The Long-Term Viability of Institutional Single-Family Rentals
Featuring commentary by Frederick Cooper
Alexander Akel, M.Des Real Estate and Built Environment ‘15
The ownership and management of single-family homes for rent is one of the oldest real estate asset classes. Historically and presently dominated by mom-and-pop investors, the single-family rental market has institutionalized as a result of the events of The Great Recession and technological advancements. This article will address whether this innovative and nascent business model is a sustainable and long-term real estate asset class.
In October of 2002 at George Washington University, President George W. Bush addressed the topic of increasing minority home-ownership. The goal was that by the end of the decade, the number of minority homeowners would increase by at least 5.5 million families. President Bush declared, “It is going to require a strong commitment from those of you involved in the housing industry.” From there, the story unraveled. The low interest rate environment spurred by the dot-com bubble urged investors to search for yield in risky places such as the housing market. Simultaneously, the torrential downpour of “free money” and home-ownership driven public policy encouraged American consumers to pursue the romanticized American Dream in the form of subprime mortgages. Financial innovations such as credit default swaps and collateralized debt obligations increased systemic risk by allowing more investors to join in on the fun.
Over-leveraged homeowners could not make due on their mortgage payments, triggering a domino effect on the U.S. economy. Mortgage defaults skyrocketed, causing the financial innovations of collateralized debt obligations and credit default swaps to fail alongside the institutions that invested in them. The market was flooded with hundreds of thousands of homes at prices well below replacement cost. Enticed by what many deemed to be a once in a lifetime opportunity, investors pounced on short sales, real estate owned (REO), and market listings. Within a few months, spawned from the doldrums of the housing crash, the institutional single-family rental (SFR) market was born.
The Competitive Landscape
The ownership and management of SFR is not a new business. Theoretically a $1.5 trillion opportunity, the SFR business is historically a mom-and-pop market even with today’s institutional presence. There are currently over fourteen million single-family homes rented, approximately 12.3% of the total occupied housing stock (Exhibit 1). Since 2007, the number of homes for rent has increased by over 2 million. What is new is the foray of institutional investors in this space. During the past three to five years, the largest institutional investors purchased over 172,000 homes for $28 billion (Exhibit 2). Institutional investors only own 1.2% of all SFRs. The institutional SFR space is dominated by large private companies such as The Blackstone Group’s Invitation Homes, the country’s largest private landlord with over 45,000 homes, and public REITs such as American Homes 4 Rent (AMH) and Starwood Waypoint Residential (SWAY). According to Rick Sharga, CEO of Auctioncom, the investment strategy is simple: “Buy the property at less-than-market value, rent it for a few years while the market recovers, and then sell it at a high profit margin when home prices appreciate.”3 In order to achieve targeted rents, owner-operators have contributed substantially to capital expenditures (10% to 20% of purchase price). Given the small market share of institutional investors, it is difficult to distinguish between David and Goliath within the SFR market.
The sudden emergence of institutionally owned SFR portfolios embodies innovation at its core through the creation of a new real estate asset class. An understanding of this innovation lies in the distinctions between the institutional and mom-and-pop business models of SFR. The first distinction is portfolio size. According to data from RealtyTrac, 51% of SFR investors own only one property while only 4% own more than 250 properties. Typically, an institutionally owned portfolio is categorized as 1,000 or more homes. The second difference is source of capital. Smaller investors use their own savings, equity from friends and family, or community bank financing, while institutional investors deploy capital from pension funds, foreign investors, high net-worth families and individuals, money-center banks, as well as the private debt and public equity markets. For the first time ever, large-scale investors have access to the SFR market thanks to the recent innovations in capital markets. For example, in November 2013, the first fixed-income securitization of SFR, Blackstone’s IH 2013-SFR1, came to market. The third differentiator is geographic diversification. While small investors tend to be monogamous, institutions play across state boundaries in multiple markets. The fourth and final distinction is that institutional owner-operators have the ability to create a branded product. David Singelyn, CEO of American Homes 4 Rent, the largest publicly traded real estate investment trust (REIT) with over 30,000 homes, declared: “We provide something that a mom-and-pop cannot. We are a known commodity. Tenants know that we are going to be in the business long-term.” The institutional ownership and management of thousands of homes scattered across dozens of markets is a new chapter in the SFR market.
Technological improvements in the form of cloud computing and in-house software allowed the largest SFR players to quickly leave an impression on the market. Singelyn emphasized this point by stating: “Technology is very important to the success of a large scale corporation. It is the reason we have the ability to institutionalize the asset class that has assets that are not concentrated in one location.”4 Cursed by soaring transactional and operational risks, the asset class sprouted with the help of technological innovations that assist with pinpointing ideal properties for acquisition and managing a portfolio of scattered assets.
