The Great American Fire Sale

Investors have played, and will continue to play, an important role in foreclosure-ravaged communities. What can towns do to ensure investors are responsible, and what role can CDCs play?

The investors have landed. Since the end of the housing bubble, house prices have plummeted. Thousands of foreclosures are taking place every day, millions of homeowners are under water, and the supply of homes for sale continues to grow. Real estate, like nature, abhors a vacuum, and with demand from homebuyers still weak across the board, the vacuum has been filled by investors.

From Las Vegas to Detroit, from Phoenix to New Haven, thousands of real estate investors are taking advantage of the fire sale, picking up distressed real estate, buying REO (real-estate-owned or lender-owned) properties, bidding at foreclosure sales, or packaging short sales for homeowners facing foreclosure. In some areas, particularly in the Sun Belt, investors may make up as many as half of all the buyers in the market.

City officials and CDCs have watched the wave of investor purchases sweep over their communities with dismay. CDCs trying to buy REO properties to fix up and resell under the federal Neighborhood Stabilization Program (NSP) have seen the properties they want picked up instead by faster-moving investors. Neighbors have watched as one-time owner-occupied houses on their blocks become rental properties or just abandoned.

Two years ago, few cities or CDCs were much concerned about investors. Today, they have become one of the most urgent issues facing those who care about urban neighborhoods, yet many still do not fully understand what investors want and how their presence affects neighborhoods. Most understand even less how local governments, CDCs, and citizens can encourage responsible investor behavior, making them a positive rather than a negative force in their communities.

What Do Investors Want?

Investors want to make money. That is neither good nor bad in and of itself, but how they make money will determine whether they have a positive or negative impact on a community. That, in turn, depends far less on the investor’s personality than on the dynamics of the local housing market. Some markets will reward responsible investor activity, while others, unfortunately, reward more predatory behavior. How investors behave is influenced by the market, but is not foreordained; their behavior can be influenced by public sector regulation and incentives.

Although it is an oversimplification, distressed property investors can be divided into four broad categories. Rehabbers and holders gravitate toward areas where market prices for distressed properties, while low enough to enable the investment to be profitable, are still high enough to discourage scavengers. For a serious rehabber to make a profit, the market price of an adequately fixed-up house in the area must be greater than the sum of the property’s acquisition and rehab costs. This is true in some markets but not in others. In many parts of Detroit, for example, a house that may cost $10,000 to buy and might need another $40,000 in rehab may not appraise higher than $30,000 after rehab. A responsible rehabber would soon go broke working without public subsidies in that market.

The same is true of holders. For an investor to maintain a property on a long-term basis while realizing a decent but unspectacular cash flow, there must be a realistic expectation that the property will at a minimum maintain its value, and be likely to start appreciating in the next few years. The property must also fall within a narrow price range — it must be inexpensive enough so that the investor will see a positive cash flow at market rent, but expensive enough so that the purchase price cannot be quickly amortized through cash flow alone. This is often true in an area like Phoenix, where investors are buying single-family houses for $60,000 or higher, and renting them out at $800 to $900 per month. Since many people believe the Phoenix market is close to bottoming out, they expect their houses will gain value over the next five years.

Detroit is very different. There, from a pure investment standpoint, it’s hard to justify a long-term holding strategy. Properties can be bought for less than $10,000, have little upside potential, but can be rented — even in poor condition — for $600 to $700 per month. Such properties attract flippers, who prey on the ignorance of others, including out-of-town investors who think that spending $25,000 on a house worth $10,000 is a good deal.

Those properties also attract milkers, who spend little on maintenance, ignore property tax bills, recoup their investment quickly through rents, and walk away from the property after a year or two with a tidy profit. While an investor who keeps properties in good shape and pays property taxes on time might be able to make money, the rents in Detroit are still high relative to the cost of buying distressed properties. Investors who milk their properties can make much more money, with far less hassle and effort. The economic environment motivates them to behave irresponsibly.

Investors Woven Into the Community Fabric

Investors are a major part of the picture in most neighborhoods affected by foreclosures and their property investments dwarf the amount being spent by cities and CDCs. Investors spent over $2 billion buying single-family houses and condos in the Phoenix area in 2009 alone — more than the entire amount appropriated for NSP2 nationally. While some prospective homebuyers are being outbid by investors, in most cases investors are buying houses that are likely to otherwise be abandoned. Without investors, Phoenix or Las Vegas might have a few more homeowners, but mainly they would have far more empty houses.

Investor purchases don’t always reduce abandonment. Some just put off the day when the property is likely to be abandoned. Many property flips result abandonment, while when a milker has got what he needs from a property a year or two down the road, he is likely to walk away from it.

Responsible small-scale investors, who are often local real estate agents, contractors, or just people with a small nest egg they are trying to put to work, tend to be selective, choosing properties with care, and buying single properties or at most a handful of separate properties at a time. What they buy they use. Large-scale investors, however, who buy properties in bulk in distressed markets, acquire a mixed bag of properties, often sight unseen. They then often cherry-pick the most appealing ones and walk away from the others. As one investment company advises its investors, “It’s best to purchase REO properties in bulk. The potential profits on the sellable properties should easily cover investor losses on the worthless ones.” These investors leave neighborhoods the worse for their efforts.

