I. INTRODUCTION
The Federal Reserve Board (FRB) released a policy statement reiterating that statutes and Federal Reserve regulations permit rental of residential properties acquired in foreclosure as part of an orderly disposition strategy. The statement also outlines supervisory expectations for residential rental activities.
The general policy of the FRB is that banking organizations should make good faith efforts to dispose of foreclosed properties (also known as “other real estate owned” or “OREO”), including single-family homes, at the earliest practicable date. In this context, and in light of the extraordinary market conditions that currently prevail, the policy statement explains that banking organizations may rent residential OREO properties within legal holding-period limits without demonstrating continuous active marketing of the property for sale, provided that suitable policies and procedures are followed.
Moreover, to the extent that OREO rental properties meet the definition of community development under the Community Reinvestment Act (CRA) regulations, the banking organizations would receive favorable CRA consideration. In all respects, banking organizations that rent OREO properties are expected to comply with all applicable federal, state, and local statutes and regulations. The policy statement, in providing guidance to banking organizations and examiners, also describes specific supervisory expectations for banking organizations with a larger number of rental OREO properties, generally more than 50 properties available for rent or rented.
The policy statement applies to banking organizations for which the Federal Reserve is the primary federal supervisor, including state member banks, bank holding companies, non-bank subsidiaries of bank holding companies, savings and loan holding companies, non-thrift subsidiaries of savings and loan holding companies, and U.S. branches and agencies of foreign banking organizations.
II. RISK MANAGEMENT CONSIDERATIONS FOR RESIDENTIAL OREO PROPERTY RENTALS
In all circumstances, the FRB expects a banking organization considering such rentals to evaluate the overall costs, benefits, and risks of renting. The banking organization’s decision to rent OREO might depend significantly on the condition of individual properties, local market conditions for rental and owner-occupied housing, and its capacity to engage in rental activity in a safe and sound manner and consistent with applicable laws and regulations.
Banking organizations should have an operational framework for their residential OREO rental activities that is appropriate to the extent to which they rent OREO properties. In general, banking organizations with relatively small holdings of residential OREO properties – fewer than 50 individual properties rented or available for rent – should use a framework that appropriately records the organizations’ rental decisions and transactions as they take place, preserves key documents, and is otherwise sufficient to safeguard and manage the individual OREO assets. In contrast, banking organizations with large inventories of residential OREO properties – 50 or more individual properties available for rent or rented – should utilize a framework that systematically documents how they meet the supervisory expectations described in the next section. All banking organizations that rent OREO properties, irrespective of the size of their holdings, should adhere to the Guidance set forth in this section.
A. Compliance with maximum OREO holding-period requirements
Banking organizations should pursue a clear and credible approach for ultimate sale of the rental OREO property within the applicable holding-period limitations. Exit strategies in some cases may include special transaction features to facilitate the sale of OREO, potentially including prudent use of seller-assisted financing or rent-to-own arrangements with tenants.
B. Compliance with landlord-tenant and other associated requirements
Banking organizations’ residential property rental activities are expected to comply with all applicable federal, state, and local laws and regulations, including: landlord-tenant laws; landlord licensing or registration requirements; property maintenance standards; eviction protections (such as under the Protecting Tenants at Foreclosure Act); protections under the Servicemembers Civil Relief Act; and anti-discrimination laws, including the applicable provisions of the Fair Housing Act and the Americans with Disabilities Act. Prior to undertaking the rental of OREO properties, banking organizations should determine whether such activities are legally permissible under applicable laws, including state laws. When applicable, banking organizations should review homeowner and condominium association bylaws and local zoning laws for prohibitions on renting a property. Banking organizations may use third-party vendors to manage properties but should provide necessary oversight to ensure that property managers fully understand and comply with these federal, state, and local requirements.
C. Other considerations
Banking organizations should account for OREO assets in accordance with generally accepted accounting principles and applicable regulatory reporting instructions. Banking organizations should also provide the appropriate classification treatment for their residential OREO holdings. Residential OREO is typically treated as a substandard asset, as defined by the interagency classification guidelines. However, residential properties with leases in place and demonstrated cash flow from rental operations sufficient to generate a reasonable rate of return(Whether a rate of return is reasonable depends on a number of considerations including local market conditions, the time horizon of the rental, and the nature of the property. Commonly used measures include a capitalization rate [known as a “cap rate,” which generally is the expected annual cash flows from renting the property relative to the price at which the property holder could expect to sell it in the owner-occupied market], as discussed in the housing white paper, or other measures of internal rate of return. Depending on the circumstances and risks associated with the property, valid indications that a level of return is reasonable could include [but would not be not limited to] comparisons with normal returns for single-family rentals in the relevant local market; rates of return on other similar local real estate investments; or cap rates or other measures of internal rate of return on investments with similar risk profiles. For example, in many markets a cap rate above 8 percent would likely represent a reasonable rate of return. Large one-time expenditures that are idiosyncratic to a given year but are normal to residential properties over their lifetime, such as replacement cost for worn-out appliances, should generally not be the reason that a property would be classified. Costs of improvement should be treated as capital expenditures with a corresponding effect on properties’ carrying value to the extent the improvements improve the properties’ values) should generally not be classified.
III. SPECIFIC EXPECTATIONS FOR LARGE-SCALE RESIDENTIAL OREO RENTALS
Banking organizations with large inventories of residential OREO properties that decide to engage in rental activities should have in place a documented rental strategy, including formal policies and procedures for OREO rental activities, and a documented operational framework. Policies and procedures should clearly describe how the banking organization will comply with all applicable laws and regulations. Policies and procedures should include processes for determining whether the properties meet local building code requirements and are otherwise habitable, and whether improvements to the properties are needed in order to market them for rent. In addition, policies and procedures should establish operational standards for the banking organization’s rental activities, including that adequate insurance policies are in place, that property and other tax obligations are met on a timely basis, and that expenditures on improvements are appropriate to the value of the property and to prevailing norms in the local market.
Policies and procedures should also require plans for rental of residential OREO properties, down to the individual property level, that cover the full holding period from the time the bank received title to ultimate sale by the bank. Plans should identify which properties would be eligible for rental. Plans also should establish criteria by which properties are chosen for marketing as rental properties, and the process by which rental decisions should be made and implemented. Plans should describe the general conditions under which the organization believes a rental approach is likely to be successful, including appropriate consideration of rental market and economic conditions in respective local markets.
Finally, policies and procedures should address all risk management issues that arise in renting residential OREO properties. Some risk elements parallel those found in other banking activities, for example, the credit risk associated with tenants’ potential failure to make timely rent payments, or potential conflict of interest issues such as the use of a firm by a banking organization to both provide information on a property’s value and list that property for sale on behalf of the banking organization. Other risks unique to such rental include:
Banking organizations may need to develop new policies and risk management processes to address properly these categories of risk.
In many cases, banking organizations will use third-party vendors (for example, real estate agents or professional property managers) to manage their OREO properties. Policies and procedures should provide that such individuals or organizations have appropriate expertise in property management, be in sound financial condition, and have a good track record in managing similar properties. Policies and procedures should also call for contracts with such vendors to carry appropriate terms and provide, among other key elements, for adequate management information systems and reporting to the banking organization, including rent rolls (along with actual lease agreements), maintenance logs, and security deposits and charges to these deposits. Banking organizations should provide for adequate oversight of vendors.