The recent innovations in SFR do not end there. Historically, mom-and-pop investors obtained leverage from Government-Sponsored Enterprises (GSEs) such as Freddie Mac and Fannie Mae through home loans and small banks. Approximately 50%-75% of SFRs are unencumbered by debt. Capitalizing on this gap, Wall Street recently developed new loan products for small and large SFR investors. Another $1.5 trillion theoretical opportunity, Blackstone’s B2R Finance and Colony Capital’s Colony American Finance, along with FirstKey Lending are providing debt liquidity to finance future acquisitions. The SFR revolution is not over. The eventual goal is to bring an unprecedented multi-borrower fixed-income securitization to market, a potential reality in 2015.
Is Institutional Single-Family Rental a Long-Term Sustainable Real Estate Asset Class?
The institutional ownership and management of SFR is not a sustainable long-term business model for several reasons. First, over the past three years, the availability of attractively priced opportunities has quickly eroded. The events of 2007–2008 that served as the catalyst for institutional SFR have fizzled, triggering a domino effect on the institutional SFR market. Second, the lack of opportunities will result in insufficient risk-adjusted returns relative to core multi-family in gateway markets. Third, institutional SFR operators will be unable to drive long-term rent growth amidst the recently high home price appreciation. This breeds a “high-quality” problem or severe capitalization rate compression. This is a great threat to publicly traded REITs in particular as it affects their ability to effectively raise capital. Fourth, the result of these three events will culminate in the shrinkage of long-term capital formation in the private equity, public equity, and private debt markets.
The days of unlevered internal rates of returns in the low teens are gone, while the underlying risks still remain. Within the next five to seven years, private equity and independent investors along with their capital sources such as pension funds and family offices will completely retreat as the number of opportunities dwindles. In response to the decreased appetite in SFR, private equity investors will redeploy their capital to multi-family located in gateway markets where there is a greater opportunity to drive long-term cash flow growth. Today, the lens of capital formation for the public equity markets is already closing. All of the publicly traded SFR REITs are faced with the uphill task of driving funds from operations (FFO) growth while combatting the looming “high-quality” problem. Furthermore, a dearth of acquisitions has altered the rules of the game from aggregation to consolidation; hindering future IPOs as the biggest firms continue to get bigger. This article predicts that institutional SFR will become a niche REIT asset class with approximately two to three companies. Finally, the absence of private equity investors and scarce number of public REITs along with rising interest rates will lessen the supply of private debt. On the demand side, a combination of higher interest rates and lower risk-adjusted returns relative to multi-family CMBS will push debt investors away from fixed-income SFR. It took a short three years to build the institutional SFR empire. It could take a second for it to vanish.
The Erosion of Attractively Priced Opportunities
The investment thesis is deeply rooted in the financial theory of mean reversion. In the context of home prices, the theory suggests that after periods of swift appreciation or depreciation, annual home price growth will eventually revert to its long-term average. Data from S&P/Case-Shiller Home Price Index for twelve Metropolitan Statistical Areas (MSAs) displays this phenomenon (Exhibit 3). Between 2007 and 2011, home prices depreciated between 35% and 75% in the Sun Belt region of the US, specifically the Sand States of Arizona, California, Florida, and Nevada. Between 2012 and 2014, several markets in these states experienced home price appreciation of at least 30%, an annual average of 10%. For perspective, the mean annual home price appreciation figure for the twelve MSAs was 3.3%, almost equal to the long-term national average of 3.5%. Throughout the last fourteen years, average annual home price appreciation was within 150 basis points of the long-term average just twice: in 2006 and 2014. The mean reversion of home prices across the country, shrinkage in shadow inventory and recent shift of gigantic SFR investors from aggregation to consolidation indicate that the original investment proposition is rapidly fading.
The swift rise in prices has encouraged investors to either sell their portfolio or invest in secondary and tertiary markets. Recent purchases from investors fell to 12%, the lowest level since the beginning of 2010.2 In 2012 and 2013, investors shifted their attention from the Sun Belt to the Rust Belt markets of Pittsburgh, Indianapolis, Chicago, Columbus, Cleveland, and Kansas City. As of early 2015, home price appreciation in some Rust Belt markets such as Cleveland has reverted to its long-term mean. As a result, some investors are looking to drive cash flow growth instead of primarily targeting appreciation. At the IMN Single-Family Rental Conference in Scottsdale, Michael Cook, Vice President at GTIS Partners, a real estate private equity firm with 3,000 homes, indicated that although secondary and tertiary markets provide moderate annual appreciation between 2% and 4%, current cash flow opportunities still exist. Instead the focus has shifted to drive unlevered yields, ranging from 5% to 7%. Cook elaborated, acknowledging that the homeruns that originally attracted investors to the space are long gone.