What Can Towns Do?

So, what is to be done? The fire sale is still under way and the wave of foreclosures and REO properties is unlikely to end any time soon. Under any circumstances, cities and CDCs will capture only a small fraction of the inventory; with home buying still anemic, most of the rest will go to investors. It is irresponsible for governments and community leaders to ignore them and hope things will work out. The future of our neighborhoods depends on local officials and others coming up with effective ways of motivating those investors who are willing to be responsible landlords, while discouraging others from setting up shop in their communities.

Local governments have strong powers to keep track of property owners and compel them to maintain their properties. While financially strapped cities and towns may find it difficult to stay on top of rapidly changing properties and owners, they can enlist CDCs, neighborhood organizations, and citizens to help them, making them the city’s eyes and ears on the ground. Failure to exercise their powers, including enforcement of housing codes and timely collection of property taxes, makes local governments de facto enablers of abusive investor behavior.

One of the first things a city can do is set up a landlord licensing program, which requires owners of rental properties to get a license. This license is only available if a landlord is current on property taxes and her property meets minimum health and safety standards. To cover the costs when a formerly owner-occupied property is bought by an investor, some cities in Minnesota charge a one-time rental conversion fee ($1,000 in Minneapolis, $500 in Brooklyn Center). This covers the cost of registering the property and conducting the initial inspection, and supports the city’s landlord education efforts.

Cities often lack the resources to track all the properties being bought by investors, and local officials readily admit that most of the rental properties in their communities are not licensed. While Minneapolis employs a “unlicensed rental property finder” to track unlicensed properties down, CDCs and citizens can play a major role in making sure such programs are effective. Cities can set up web-based systems to make it easy for citizens to report unlicensed properties, while Atlanta has created a program of “neighborhood deputies” to report violations to the city and follow up on whether they are corrected by the owners.

Some cities have gone after the “bad apples,” or the minority of investors and landlords who are typically responsible for most of the problems. Landlords who accumulate code and nuisance violations in Brooklyn Center get inspected more often and have to go through an extensive crime prevention program, including taking an eight-hour training course, using a model lease, and completing a security assessment of their properties, to be eligible to renew their rental license. In Raleigh, North Carolina, landlords who have violated property or nuisance ordinances must obtain a two-year Probationary Rental Occupancy Permit (PROP) from the city. Landlords in the PROP program must pay $500 per year for the two-year permit to cover the cost of administering the program, and must attend a city-approved residential property management course.

The state of Utah has come up with a way of combining the stick and the carrot in a two-part state law. The first part allows cities to impose a “disproportionate impact fee” on rental properties based on a study that determines how much they impose greater service burdens on the city. In West Jordan, a fast-growing suburb of Salt Lake City, for example, the fee runs from $60 to $200 per unit per year over and above the $75 annual license fee, depending on the type of building. The second part of the Utah law is that if a city enacts a disproportionate impact fee, it must also enact a “good landlord program,” and offer landlords a substantial discount from the fee if they complete an approved landlord training program, implement a series of crime reduction measures, agree to certain tenant selection procedures, and have no outstanding code violations. West Jordan rebates all but $7 per unit of the disproportionate impact fee to landlords who participate in the program.

But solid regulations and effective enforcement are only a starting point. Enforcement may be able to drive out some bad actors, but if the community wants to foster more good actors — that is, responsible landlords who maintain their properties well and select their tenants carefully — they should think about incentives. The Utah program is one example, but a program widely used in the United Kingdom, known as a Landlord Accreditation Scheme, is worth emulating in the United States.

While its use is actively promoted by the national government, it is locally controlled, and each city can design its own program. Under the program in Oldham, a small city near Manchester, the landlord must adhere to a code of standards that includes both property and management standards. Those landlords who participate in the scheme receive a variety of benefits, including:

  • Free loft and cavity wall insulation;
  • Free energy efficiency check and report;
  • Free gas safety certificate (during the first year of membership);
  • Free carbon monoxide alarms and smoke detectors;
  • Free security lights and secure door and window locks;
  • Free electrical safety check;
  • Free property advertising; and
  • Discount on building and contents insurance.

Other British local governments offer a variety of other benefits. Reading, west of London, has arranged for accredited landlords to receive a significant discount from a variety of local businesses, including builders, bed suppliers, and hardware shops. In Rochdale, the city guarantees tenants’ security deposit to participating landlords for otherwise-qualified tenants who don’t have the money. Even more important than the specific benefits, perhaps, participating landlords benefit by having a one-stop point of contact with city government and regular meetings between them and city officials; as such, these incentives can be worth a lot to a landlord. In return, the city can reasonably demand a high standard of landlord behavior, including maintaining the property in sound condition, selecting tenants responsibly, cooperating with anti-crime and drug activities, resolving disputes and making repairs speedily, and paying taxes and other obligations in timely fashion.

