Homes Are Becoming Liquid Assets
I was having lunch with a friend of mine last week who has been an executive at several companies and done very well for himself. Having just separated from a company with a decent package, he was contemplating retirement but felt that he had another three years left of work at an executive level before he could retire the way he wanted to. He was sitting on an offer from one of the top technology firms to be an SVP but was lamenting the cost of housing in the Bay Area and wondering whether it was even worth it to take the job.
“We are in the midst of another real estate bubble and it can’t hold up,” he said to me. But in my retort to him, one of my current investment theses came to life for me. I argued to him that just because housing has returned to pre-recession levels (and acutely worse in several local areas such as San Francisco and Seattle) doesn’t mean we are in a bubble. To me, the rules of home prices are being rewritten by a collection of companies (i.e. the most valuable residential real estate startups) launched in the last ten years and I fundamentally think that how we think about residential real estate valuations must change.
Factors that Affect Asset Pricing: Basics
Prior to my career in ventures, I spent seven years in various investment banking and business valuation roles. Entities are primarily valued in three ways: the sum of the value of their assets sold individually (Asset Method), the sum of expected future cash flows produced from those assets discounted at a rate that properly reflects the risks of achieving those cash flows (Income Method), and/or by comparing the prices paid for similar entities either in the public market or via private transactions (Market Method). Through the triangulation and weighting of the outcomes of these approaches, one can get a perspective on the value of an entity. From there, if you are valuing an economic interest in that entity you must account for two distinct features of the security that change the value: marketability and control.
The concept of control is simple; if you are selling a stake in a business or an asset that does not have rights that allow you to control distributions, financing or strategy of the underlying business or asset then you are at the mercy of those who do have control. Control of an asset yields a premium whereas lack of control warrants a discount to the fair value of that asset. This is most notable in public company acquisitions where a buyer will pay a premium over the market value of the equity for the chance to control the asset and thereby reap additional synergies. Control premiums tend to range between 20–40% but can exceed that in certain circumstances. Discounts for lack of control are generally calculated as the inverse of observed control premiums but can be extremely high in cases with substantial restrictions (such as a 1% stake in a land holding entity with no rights to force a sale or distribution).
Marketability, another term for liquidity, is defined as the ability to quickly convert property to cash at minimal cost, with a high degree of certainty of realizing the anticipated amount of proceeds. In the absence of these qualities, a discount for lack of marketability is applied. This is often applied to shares of closely-held entities or assets where there is no known liquid market for the assets. Factors that affect marketability include the ability to create distributions or dividends, quality of management, the amount of control over the asset, restrictions on transfers or the anticipated holding period necessary to achieve a financial return. Discounts generally average between 20–40% with most restricted stock studies showing results in the low 30% range (although newer studies are in the mid-20s).
How the Startup World Has Changed Liquidity Features of Housing
Outside of a greater prevalence for HOAs, very little has changed in terms of the amount of control a homeowner has over his or her property. Mortgage companies may impose some minor influence over the property (i.e. must carry hazard insurance) and HOAs or POAs may impose some restrictions on home and maintenance such as yard maintenance requirements, parking requirements, restrictions on commercial or recreational vehicles or guidelines of certain capital improvements to a home. But in general, owners have full right to improve it, renovate it, rent it or burn it to the ground.
However, when it comes to elements of marketability there are major changes afoot. If we look back at our definition of marketability we can discern that any discount to an asset is determined by four common factors: transaction costs, transaction timing, dividend capacity, and certainty of cash flows. I want to caveat that I am not insinuating that housing has a marketability discount of 20–40% or that I can calculate what that is. I am merely stating that if these factors change pricing for assets then a change in these factors would directionally influence pricing.
So let’s examine how some of the most valuable and influential startups in the world are focusing on reducing marketability discounts across these various factors.
Transaction Costs. For most home sales in America, the seller hires a real estate agent and pays him or her a commission of 6% to sell the property. In addition, homeowners will make repairs or upgrades to the property ranging from $5,000 to $15,000 or more to get that property ready for sale. The result is that to sell an average home for $300,000 the seller will incur costs ranging from $23,000 to $33,000 or roughly 8–11% of the total proceeds. This massively restricts liquidity for sellers who have recently purchased a home and haven’t accumulated $30,000 of additional equity to offset transaction fees. As such, the amount of available inventory is naturally constrained to those who meet that criteria.
