RealEstateEconomyWatch.com

Boasting of spending up to $8 billion dollars to buy tens of thousands of foreclosures to convert into single family rentals, nearly 50 Wall Street investment firms set real estate markets on fire over the past 18 months. Now they are running for cover as soaring prices water down their return on investment.

The winds have already started to shift in the single-family rental business, according to data from RadarLogic. The composite price per square foot paid by institutional investors in 25 of the largest metropolitan area housing markets increased 14.4 percent year over year in March. Over the same period, asking prices for rents have increased just 2.4 percent, according to Trulia, Inc. As a result, yields on single-family rentals are declining.

During the twelve months ending March 2013, purchases of residential real estate by corporations, partnerships and investment trusts in the 25 metropolitan areas included in the RPX Composite increased 41 percent. To put this figure in context, purchases by all other buyers increased only two percent during the same time period. Across the 25 metropolitan areas, institutional investor purchases accounted for 12.2 percent of all property transactions in March 2013, up from 8.8 percent in March 2012, reported RadarLogic.

Conditions for purchasing investment properties have worked in most markets during the intervening weeks. Since March, the median year-over-year list price has risen 2.63 percent according to Realtor.com and much more in some markets where hedge funds have been active like Oakland (up 12.77 percent in April), Las Vegas (up 7.25 in April), Phoenix (up 4.09 percent in April) and Atlanta (up 2.94 percent in April).

A article last week reported two smaller investment funds have curtailed purchases. Och-Ziff pulled out of the business last fall and Carrington Mortgage Holdings has stopped buying. The Bloomberg piece by John Gittelsohn reported that funds are buying property now, including homes sold by Carrington, for rents that yield 6 percent to 8 percent a year, before costs such as insurance, taxes and vacancies, according to Bruce Rose, Carrington”s CEO. Carrington”s model called for mid-single digit net returns on annual rents on an unlevered basis, according to Rose. While returns would vary by market, they would generally be in the mid- to high teens over the duration of the holding period, with the profit from home price appreciation.

However, a spokesman for the largest institutional, Blackstone, said, “We”re continuing to purchase homes where they fit into our business plan.”

In an interview last February, Carrington”s Rich Sharga described what it”s like to compete against the larger funds. “You”re seeing the investors coming in and looking at distressed property pricing in hard hit markets where there appears to be inventory and the opportunity for rental transactions, and then bidding each other up. We got to a point in Phoenix where we said these prices don”t make any sense. It”s mind boggling to hear an institutional investor say that their model is based on buying a property, holding it and then flipping it as prices appreciate and then buying a property for 25 percent over list price. It makes no sense. But that”s not our model so we”ll let everyone else do what they want.”

Now that year over year price increases are hitting double digits, experts see reducing purchases as necessary and prudent for all investors.

“Hedge funds came into all these markets across the US in a big way because they realized return on investment was too high. Sacramento, Riverside you could buy houses with 10 percent return on investment all day long. So they came in and pushed prices up dramatically very quickly because they realized they should back up the truck until return on investment was below seven, in which case they should stop,” said PropertyRadar”s CEO Sean O”Toole said in a recent interview.

“As prices go up, return on investment goes down. This year I expect to see prices go up and return go down. Return on investment and affordability are closely linked. It really comes down to income, affordability and what a person can pay for rent.

Institutional investors are outcompeting normal buyers for homes, said RadarLoic. “They have access to less expensive capital than households and frequently pay for homes entirely in cash rather than using a mortgage, which helps expedite purchases. Moreover, institutional investors typically purchase homes through channels that are not available to other buyers, such as via foreclosure auctions and bulk sales. As such, they acquire homes before realtors and normal buyers get a chance to see them. The rapid increase in institutional investor purchases has contributed to the shortage of homes available for sale to normal buyers.

“Rising prices will reduce the purchasing activity of investors. When prices rise to the point where the economics of the buy-to-rent strategy no longer makes sense, investors will slow their buying and start to sell. The result could be a significant decline in demand accompanied by an increase in supply, which could cause prices to reverse their current upward trend. It should be noted that institutional investor purchases over the last year have been concentrated in seven metropolitan areas: Atlanta, Los Angeles, Las Vegas, Miami, New York, Phoenix and Tampa. One would expect changes in investor behavior to have a particularly severe effect in these markets.”