Lone Star Funds is turning to residential rentals as it grapples with the dregs of more than USD 30bn in delinquent loans purchased over the past several years, according to two sources familiar with the matter and an investor.
The USD 70bn private equity firm is embarking on an aggressive strategy to fix and rent out thousands of REO properties that it could not sell at expected profits, the sources said. To accomplish that, it is shifting control of all REOs from its servicer, Caliber Home Loans, to Residential Capital Management, a single-family property advisory firm specializing in renovations and rental management.
Atlanta-based RCM could eventually manage more than 21,000 of Lone Star’s residential properties, representing nearly half of all REO and non-performing loans in Lone Star’s Fund VIII and Fund IX, the two sources familiar said. At least 5,000 properties were transferred to RCM in 2Q17 and 3Q17, they said.
Lone Star pressed for the change as returns from REOs lagged, the sources familiar said. Lower-than-expected REO values are shedding light on the “tail risk” faced by Lone Star as it works through and sells the best assets, leaving behind difficult loan workouts and houses in less desirable areas, they said. Some early buyers of NPLs were also dogged by tail risk.
REO sales from Lone Star Funds VIII, IX and X have been at prices 23% lower than broker price opinions, much lower than the 13% discount cushion that Lone Star built into base case analyses, the sources familiar said. Much of the shortfall is due to the sale of lower-value homes, some of whose prices have been more than 30% below BPOs, which are notoriously imprecise, one source familiar said.
“You get a lot of early wins and the bad stories come up five, six years later,” said one residential loan investor, of NPL investing.
Lone Star’s new REO strategy is reflecting the difficulties typically expected from big pools of NPLs, which can often be a mish-mash of gems and junk. Lone Star sometimes bid large pools so aggressively that it drew jeers from competitors who doubted the profitability of the trades.
In 2014, Lone Star surprised the market by purchasing all 16 pools in a USD 3.9bn US Department of Housing and Urban Development auction at an average BPO of 77.6%, up from previous sale averages below 70%, according to two investors and HUD data. The purchase was by Lone Star Fund IX, the first source familiar said.
“That trade was a disaster,” said one of the investors.
Disclosures for Lone Star’s VOLT NPL securitizations have suggested the firm was growing heavy with REO. In most cases, it makes sense to sell immediately, even taking a loss, because the carrying cost of real estate is high, a third investor said.
Among them, REOs in a May issue — VOLT 2017-NPL6 — were 3–628 days old, compared with the 3–412 day range for foreclosed properties in a deal two years earlier, VOLT 2015-NPL8, according to third and fourth sources familiar. In May’s deal, Lone Star disclosed that renting REOs could extend bond WALs but that it had “only recently initiated a pilot program for the evaluation of REO properties for inclusion in a rental program and has little historical experience with respect to renting residential REO,” the fourth source familiar said.
Doubling down on HPA
Lone Star expects that renovations and rentals by RCM will help lift IRRs significantly — perhaps even more than thought when the NPLs were purchased — though that could take several years, the first source familiar said. Lone Star is also betting that its REOs will get bailed out by home price appreciation, even though HPA has been sluggish in areas where properties are concentrated, the second source familiar said. Prices in those areas are still 10% below peak levels and should catch up to national averages, the second source said, citing company thinking.
“It’s weird, at this point in the cycle, for Lone Star to suddenly stop selling REO,” said one NPL investor who has turned REOs to rentals. Because gains from rentals are generally from HPA, not rental yield, it’s more likely that Lone Star’s move is directed at mitigating losses versus it taking a bullish view on SFRs, he said.
Lone Star may have trouble meeting its goals, the loan investor said. Most economists expect home price appreciation to slow in 2018 and 2019 after more than five years of steady growth, he said. What’s more, US housing is likely to face additional headwinds if President Trump signs tax reform as drafted, he said.
Lone Star founder and billionaire John Grayken, who according to The New York Times renounced his US citizenship in 1999 to get more favorable tax treatment in Ireland, was not made available for comment. Grayken is known for his prowess with buying and managing distressed loans, starting with the fallout from the US savings & loan crisis of the 1980s and early 1990s.
At least one executive has left Lone Star this year. Sam Loughlin, president of the North American division, stepped down in July, the Times reported. At the time, Lone Star’s president told employees it was a pivotal time to realize the value of the North American portfolio, the Times reported.
Caliber pushed for sales
Lone Star is transferring REOs because Caliber Home Loans typically worked to quickly liquidate the assets instead of considering longer-term plays that could produce better returns, the second source familiar said. Caliber eventually began an REO renovation program in 2016, and results were positive, the source said. But Lone Star and Hudson Advisors, its asset manager, are still moving properties to RCM, which has renovation and rental expertise, the source said.
“For nearly two years, Lone Star has been investing capital to repair and improve foreclosed REO properties,” a Lone Star spokesperson said. “We will continue to do so so long as this strategy continues to prove effective in helping us achieve our goal of maximizing returns for the benefit of our investors.”
The new REO advisor, RCM, has expanded and is currently looking to hire an additional 224 employees including construction managers across the country, according to RCM’s website. Lone Star or Hudson Advisors might even consider buying a stake in RCM, the second source familiar said.
RCM co-founder Andy Capps did not return a call or email.
Lone Star is expecting to provide RCM with a renovation budget of USD 1.2bn, paid for in part through sales of re-performing loans, where demand and prices have soared, one source familiar said. The firm has sold about USD 3bn in RPLs this year at an average 94% of UPB, the source said.