However, the digitization of the real estate brokerage process is enabling sellers to gain liquidity at lower costs than in the past. Our first example of how startups (using that term lightly here) are changing marketability factors is Redfin. Redfin leverages technology to improve the value received for homes and lowers the cost of home transactions for sellers (1.5% listing fee vs. 3% sell side fee). In addition, the company will share their buy side commission with buyers which can be put towards higher purchase prices. The model has resonated with many buyers and sellers as more than 120,000 homes worth $60 billion + have been sold on the platform. Redfin recently went public and has a market capitalization of $1.6 billion.
Timing and Certainty. The second element of marketability relates to a high degree of certainty of realizing proceeds which is often influenced by the timing of receiving those cash flows. For the timing aspect, there are two ways to consider the effects of timing on marketability: total holding period and time to sell. Total holding periods are affected by the above-mentioned issues with transaction costs. If you just bought a home, chances are you will have to hold on to that home for at least a few years to accrue enough additional equity to break even after covering the transactions costs. During that period, you will be subject to risks related to home price volatility and adverse events like flooding that could impact the structure itself. While most people likely don’t quantify this risk directly when purchasing a home, the price one is paying for a home certain has an implied discount associated with this holding period risk. Solving the transaction cost issue should have a positive impact on this implied discount.
Time to sell is also a factor, although likely a smaller discount than holding period due to the duration of the risk. In the past, there was no clearinghouse for homes and so the ability to sell a home was dictated by the number of buyers seeking a homes with your home’s qualities with the average time to sell home in excess of 80 days. Today, companies like Opendoor (valuation north of $2 billion), Offerpad and Zillow Offers are changing that paradigm. Each of these “i-buyers” will provide an offer on a home using data analytics within hours and can close within days. Given these offers incorporate not only a brokerage fee but also costs of repairs and improvements and holding costs to liquidate, they satisfy the timing and certainty element of the equation but not the “minimal cost” element. Other startups have attacked this by providing guarantees to buy a home if it doesn’t sell in a certain time period. As analytics and processes improve, it is expected that costs will decline considerably.
Dividend Creation. The ability to create interim cash flow from an asset and distribute that cash to its owners also has an impact on its pricing. Assets that can distribute cash are less risky than assets that only produce cash through a full sale. AirBnB ($40B+ private valuation) creates dividend streams for residential properties through short-term rentals. So does VRBO. And Roofstock helps people purchase properties that have longer-term dividend streams already attached to them.
As these digital marketplaces for renting homes have increased, some interesting new startups are starting to help investors increase the dividends they receive. Rabbu, a Charlotte-based startup, has developed a property management platform that helps people increase the revenue streams from their annual rental properties by making it easier to be a short-term rental manager. They do this by either directly offering property management of the property and allowing asset owners to take the risk or by signing the annual rental agreement from the owner (sometimes for more than they were looking to get in rent) and then taking on the risk themselves. They have experienced great success in creating a large marginal increase in rents created. Another NC-based startup who is optimizing the dividend creation of rental real estate is Living Labs. Based in Durham, the company has developed a technology that makes it simple to turn a standard rental into a co-living property by simultaneously matching geographic preference, desired housing attributes and roommate characteristics to turn each bedroom into a cash generating entity. This increases rental income by as much as 100% per month without the hassle of true short term rental management. It’s this form of innovation that will continue to drive up the dividend capacity of real estate assets like never before.
So What Happens Next?
Given that this post is already so long, I will save a deeper dive into this subject for future blogs. But as I play out potential future states I think it will be interesting to monitor where the spectrum of institutional versus personal ownership lands. It is highly plausible that housing as a more liquid asset encourages greater personal ownership of property as it has less risks or strings attached. Individuals may be more willing to purchase multiple homes or more expensive homes because they can easily shift their consumption of home with their economic capability. Another highly plausible future is that residential real estate becomes so expensive and the cash flow generation becomes optimized to a point where only institutional investors can afford it. Early signs point to the latter as there has been a massive proliferation in the number of institutionally managed single-family homes over the last decade. In addition, there are new ways for individuals to participate in funding investors and institutions in these pursuits. The actual future probably sits somewhere in the middle.