The NSP Factor

Some neighborhood stabilization programs are also working with investors. Milwaukee has established the NSP Rental Rehabilitation Program to make forgivable second mortgage loans up to $17,500 to responsible landlords to rehab properties for affordable rental housing. Elsewhere, CDCs and others are exploring such ideas as capital pools for investors in NSP target areas and partnerships between private investors and neighborhood-based nonprofits, where the nonprofit can provide property management services or help select responsible tenants or qualified buyers as part of the investor’s exit strategy.

In the end, investors are an important, and most probably permanent, part of the neighborhood landscape. The houses they buy and rent out will continue to make up a major part of the rental housing stock in our towns and cities. After all, absentee owners have always owned a large part of the one- and two-family houses in American towns and cities; the biggest differences between the past and the present is the volume of investor purchases and the speed with which neighborhoods are changing. The trick is to find the right mixture of carrots and sticks to motivate responsible investor behavior and turn their presence into a community asset. Any community that is serious about trying to deal with problem properties and revitalizing their struggling neighborhoods should make this a major part of their strategy.

Alan Mallach
Alan Mallach, senior fellow at the Center for Community Progress and the National Housing Institute, is the author of many works on housing and planning, including Bringing Buildings Back, A Decent Home, and Inclusionary Housing in International Perspective. He served as director of housing and economic development for Trenton, New Jersey, from 1990 to 1999, and teaches in the City and Regional Planning program at Pratt Institute.

2 COMMENTS

  1. Let’s think some more about the $10,000 home in Detroit that needs $40,000 of rehab but then would be worth only $30,000 post-rehab. The property’s economic value (to what the article calls a “responsible” owner) is not $10,000 but, instead, is negative $20,000 (if you buy the property, fix it up, and sell it, you lose $20,000). In this situation, no long-term investment strategy makes sense.

    Accordingly, anyone who happens to own that home and who is economically rational has only two choices, both short-term:

    #1: Sell the property for $10,000 (or less). Note, however, that the property has no value to anyone who might want to convert it into standard housing; its only value is to someone who is willing to follow strategy #2 (the “milker”). So if you offer the property for sale, the only buyers are the “milkers.”
    #2: Rent the property for $600 to $700 a month, while spending as little as possible on maintenance, taxes, or utilities. Don’t buy insurance. Whenever the maintenance/taxes/utilities costs become too high, fall back on strategy #1. This is what the article calls the “milker” strategy.

    That is, if you own such a home, there are only two things you can do that make economic sense. You can become a milker, or you can sell to a milker. And, if the milker complies with local landlord-tenant law and with local codes, I personally would label that a “responsible” strategy.

    Consider a local government faced with a significant number of low-end homes (whether owner-occupied or renter-occupied or vacant) that are delinquent on their real estate taxes and whose post-rehab value would be less than the cost of the rehab. Only these strategies would stabilize neighborhoods and remove blight:

    -Aggressively condemn and demolish the homes, probably incurring a cost to the local government of, say, $20,000 per home.
    -Aggressively condemn the homes and subsidize their rehab and resale (whether for owner occupancy or renter occupancy), probably incurring a cost to the local government of, say, $30,000 or $40,000 per home.

    It seems to me that the sorts of lower-cost strategies discussed in the article would work in healthier markets, but not in places like Detroit.

    -March 29, 2011

  2. As far as the issue of “milkers” is concerned, I largely agree with you. Arguably the principal, if not the only, goal of regulatory strategies when dealing with milkers in very low-value markets is to accelerate their removal from the market. In that respect, I would disagree with one of your points; namely, the distinction between “responsible” and “not responsible” milkers. Almost by definition, there is no such thing as a responsible milker. While some milkers may comply with codes when it is relatively inexpensive to do so, the milker business model assumes that little or none of the cash flow is reinvested in the property, and that the ultimate outcome in most cases will be abandonment.

    The article, however, was not principally addressed at the milkers who infest places like Detroit, where ultimately demolition of most of these properties is likely to be the most appropriate outcome, a point I made in the more extensive report, Meeting the Challenge of Distressed Property Investors in America’s Neighborhoods, from which the article was drawn.

    In Detroit or Youngstown, there is no credible alternative to demolition of a substantial part of the housing stock. In most other market areas—including many inner-city areas like Minneapolis or New Haven, as well as Sunbelt areas—the strategies that I propose, which combine strategic regulation and incentives—can have a significant effect on changing investor behavior.

    These strategies may not require massive capital outlays, but they are far from easy (nor did I imply that they were), but they are doable, with the right leadership, organization, and technical capacity, between local government and locally-based nonprofits and CDCs. For better or worse, once NSP funds have been exhausted, neither local, state, or federal government are likely to be able to come up with the money that would be needed to see subsidization of rehab as a viable strategy for more than isolated, scattered cases. As a result, relatively low cost—even if difficult—strategies are likely to become the only alternative to doing nothing.

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