Cerberus Financing Landlords Wall Street Can’t Reach

Cerberus Capital Management LP is entering the booming market for single-family homes to rent, planning to lend billions of dollars to investors too big for government programs and too small to get Wall Street funding.

The investment firm, which oversees more than $20 billion, started First Key Lending this year, charting a separate path from rivals such as Blackstone Group LP and Colony Capital LLC that are competing to buy thousands of foreclosed properties a month in cities across the U.S.

“We want to build this up into a big business,” Eric Atlas, senior vice president of First Key, said at a forum on single-family rental homes in Miami last month. Cerberus is putting “billions of dollars into this space,” he said.

The New York-based firm is seeking to fill a void left by regional lenders that prior to the housing crash were the primary source of loans for landlords buying properties. At least 475 banks have failed since the real-estate collapse, according to the Federal Deposit Insurance Corp., while larger banks have tightened mortgage underwriting standards and are focusing on the biggest investors.

“There’s a real vacuum and Cerberus sees that and they are filling it,” said Jack BeVier, partner at Baltimore-based Dominion Group, which buys and renovates homes. “That niche used to be filled by commercial banks, the local savings and loans or the small regional banks, which would do blanket mortgages across many rental properties, but those players are largely out of the market right now.”

Soaring Demand

Demand for properties is rising as investors seek to take advantage of home prices that are still 29 percent below the 2006 peak and to meet the unprecedented need for rentals from millions of homeowners who went through foreclosure and can’t get mortgages.

The biggest rental buyers have been able to access either public markets or bank-arranged credit lines to finance purchases. Blackstone, which has invested more than $4 billion to buy 24,000 homes, got a $2.1 billion loan led by Deutsche Bank AG. Colony’s single-family rental division, which owns more than 9,500 properties, is negotiating a loan for additional capital, the company said in a regulatory filing this month in which it announced plans to issue public shares.

American Residential Properties Inc. raised $287.7 million in an initial public offering yesterday led by Morgan Stanley, with proceeds used to buy, restore, lease and manage homes. The shares, which sold at $21, fell 2.4 percent to $20.50 at 10:08 a.m. in New York trading.

Even as private-equity firms dominate some foreclosure auctions and complete the biggest bulk purchases, the combined pool of institutional ownership is less than 1 percent of the $2.8 trillion rental-home market, according to Goldman Sachs Group Inc. estimates.

Fannie Limits

Cerberus is seeking to lend to the majority of investors -- those who can’t access that type of institutional funding -- and have also outgrown government-backed mortgage guarantors. Fannie Mae limits landlords to loans on a maximum of 10 properties, and Freddie Mac will lend on four.

The firm started First Key in January. It will focus on financing investors in $5 million to $100 million increments, according to Atlas, a former Cerberus bond trader who’s leading the company with Charles Macintosh, previously a banker at Lehman Brothers Holdings Inc., and Merrill Lynch & Co. The loans will typically have a 24-year term with a 6 percent to 7 percent interest rate and be secured by the real estate.

Tim Price, a spokesman for Cerberus, declined to comment on First Key.

Revolutionizing Market

Yanir Ram, chief financial officer of DRI Holdings LLC, said this will revolutionize the market for borrowers like him.

He expects to close on a First Key loan tied to 215 homes in southern California after using short-term debt with interest rates as high as 14 percent to expand his rental business. He’s also used credit lines designed for buyers who flip houses, then refinanced with regional banks.

That’s become more difficult because most local lenders limit the loan size based on the purchase price, said Ram. In California, the median home price jumped to $313,000 in March, up 25 percent from a year earlier, according to DataQuick.

“They are punishing me for buying well two or three years ago,” he said. First Key is “less concerned with the loan-to-value ratio because the cash flow is so rich,” Ram said. “What they are really doing is underwriting the company, the cash flows, the net operating income and the soundness of the business, which is just a whole new approach.”

U.S. home prices climbed 10.5 percent in March from a year earlier, the fastest pace in seven years, according to CoreLogic Inc. Increases have been even greater in the most popular areas for large-scale landlords -- with 18.8 percent gains in Phoenix and a 14.2 percent surge in Atlanta.

Natural Borrowers

“There’s a natural market that’s already been created for them to lend into,” said Oliver Chang, a former Morgan Stanley analyst who left the firm last year to co-found Sylvan Road Capital LLC, an Atlanta-based single-family home rental investment fund. “So they enter later and they can do more volume quickly, but that usually comes with lower returns, because they’re higher up in the capital structure.”

Lenders such as First Key are reliant on the ability of borrowers to collect rent from the residents of their properties, so the underwriting of the operator should be just as important as the underwriting of the assets, Chang said.

Cerberus, founded by former Drexel Burnham Lambert trader Stephen Feinberg in 1992 and named after the three-headed dog from Roman mythology that guards the gates of Hell, has a long track record of finding value in out-of-favor industries, as well as some high-profile failures.

Cerberus Investments

The firm started off buying distressed bonds, including investing in Japanese loans for as little as five cents on the dollar in the late 1990s. It later evolved into one of the world’s largest private-equity firms, taking control of companies.

Its most prominent lending venture was the 2006 purchase of 51 percent of GMAC, the finance arm of General Motors Corp. GMAC, now called Ally Financial Inc. almost collapsed in 2008 under the weight of bad subprime mortgages during the financial crisis. In 2007, Cerberus led the buyout of Chrysler Corp., an 82-year-old American auto icon that was later forced into a government rescue during the financial crisis.

Since then, Cerberus has had success buying distressed mortgage bonds that had sunk in value after the housing crash. It started a fund in August 2011 that posted double-digit returns last year. It’s also raised $1.3 billion for a fund to lend to mid-sized companies, after the wave of bank failures starting in 2007, restricted credit.

Securities Possible

First Key is structuring the rental home debt with separate loans on each property, Atlas said at the Miami forum. That could make it possible to sell bonds tied to the mortgages and increase potential returns, a market that Wall Street is trying to create.

“With a virtually government-only mortgage finance market, there are very few options for debt investors to invest in the housing recovery,” said Carl Bell, senior portfolio manager at Smith Breeden Associates. “For tax, regulatory, and operational reasons, financing versus owning within the single-family rental home market is the better fit for many institutional investors.”

Cerberus and other lenders may miss out on the profits buyers make on rising property values from future sales. Yet demand for rentals continues to grow, with the homeownership rate last month falling to the lowest in almost 18 years. As home prices have risen, rental yields have also compressed to 5 percent in the most popular cities for investors, according to Goldman Sachs. Unless home prices continue to rise, the better investment may be funding landlords.

“There’s always going to be tens of thousands of local entrepreneurs across the country that want to buy houses to rent,” said Rick Morgan, chief executive officer of CFAM ResCap, a Dallas-based lender which has been underwriting rental home loans for small investors for two years. “We think there’s room in this industry for half a dozen companies like ours.”