or condos. Alan Mallach has defined a typology of investors in homes in distressed neighborhoods, with a key distinction being between those who seek to make their profit by quickly flipping properties to other buyers and those who seek to profit by holding onto properties for rental income. The study found that in Suffolk County a buy-and-hold strategy was most often pursued by large investors, supported by the healthy demand for rental housing in Boston. Although a few investors did turn over a majority of their purchases in a fairly short time, others who held onto most of their properties also sold a portion of their acquisitions when the right opportunity arose.  Overall, 66 percent of foreclosures purchased by large investors between 2007 and 2012 were still owned by these entities as of February 2013. 
• Cash was the most common form of financing, but hard-money loans from investor-affiliated lenders and mortgages from small community banks played an important role (Figure 1).
  
  

Note: Includes all legal variations of the same lender. Some investor-affiliated lenders have multiple iterations. Mortgages include only primary-lien purchase-money loans, as identified by the authors.

Source: Authors’ calculations of data from the Warren Group.

• Given the significant presence of large investors in more distressed neighborhoods, this study primarily focused on the activities of these investors. However, based on anecdotal information, small investors face more challenges than large investors in distressed property acquisition, rehabilitation, and management due to more limited financial resources. 

The primary motivation for this study was to gain a better understanding of the extent and nature of investor activity in acquiring foreclosed properties in Suffolk County in order to determine the impact investors are having on the neighborhoods where foreclosures have been common.  In the end, it can be difficult to predict the long-term impacts of investor activity.  On the one hand, investors have channeled a significant amount of capital into distressed neighborhoods, which may have helped absorb the high volume of foreclosed properties and stabilized conditions in those communities.  Our research team found that predatory flipping and irresponsible rental property management in Boston was rare.

On the other hand, there is concern that investors who acquire foreclosed properties may not maintain them to the same degree as owner-occupants.  In interviews, investors reported that due to factors such as the high market values of the primarily multifamily housing stock in Boston and the increased competition to attract tenants with Housing Choice Vouchers, they routinely undertook a fair amount of investment in properties they acquired. In fact, the median time to resale among properties resold by investors is about six months, which suggests that investors are likely to make some improvements to the properties before they are resold.  However, in the view of many nonprofit advocates, these market-driven property improvements are not enough to ensure the long-term affordability and sustainability of these units. The discrepancy in these points of view reflects the motivation of many investors to undertake improvements up to the point that a decent return on these investments is likely, while community groups have broader goals of providing high-quality affordable housing and developing properties that have a positive impact on the surrounding community. Other advocates worry about investor decisions to increase rents that may displace low-income individuals and families who are no longer able to afford these units, and whether investors are crowding out potential owner-occupants looking to buy in these neighborhoods.

Nonprofits partnering with city officials and investors have been working to alleviate these concerns.  One nonprofit organization’s partnership with the City of Chelsea to track code violations in investor-owned properties has led to improved accountability and code compliance among investor owners.  Other groups have recognized the value of leveraging investors’ support networks and informational advantages, with some partnering successfully with local investors on the acquisition and rehabilitation of foreclosed properties. One example is the Coalition to Occupy Homes in Foreclosure (COHIF), a group of nonprofits working with the City of Boston, the state of Massachusetts, and others that are looking to acquire 30 foreclosed or at-risk homes over two years.

The Boston case study—along with other studies conducted by research teams in Atlanta, Cleveland, and Las Vegas—made an initial attempt to fill in the gaps of knowledge regarding investor activity in these central urban neighborhoods.  The vast majority of investors across the four case study areas operated on a rather small scale, with a sizeable share of foreclosed properties acquired by “mom and pop” investors who purchased one or two properties. For the most part, even “large” investors in these communities were defined as those buying 10 properties, over a 4 to 6 year period, with few purchasing more than 100 properties. While these studies have shed some light on the extent and nature of investor activity, there is a need for more systematic research that can address the concern of whether investors are worse stewards of foreclosed properties than owner-occupants, as well as better determine their long-term impact on the health and stability of distressed neighborhoods.

Watch the Inventory – and the Investors

by Eric Belsky
Managing Director

As housing demand has been coming up, the inventory of homes for sale on the market has been going down.  This tightening of supply relative to demand is the bedrock of the recovery. It gives consumers confidence and a sense of urgency to buy.

Those interested in the course of home prices should watch inventory levels, especially relative to demand.  Multiple listing services (MLS) provide measures of inventories at the metropolitan level and typically even for submarkets within them.  If you start to see inventories in a market climb, the recovery in prices—and demand which is partly linked to the urgency created by rising prices—may not stay on course.

In assessing housing market recovery, then, an important question is what is in store for inventories of homes for sale.  Will demand at some point be outstripped by inventory growth as new home building ramps up again and more existing owners place their homes on the market because of rising prices?

The answer to this question of course will hinge on conditions in individual housing markets.  Broadly speaking, the dynamics will likely differ depending on the share of homeowners in a market who are underwater and the activity of investors in single-family rental properties.

In places where only a small fraction of homeowners are underwater, rebounding homes prices may be enough to spark owner interest in selling their existing homes to trade up or down.  With interest rates so low and the potential to move unfettered by negative net equity, many may start to feel that now is the time to sell.

In places where many owners are deeply underwater, however, even a strong single-digit increase in home prices may not be enough to induce many owners to place their homes on the market.  After all, they would still have to write a check at the closing table if they did. Therefore, one would expect inventories to fall more in places with negative net equity as demand picks up because homeowner interest in selling does not follow suit.

In fact this is precisely what seems to be occurring. Inventories have fallen more sharply and asking prices risen more in areas with more underwater homeowners (click figure to enlarge). 

JCHS tabulations of data from CoreLogic and www.deptofnumbers.com

However, the buyers of these homes are not necessarily individuals looking to move. In many of these places much of the demand has come from investors who snapped up homes at low prices and then rented them out. Figure 2 lists places where there has been a significant shift in the share of single-family homes that are rented. These are the markets where investors have been most active, helping to soak up the excess supply of distressed homes.

Source: JCHS tabulations of US Census Bureau, American Community Survey data.

Moving forward, it is therefore not just what homeowners in these places do that matters but also what investors will do with recently acquired single-family properties they are currently renting out. Many will look for a chance to exit their investments when prices appreciate enough to make it worthwhile.

For investors in distressed markets, the run-up in prices from the trough is pure upside. Many may head for the door at about the same time, especially if they discover that it is both more arduous and costly to manage scattered-site, single-family rentals than they had anticipated.

If enough investors in any of these markets start to head for the door to try to gain from capital appreciation, home price appreciation could slow.  So to predict where prices may be headed, keep your eyes on investors and what they are doing.  Local realtors will see the first signs of activity in homes now rented shifting back to the for-sale market.  Seek them out and find out what they are seeing.