Foreclosures, REOs, and shadow inventory opportunities were the focal point of the early feeding frenzy but have drastically dropped off in recent years. Distressed transactions as percentage of existing home sales peaked at 50% in 2009. In 2013, the figure was 16.5% and today it is 10% indicating that quantity of distressed inventory is gradually shrinking. Foreclosure filings are also down with monthly filings at around 120,000 compared to the high of 367,000 in March 2010. Michigan, Illinois, Ohio, Wisconsin, and Indiana boast some of the country’s highest REO inventory levels, explaining why investors have shifted their interest to the Midwest. As of July 2014, the shadow supply of delinquent and foreclosed loans was 3.7 million. If listed inventory and seriously delinquent loans are included, the total potential additional supply is 8.2 million homes. The prediction is that investors will maintain moderate interest in 2015 and 2016 but beyond that remains unclear.
The recent shift from aggregation to consolidation is a glaring hint that the “go-go days” of institutional SFR are behind us. Forced to grow or go to achieve economies of scale, behemoth owner-operators are providing small to mid-tier investors with attractive exit opportunities if sellers leave some home price appreciation on the table. “Now we will sweep up everybody over the next two years who got stuck, who say I have home price appreciation, which they do. They bought right, but now they are stuck,” mentioned Tom Barack, CEO of Colony Capital. Last year, American Homes 4 Rent acquired 1,300 homes from Beazer Pre-Owned Rental Homes for $263 million and 900 homes from Ellington Housing for $126 million. The dawn of the consolidation period signifies the beginning of the end of the golden age for acquiring homes.
Although the outlook for the next two years is still fairly attractive, the long-term prospective is bleak. The capacity to apply the original investment thesis behind institutional SFR is quickly diminishing. Home prices will revert to their historical average and the supply of attractively priced opportunities will continue to diminish. The absence of the elements that created the perfect storm for the business model will impede the long-term growth of institutional SFR.
Insufficient Returns for a Transactional and Operational Headache
The institutional ownership and management of SFR is riddled with risks. The potential formation of a housing bubble or another housing market crash gives investors nightmares. However, an economic collapse or the development of frothy pricing can affect all real estate asset classes. The inherent attributes of institutional SFR exacerbate the transactional and operational risks relative to core multi-family located in gateway markets.
Imagine aggregating 1,000 multi-family units and single-family homes. Under the assumption that each multi-family building possesses 200 units, only 5 separate transactions are needed. On the other hand, 1,000 separate transactions are required to acquire the same number of SFR units. Even with bulk purchases, each home requires its own proper due diligence to understand the necessary capital expenditures and title status. The ability to quickly sift through hundreds of thousands of homes across the country epitomizes the role of technology in enabling this type of innovation. Like the buy side, the disposition of SFRs is more challenging relative to multifamily. Most portfolios are geographically dispersed over several states but concentrated in several large MSAs, creating a skewed perception of diversification. For example, values could nosedive if several hundred homes from one market need to be liquidated. However, SFR does offer disposition flexibility. “Owners can sell their units to another landlord such as a private equity firm or REIT or sell them to individual buyers,” proclaimed Dennis Cisterna, a managing director at FirstKey Lending. Unsurprisingly, owner-occupiers have not been the major source of liquidity. Even if potential homeowners existed, the selling process could take months to sell just one home. Instead, the true source of liquidity has come from the largest SFR such as Invitation Homes and American Homes 4 Rent who are looking to consolidate. This liquidity ties directly to the ability of REITs to tap into the public markets. Private equity investors who wait to exit risk missing the window of opportunity that could close once the appetite of behemoth investors is satiated or the public equity markets shun SFR.
Operational Risk: “Hell of an Operation to Run”
Since day one, the ability to efficiently lease and maintain a large-scale portfolio of scattered homes was in question. Sam Zell, the Chicago billionaire and real estate investor, agreed:
“Operating a pool of rental homes that are not next door to each other is a challenge that nobody has ever dealt with yet…It is gonna be a hell of an operation to run.”
He was right. Citing a report from Moody’s, a global rating agency, the first risk is that individual SFR properties are geographically dispersed across multiple markets making property management an uphill battle. The report states: “Every home has unique features, appliances, and building materials, making the renovation, maintenance, and marketing more demanding than typical multi-family properties.” In comparison to multi-family, this dispersion also makes it difficult to maintain touching points with consumers, explained Jordan Kavana of Transcendent Investment Management, a private equity firm with $415 million assets under management across the southeastern United States. This issue has spurred the development of in-house property management capabilities among the largest SFR investors, in particular, the public REITs.
