The new mortgage-backed security in a renter’s world

September 18, 2012, 6:39 PM UTC

FORTUNE – At a time when higher returns on Treasury securities and stock dividends are hard to come by, Wall Street has been turning to the market for rental homes. America’s housing market is of course still quite a mess, but large institutional investors have been snapping up foreclosures on the cheap with plans to turn properties into rentals — and then profit when the housing market makes a comeback.

A few of the big players: Colony American Homes, a unit of private-equity firm Colony Capital LLC, which owns about 3,600 homes thus far and hopes to buy more; private equity firm Blackstone Group (BX) announced in July that it would spend more than $300 million to purchase more than 2,000 foreclosed homes for rent; Beazer Homes USA (BZH) announced in May it would lease recently-constructed and previously owned single-family homes under Beazer Pre-Owned Rental Homes.

As The Wall Street Journal reported on Monday, the Oakland, CA-based investment firm Waypoint Real Estate Group LLC has secured a $65 million loan from Citigroup (C) to help buy up foreclosed properties. The deal, as The Journal noted, is the first time the industry has tapped into the debt markets and signals that bankers may be making progress on creating the first security that would be backed by home-rental payments.

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The bonds would work similarly to mortgage-backed securities – only the flow of investor returns wouldn’t come from monthly mortgage payments, but rather income from rents of thousands of tenants living in formerly foreclosed properties. Sale of such bonds could help investors, such as Waypoint, repay their lenders and raise funds to buy up more foreclosed houses, helping the broader housing market absorb the inventory of vacant homes. Everyone wins, right?

The idea seems to make sense, given that there have been more people renting than buying as the economy continues to struggle and mortgages remain difficult to secure. Homeownership has dropped to a 15-year low at 65.4%, while demand for rentals have been rapidly rising. And so have asking prices.

But securitization of lease payments is uncharted territory. As the Journal notes, Fitch Ratings said initial deals, at least, were unlikely to be rated above single-A category – in part because of the lack of long-term data that prove tenants living in previously foreclosed homes pay rent on time.

There are other risks to consider. Unlike mortgage-backed securities, there seems less of a risk of default. However, renters generally sign month-to-month or yearly leases, increasing the risk of the renters canceling their leases, says Anthony Sanders, real estate finance professor at George Mason University.

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“In hot markets, this is not a problem,” Sanders adds. “But in oversupplied markets like Las Vegas, a guarantee would be rather expensive.”

What’s more, there may be less of an incentive for renters to pay their rent on time. If mortgage borrowers are delinquent, they risk losing their homes and whatever equity they’ve built on the property. If tenants break a lease, they risk losing their deposits (which is often equivalent to one month’s rent).

What’s also less certain is how will the bonds be collateralized, says Lynn Fisher, real estate professor at the University of North Carolina. With mortgage-backed securities, bondholders ultimately have rights to the real estate itself.

Perhaps the biggest issue is that bond buyers would be betting on the ability of large institutional investors to manage rental homes – something that’s rarely, if ever, done. Typically, large Real Estate Investment Trusts and private equity funds focus on apartment buildings and commercial real estate, such as malls and apartment complexes.

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“Publicly traded REITs, like Avalon Bay or Post Properties, for example, have expert management teams who know how to adjust rent almost daily in response to market conditions, work on tenant retention, etc.,” Fisher says. “Who knows how to do this in the single-family space?”

And there’s the issue of economies of scale. The trouble with managing a portfolio of hundreds of homes scattered about different parts of a city or state is that, unlike apartment complexes, everything from faucets to sinks to cupboards aren’t uniform, says Barney Hartman-Glaser, finance professor at Duke University. So when it comes time to repair or replace appliances, fixtures and such, it could become logistically more difficult – if not, more costly.