The Impact of Credit Expansion on Rental Residential Market

The Impact of Credit Expansion on Rental Residential Market

Introduction

Between 2002 and 2007, the US saw an unprecedented housing price bubble as subprime mortgages became more prevalent. Home loan underwriting standards relaxed considerably, fueled by growth in the subprime mortgage industry and securitization. With easy credit, homeowners and buyers leveraged up, in many cases borrowing more than the value of their houses. Lenders competed aggressively to originate loans, which drove mortgage rates and spreads downward. In rental residential markets, this led to a large number of bidders for each property that was placed for sale on the market. Purchase and sale became an auction process, with finalists, chosen from among the many bidders, encouraged to bid again at even -higher prices (Ratcliffe, Stubbs, Shepherd, 2003, 89-97). In this seller's market, investors had to reformulate assumptions about cash - flow expectations, and/or reduce their required rates of return on equity to be able to bid enough to own assets.

Discussion

With a glut of debt and equity capital, capitalization (cap) rates (yields required by investors) dropped to unprecedented levels as low interest rates and less restrictive underwriting impacted rental residential pricing. In 2002, cap rates were hovering at the 8.5% to 9% level, consistent with historical experience. The precipitous drop in cap rates, in some sectors to below 5%, signified a bubble in commercial asset pricing that was nearly as significant as the bubble in the housing markets (Titman, Tompaidis, Tsyplakov, 2005, 49-65). Commercial mortgage lenders were forced to compete to make loans in much the same way as residential lenders were. Underwriting standards fell as originators pushed to make more loans to sell into the secondary mortgage market.

Impact of Credit Expansion on Rental Residential Market

In 2007, defaults on residential mortgages increased as the effects of poor underwriting came home to roost. Fixed - income investors exited credit markets in general as investors lost confidence in the credit quality of highly rated residential mortgage - backed securities and the CDOs that were backed by them. Further, investors reasoned that since the credit rating system was so flawed in mortgage - backed securities markets, ratings for all types of debt instruments were flawed as well. In some sense, the 'toxic' nature of residential mortgage - backed securities was felt to be contagious, affecting other securities backed by similar assets in the same way. Commercial mortgage - backed securities ...