Second, the asset class has an unproven track record. The appropriate costs for turnover, repairs and maintenance, and long-term capital expenditures are unknown. It may sound surprising, but net operating income (NOI) margins of SFR REITs have penciled out to 61% compared to 63% to multi-family REITs. The narrow spread is primarily a result of SFR’s lower turnover rate. The turnover rate for multi-family is 70% compared to 50% for SFR but there is a caveat. “Our turns cost more but people stay longer,” stated Doug Brien of Starwood Waypoint Homes, the second largest public REIT. It should also be noted that in addition to utilities, some SFR tenants pay for landscaping and pest control costs. With respect to capital expenditures, they are variable and generally higher than multi-family depending on the age and size of the home, and rentership of the tenant. Due to the infancy of the business model, most institutionally owned SFRs were rehabbed within the last three years, allowing firms to post attractive net cash flow (NCF) margins of approximately 57%. As the properties age, the expectation is that NCF margins will drop over the long-term, reducing the property’s cash throw-off.
The uncertainty of actual turnover costs and long-term capital expenditures are the key operational challenges, while the disposition issues of SFR compound the illiquidity uncertainty faced by traditional real estate. Without a doubt, the inherent characteristics of SFR make it a riskier proposition compared to multi-family. Over the next five to seven years, the expectation is that forecasted returns for SFR will be higher than core gateway multi-family but not enough to warrant an attractive risk-adjusted return.
Two separate approaches were applied to forecast returns: a financial pro-forma and the value chain analysis. The former was utilized for institutional SFR only and the latter for commercial real estate products. A value chain analysis deciphers the underlying components driving returns. The value chain analysis utilizes the going-in capitalization rate, the change in the capitalization rate over the holding period, annual cash flow growth, and the impact of leverage to derive unlevered and levered returns with both speed and accuracy. Forecasts of capitalization rates for multi-family, office, retail, and industrial, in addition to rent growth and vacancy expectations across national gateway markets between 2015 and 2021 were pulled from CBRE Econometric Advisors. Boston, Chicago, Los Angeles, New York City, San Francisco, and Washington, D.C. were selected as the represented markets, as they tend to be the beneficiaries of long-term economic growth. Returns indicate that retail is expected to continue to dominate due to strong NOI and cash flow growth expectations with industrial, office, and multi-family in second, third, and fourth place respectively (Exhibit 4).
An Illustrative Example
The exemplary model represents a portfolio of 3,000 SFRs across ten markets: Charlotte, Chicago, Columbus, Dallas, Indianapolis, Kansas City, Miami, Nashville, Pittsburgh, and Tampa. Base acquisition costs and monthly rents for each market were sourced directly from Zillow. Depending on the market, acquisition costs range from $125,000 to $190,000 per home, averaging to $148,000. Furthermore, the portfolio is 90% occupied at stabilization with monthly rents between $1,100 and $1,800 or an average of $1,300. The initial average capital expenditures per home are $16,650 resulting in a total average investment cost of $164,650.
For home price appreciation forecasts between 2015 and 2021, the forward-looking S&P/Case-Shiller 20-City Composite Home Price Index was used. Home prices are expected to continue to hover at 3.8% until 2016. From 2016 to 2018, the average annual home price appreciation is forecasted to fall to 2.5% then increase to 5.54% between 2019 and 2021. Over the next seven years, the model assumes a 3.3% average annual home price appreciation, slightly below the historical average of 3.5%. The CAGR is 3.9%.
The major operating expenditure assumptions were pulled from the third quarter 2014 10-Q’s of public REITs. The typical operating costs of SFRs are repairs and maintenance, homeowner association fees, property taxes, property management fees, insurance, turnover, and leasing and marketing. The stabilized NOI margin for the model is 59% compared to 61% for public SFR REITs. The slightly higher turnover costs in the model are responsible for the lower NOI margin. The only below the line expense is capital expenditure reserves of $1,020 per year for infrequent structural repairs such as a new roof or HVAC system. The resulting NCF margin is 52%. The pro-forma applies annual rent growth of 3% and expense growth of 2%.
The model assumes that the entire portfolio is purchased in December 2014 with a four-month period to renovate and lease the homes. The whole portfolio is sold at the end of the holding period in a bulk sale. Given the transactional risks of purchasing and disposing of a large number of assets, the model assumes the unlikely scenario of purchasing or selling 3,000 units at once.
Exhibit 4 shows the returns for SFR relative to other real estate asset classes, and a benchmark, the 7-year BBB+ corporate bond yield. Zooming in on SFR and multi-family returns for a five to seven year hold between 2019 and 2021, SFR is expected to outperform multi-family by a small margin, with an average unlevered IRR of 7.2% over this period, compared with 5.6% for multi-family. The brief history of institutional SFR makes it impossible to adequately quantify the risk of the expected returns. However, based on the qualitative discussion of the transactional and operational risks, the delta of only 1.6% is insufficient given SFR’s inherent risks, value-add characteristics, and the model’s exit assumption. In recent years, the unlevered IRRs of core multi-family located in gateway markets hovered between 5% and 7%, similar to the forecasted returns. First-movers in the SFR space with double-digit annual home price appreciation achieved unlevered returns in the low teens, an extremely attractive spread to core multi-family of approximately 4% to 7%. SFR has lost its initial flair as home price appreciation reverts closer to historical levels, impeding the investment thesis. The expectation is that smart capital will exit the investment and flock towards core multi-family to lock in slightly lower yet more attractive risk-adjusted yields.
For institutional owner-operators with a long-term perspective, appreciation can be a double-edged sword. The annual double-digit appreciation experienced across the Sun Belt states between 2011 and 2013 was a once-in-a-lifetime opportunity. On the other hand, rapid appreciation without substantial NOI growth can result in severe capitalization rate compression to levels below other real estate investments. Exhibit 5 displays this phenomenon also known as a “high-quality” problem. As long as appreciation surpasses NOI growth, the capitalization rate will compress over the hold. From the perspective of a REIT investor, would they invest in SFR equities with assets at a 4.5% capitalization rate or core multi-family REITs at a 4.5% rate? This is a major problem for REITs as the public markets must be willing to value the assets at the low capitalization rates. If not, REITs will perpetually trade at a discount to net asset value (NAV). This may force REIT executives to liquidate the portfolio.
The prospect of growing NOI over the long-term is clouded by historical stagnant wage growth relative to rent inflation. The Economic Policy Institute conducted a study indicating that wage growth has been sluggish for more than a decade. The study cites statistics from the Bureau of Labor such as the Employment Cost Index (ECI) that gauges compensation and wages for the private sector (Exhibit 6). Between 2000 and 2007, compensation grew 5.5% and wages only 2.4% while inflation increased by 20.4% and rent by 27.6%. Annual wage growth of middle-class Americans was nonexistent during the economic boom and the period during and after the recession. Over the last twelve years, wage growth was nonexistent while rents grew by 3.4% annually. The increased demand for rental housing has created an upward motion on rents but the disconnect between wage and rent growth is unsustainable. According to a study by the Harvard Joint Center for Housing Studies, in Arizona, California, Florida, Georgia, Illinois, and Nevada, all states with some of the most institutional SFR activity, 50% of renters are housing cost burdened. These renters are paying more than 30% of their household income on housing. SFR REITs are banking on their ability to drive funds from operations (FFO) growth to avoid the “high-quality” problem. Multi-family investors are also seeking the same rent bumps. Compared to SFR, these increases may be more attainable for newer developments located in gateway markets with higher median household incomes and more amenities than SFR. Without FFO growth, the “high-quality” issue will lead to the demise of several SFR REITs.
Shrinking Lens of Capital Formation
Private equity firms categorize today’s environment as constrained by opportunity, not capital. Pension funds are the largest private source of capital invested in SFR. The Alaskan Permanent Fund invested over $750 million in American Homes 4 Rent early on. The California Public Employees Retirement System (CalPERS), the nation’s largest public pension fund, invested $300 million in GI Partners, one of the lead investors in Waypoint Homes.16 Additionally, the California State Teachers’ Retirement System (CalSTRS) invested in SFR through The Blackstone Group’s fund. Both CalPERS and CalSTRS view their investment as tactical and short-term, unlike their long-term multi-family portfolio. Others such as Prudential Real Estate and Allstate Insurance avoided the sector completely, citing the aforementioned transaction and operational risks. In recent months, a notable shift in the appetite of pension funds has occurred, pushing them away from SFR. The capability of raising capital has not changed. Filling in their shoes are foreign investors.
According to Cook of GTIS Partners, pension funds are “a little less excited because they are fully invested or partnered up. Today, they are re-upping with whoever they came to the dance with.” Instead, Cook’s firm has seen a growing interest from European and Middle Eastern investors.5 Foreign investor interest has ballooned due to the “safe haven” perception of the U.S. market. With capital sitting on the sideline, the current challenge of fund managers is how to deploy it. Fund managers will avoid SFR, as the decrease in attractively priced homes will make it impossible to achieve their target “bogey.” This is the primary reason why a majority of small institutional SFR investors have exited. Private sources of capital such as pension funds and foreign investors in search of a 6% to 7% unlevered yield will funnel capital to core multi-family, office, and retail.
Unlike private equity firms, public companies are constrained by capital, not opportunity. Today, there are five publicly traded SFR REITs. As of January 2015, the total market capitalization for the public SFR market is over $6.7 billion. Invitation Homes is likely the next company to tap into the public equity market sometime in 2015 or 2016, allowing Blackstone to finally exit its investment. The poor historical performance of SFR REITs and potential threat of a “high-quality” problem are the culprits of the capital constraint.
Last year, the FTSE NAREIT Equity Apartment Index posted a total return of 31% compared to the S&P 500’s 13.7%. For the same calendar year, American Homes 4 Rent, Silver Bay Realty, and American Residential Properties posted total returns of 6.8%, 2.6%, and 2.5% respectively (Exhibit 7). An investor looking for residential real estate exposure would be better off in the hands of multifamily. Companies like Equity Residential, AvalonBay Communities, UDR, and Camden Property Trust posted total returns between 32% and 42% for last year. These multi-family REITs have price to book values between 2.4 and 3.1 compared to the average 1.1 price to book value of SFR REITS. The poor performance of SFR REITs is a result of recent investments in the internalization of property management. However, SFR FFO forecasts are still not as attractive when compared to multi-family. Anthony Paolone, a REIT analyst with JPMorgan Chase & Co. agrees, stating: “One of the challenges now is the conventional apartment business is just so good, it is hard to get a real estate-dedicated investor to say, I am going to move away from apartment REITs and buy single-family rental guys.”
Amidst the fear of rising interest rates, the looming “high-quality” problem, and substandard performance, SFR REITs are experiencing growing pains. The public equity market is slowly starting to shun the asset class. These factors will make it challenging for SFR firms to issue new shares or go public. As a result, this paper predicts that SFR REITs will become a niche public equity asset class with one to two companies within the next five to seven years. Public equity investors looking for rental residential real estate exposure would be better served by multi-family REITs.
In the beginning, the sole source of debt financing came from the JPMorgans and Deutsche Banks of the world in the form of billion dollar lines of credit. Between 2012 and 2013, money-center bankers lent almost $11 billion through floating rate credit facilities in the 3% to 4% range.2 Investors understood that money-center bank debt alone would not legitimize the asset class. By November 2013, Blackstone brought IH 2013-SFR1, the first single-borrower SFR securitization, to market.
As of January 2015, there have been sixteen SFR fixed income securitizations helping institutional owner-operators raise $9 billion. Three are long-term fixed rate deals that mature in ten years. The rest are short-term (five years including extensions) floating rate bonds. Vishal Khanduja, Vice President and Portfolio Manager at Calvert Investment Management and owner of SFR paper, explained the demand for these securities. He commented: “The SFR deals are attractive due to the shifts in U.S. demographics, not so stellar global growth, anemic wage growth, and low interest rates, which have created a need for US dollar denominated income-based assets.” The low interest rate environment spurred demand for SFR bonds. Like the equity model, the SFR bonds do not provide proper risk-adjusted returns relative to multi-family CMBS.
A quick comparison between two fixed rate American Homes 4 Rent issuances (AMH 2014-SFR2 and AMH 2014-SFR3) and two recent Freddie Mac Multifamily K Series bonds (K-39 and K40) from September and November sheds some light on this (Exhibit 8). The Freddie Mac Multifamily K Certificates are regularly issued structured pass-through securities backed by recently originated multifamily mortgage loans. Due to the riskier nature of SFR, the interest rate and debt service coverage ratio (DSCR) on Freddie Mac K-Series debt should always be equal or lower compared to SFR bonds. The AMH 2014-SFR2 Class A tranche and K-39 debt deals were priced at S+119 basis points and S+46 basis points in September 2014. S is denoted as the 10-year fixed-for-float LIBOR swap rate. K-39 has a DSCR of 1.64 compared to 1.62 for AMH 2014-SFR2. In November 2014, the AMH 2014-SFR3 Class A tranche and K-40 had interest rates of S+123 basis points and S+71 basis points, a major tightening in spreads in two months. The spread between the first pairing of securities was 0.73% compared to only 0.52% for the second grouping.
However, there are additional risks specific to SFR debt. To date, none of the sixteen bonds have been refinanced, a significant risk given that interest rates are expected to rise. Another risk is that the US government guarantees K-Series and not SFR debt. Furthermore, The Supreme Court of Nevada recently ruled in September 2014 in SFR Investments Pool 1, LLC v. US Bank that a homeowners association (HOA) lien is a “true super-priority lien and that a properly conducted foreclosure on the HOA lien extinguishes first deeds of trust”. In this case, the HOA lien was $6,000 compared to an $880,000 first mortgage. The ruling created shockwaves around the sector with bond investors calling for higher levels of cash reserves to combat HOA fees. He admits that not all investors share the same perspective. Khanduja believes that in today’s low yield, low spread environment, his firm is getting compensated for the risk. Simultaneously, many money managers are avoiding SFR debt due to an insufficient premium over multi-family debt.
Compared to 2011, institutional investors have multiple options when choosing leverage. Money-center bank debt has become less prevalent as investors choose between balance sheet lenders and securitization. Private equity backed lenders such as Blackstone’s B2R (Buy-to-Rent) Finance, Colony American Finance, and FirstKey Mortgage have revamped the SFR debt market with tailored loan products for entrepreneurial and institutional investors. In 2014 alone, they closed on over $1 billion in loans. The expectation is that 2015 will be another record-breaking year with another $6 to $8 billion in debt issuances and at least another $1 to $2 billion in balance sheet loans.
The decreased number of opportunities to purchase new inventory and a fall in demand from the private and public equity markets could choke the issuances of SFR debt. The clock is ticking, and if SFR companies cannot refinance their debt in the next few years, debt liquidity could completely dissipate. Investors looking for a safer proposition at slightly lower yields should focus on multi-family CMBS.
Round One: Homes, Round Two: Loans
The shrinking supply of appealing acquisition opportunities, the inherent transactional and operational risks and poor risk-adjusted returns relative to multi-family, and the inability to drive NOI growth are the detriments to the sustainability of the institutional SFR business. These factors will hinder the long-term development of capital around the sector. The institutional SFR business was created during the perfect storm of the housing crisis. In order for SFR investors to exit and generate profit from their one time trade, they had to convince investors that it was a long-term business.
The innovation of the institutional SFR business has left a lasting footprint on the housing market: a new set of tools for mom-and-pop investors. Previously unavailable technologies and services to assist with property management and malleable financing options are now at their fingertips. Wall Street has already shifted its attention to its new invention: blanket loans to small SFR investors. Unlike the first round of SFR, the debt model does not have a compact window of opportunity.
As the old adage goes, “Rome wasn’t built in a day.” In three years, institutional investors reinvented one of the oldest real estate businesses. In the beginning, the investment proposition was attractive on paper but inundated with roadblocks to implementation. Overall, the institutional foray into SFR was a successful experiment despite the daunting challenges. Over the last quarter of a century, Wall Street brought us mortgage-backed securities, collateralized debt obligations, and credit default swaps, all of which were innovations that transformed real estate as an industry. The brief institutional presence in the SFR market allowed investors to build upon the aforementioned inventions. Wall Street has a new formidable tool in its arsenal: the ability to build Rome in a matter of months and subsequently sell it in the blink of an eye.
Commentary by Frederick Cooper
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Fred Cooper manages Toll Brothers’ Wall Street, banking and rating agency relationships, and its investor relations and financial marketing activities in the U.S. and internationally. Fred joined Toll Brothers in 1993 and has been involved in raising over $7 billion to support the firm’s growth. He also oversees its joint venture partnering relationships with major financial and development institutions and its exploration of international development opportunities in Asian, Latin American, and Middle Eastern markets. He has been financial point for Toll Brothers’ entry into the urban high-rise condo development business and into the rental apartment business. Since 1993, Toll Brothers has expanded from a regional home builder with $400 million in revenues to a national land developer/home building company with peak revenues of over $6 billion in 2006. He holds an AB from Brown University and a Master of Public Policy in finance and international development from Harvard University’s Kennedy School.
The author has done an impressive deep-dive into the Single Family Rental (SFR) business from a number of perspectives: demographic, financial, and operational. He clearly lays out the competitive advantages that institutional SFR firms have over their mom-and-pop competitors. These include portfolio size; access to capital; geographic diversity; branding potential (perhaps); and technology capabilities (for management efficiency and property target identification). He also outlines the major operational challenges faced by even the largest firms in the sector: inefficiencies in managing a scattered portfolio of single-family homes; one-of-a-kind, and, in some cases, older homes that have their own unique maintenance and capital improvement requirements; and tendencies toward less than “A” markets and locations.
A confluence of economic events during the Great Recession created a perfect storm that established the underpinnings for the formation of the Single Family Rental business as an institutional sector:
A flood of supply of foreclosed and distressed homes coming to market over a relatively short time-frame that significantly depressed home prices to, in many cases, well below replacement cost
Dramatic dislocation in the job market that pushed millions of previously homeowning families to become renters and caused many others to defer home buying
Technologically enabled high volumes of distressed loan and REO sales that created some efficiencies in amassing large portfolios of potentially rentable homes
Now as the economy, and, somewhat more slowly, the housing market, have begun to recover, it appears that the SFR industry is no longer benefiting as much from an environment of abundant, low-priced homes to buy. Early in the recovery, these homes could be purchased well below replacement cost, thus providing a downside floor to their book value. Instead, the current dual headwinds of (1) potentially increasing rates of ownership and (2) rising home prices that limit the opportunity to purchase houses at such advantageous prices, suggest that the total supply of potential rental units or customers to rent these homes could be shrinking. Based on this transition and other factors he outlines, the author believes that single family rentals as an institutional quality investment sector is heading toward a sunset in the not too distant future.
I do not agree with the author’s conclusion that, when the dust settles, the industry will revert to its previous status as a mom-and-pop sector, whose small- scale participants will benefit from some of the innovations of the last several years, but will not attract the type of institutional investment to make it an appealing asset class at that level. I foresee future opportunity for continued industry evolution and institutional investment.
The author sees the exit planning of many of the initial institutional players as a sign of this. However, many to most of the large institutional capital players who first came into the own-to-rent market on a large scale during that period are recognized as foresighted risk takers. As pioneers, they seek outsized returns and have strong track records of creating value then harvesting their returns as a sector matures and stabilizes. They often exit as the market becomes more competitive and attracts more ‘staid’ institutional capital willing to accept lower yields in exchange for more dependable returns.
I see additional potential for growth and the ability to attract institutional quality investors to the sector. Here is why: There still appears to be a tremendous consolidation opportunity. Large companies can bring scale of marketing and management, lower priced capital, and other efficiencies to an industry that remains tremendously fragmented. A consolidation opportunity exists just considering the universe of current single-family rental homes in the U.S. The author estimates that there are over 14 million single-family homes rented, which represents approximately 12.3% of the total relevant occupied housing stock. He further estimates that 1.2% of these homes are under institutional ownership.
There is clearly a customer appeal for the product, which offers some of the benefits of a “home ownership” lifestyle to those who may never be able to afford to own, have become wary of owning, are in transition on their way to becoming homeowners, are relocating to a new market or, in preparation for retirement, want to stay in the suburbs but not remain homeowners. There are public policy reasons to support a solid single family rental industry as it clearly fills a niche between home ownership and apartment rentals. As the industry matures and cash flows become more predictable with a track record of measurable data, the asset class will become more appealing to investors seeking dependable returns.
Financial engineering is already creating additional ways to increase value for debt and equity investors in the sector. Credit agencies are rating various securities offerings. Banks are making company debt available in the form of corporate credit facilities, rather than just individual asset-specific loans, to the large firms in the sector. The securitization market has already accepted portfolio-based debt financings. With increasing comfort, the loan to value limits are being raised as debt pricing drops on these deals. Additional equity and equity-like products are available to the industry’s largest players, which allow investors to benefit from both predictable cash flows and home price appreciation. Providing financing for house acquisitions is another avenue being explored by private equity firms. And creative structures such as UP-REITS may allow small scale SFR owners to exit the asset ownership business in a tax-efficient manner.
There are a variety of exit potentials for big players: public markets, selling individual homes and portfolios, and selling to current renters, among others. This provides some solid liquidity to the sector. Looking to the future, it is still unclear whether the current very low post-recession rate of home ownership reflects a permanent shift in Americans’ appetite for, or ability to achieve, home ownership or is a temporary trough compared to historical home ownership levels. If the former proves true, the SFR market will benefit greatly. And the housing industry is notoriously cyclical, which suggests there will be future opportunities to purchase assets in scale when the industry hits a downturn. Given the scale of single family rentals in the U.S., the industry can evolve in many ways in the future. I can forsee:
Franchise systems where some of the largest companies become, essentially, booking and management agents divested of the hard assets.
The potential for firms to develop whole communities of single family rental homes that will create efficiencies of management and ability to brand.
With retirement looming for an aging population of Americans, some may choose to monetize the investment they have in their own homes by selling them and remaining renters in those very same homes or communities. Others may want to rent with compatible unrelated friends with whom they can age in place.
In summary, given the potential scale of consolidation, the increasing predictability of income streams, and the many ways to make money in the SFR industry, I see a strong future for institutional players in the market.