The large scale buying of single family houses being undertaken by firms such as Silver Bay (NYSE:SBY), American Residential Properties (NYSE:ARPI) & Colony American Homes will result in disappointing income & total returns to investors. Please note Colony American Homes (NYSE:CAHS) is currently pursuing a public listing & the latest news is that it is to be delayed. I myself run a Limited Partnership that is building a portfolio of single family houses in the south east of the US. Please consider the following points.
Diseconomies of scale
There is little chance that the very large scale and rapid deployment of capital being undertaken will be invested efficiently. These firms have incentives to focus on volume of purchases and deployment of capital rather than performance of the purchased assets. Investors will end up owning portfolios that contain a large proportion of lower quality assets that contain several risks. These risks include overpayment, title issues & ownership of hard to rent houses. These risks are accentuated by a large proportion of homes being bought unseen at auction.
Diseconomies of scale
A key building bock for success in this business is asset selection & deploying capital smartly, rather than just deploying capital in bulk.
Misalignment of incentives
The incentive to deploy rapidly is very transparent. Please note Silver Bay pays $2000 per house purchased to its property manager. This gives Silver Bay's property manager a natural incentive to deploy capital regardless of the potential performance of the asset. It should also be noted that Silver Bay's management fees are set as percentage of Silver Bay's stock market capitalization. This gives Silver Bay's management the incentive to deploy the initial capital raised from the equity market as soon as possible and then come back to raise further capital from the equity market.
The major point is that there are significant diseconomies of scale inherent in large scale capital deployment. This business model is not characterized by economies of scale. Operationally pursuing such a large scale model leads to the inevitable creation of several management layers. These layers of management serve to eat away the returns generated from the purchased houses. Investors may note that Colony American Homes even has internal property managers managing the relationships with their external property managers.
These aforementioned risks are starting to be manifest in some of the metrics being reported by firms such as Silver Bay, American Residential Properties & Colony American Homes.
These metrics such as the vacancy rate for properties owned for over 6 months are a cause of concern. The vacancy rate on properties owned for over 6 months ranges from 14% at Colony American Homes to 21% at American Residential Properties. The gross rental yields are also materializing at lower levels, with homes owned for over 6 months showing a gross yield of 9.9% at American Residential Properties and 10.7% at Colony American Homes. If these gross yields are adjusted for the vacancy rate, the gross yields fall to the 8 - 9% range. Please note I expect these headline gross yield numbers to go lower given rising house prices & an acceleration in the rate of house purchases by these firms over recent months.
Age of portfolios
Additionally the quality of the portfolios can further be questioned by the average age of homes in the portfolios. The average age of homes owned by Colony American Homes stands at 27 years & for American Residential Properties it is 20 years. This helps explain the high ratio of maintenance costs as a percentage of rents. This ratio is approximately 19% at Colony American Homes & 40% at American Residential according to its S-11, p.71. This equates to between 200 & 400 basis points of gross yield being absorbed by just the maintenance costs associated with looking after the portfolio of homes. Further costs related to the properties include insurance, property tax, homeowner association fees, as well as general, administrative and managerial expenses. The resulting income left for investors will be below expectations.
There is often a big overlap in the states where these firms are concentrating investments. Many firms have large exposure to the same markets such as Arizona, Nevada, Florida, California & Georgia as these are the markets where prices fell the most from peak. However for the long run success of this business model there has to be strong & positive economic & demographic drivers to create a growing demand from renters. Not all the states and cities where investments are being concentrated benefit from such positive drivers.
The main risk is that regional overlap by different firms will lead to over-competition for renters as the supply of rental properties grows. This will result in lower returns due to falling rental rates & higher vacancy periods. At present the focus on similar regions is driving prices higher in these markets. However a large part of these price increases is actually caused by investors competing with each other for the same assets.
These firms' investment strategies are focused on maximizing income yields. This naturally leads to these firms purchasing assets towards the lower end of the housing market. The higher potential yields available from lower quality houses reflects the higher risk around the cash flows these houses produce. These risks include tenancy risks as well as lower capital appreciation potential. The owner-occupant buyer of lower end assets is likely to be constrained due to less access to credit than those buyers at higher price points.
Investors are also obviously focused on investing in these firms as a way to play a recovering housing market. However the drags on income returns described previously will also negate some of the house price appreciation potential in these large scale portfolios.
I also have compared these metrics to the smaller fund I have developed which is focused on cherry picking assets to deliver high risk adjusted returns. This is to illustrate the better returns investors receive when following more selective investment strategies in the housing market.
Colony American Homes
- Gross yield on total cost of houses owned for over 6 months = 10.7%
- Vacancy rate of houses owned for over 6 months = 14%
- Vacancy adjusted gross yield on houses owned for over 6 months = 9%
- Average age of inventory = 27 years
- Maintenance costs as a percentage of the rent roll = 19%
- Price per square foot per house after repair costs= $90
American Residential Properties
- Gross yield on total cost of houses owned for over 6 months = 9.9%
- Vacancy rate of houses owned for over 6 months = 21%
- Vacancy adjusted gross yield on houses owned for over 6 months = 8%
- Average age of inventory = 20 years
- Maintenance costs as a percentage of the rent roll = 40%
- Price per square foot per house after repair costs= $76.5
- Gross yield on total cost of houses = 11.2%
- Vacancy rate of houses owned for over 6 months = 0%
- Average age of inventory = 10 years
- Maintenance costs as a percentage of the rent roll = 10%
- Price per square foot per house after repair costs = $71
- Average time from date of purchase to date tenant living in a house = 6.7 weeks. This compares to Silver Bay that has a repositioning time of 3 - 6 Months.
- Average tenant credit score = 686. Please note all tenants have a ratio of income to rent of over three times. The public firms have not to my knowledge disclosed this figure.
I think the rate of house price appreciation will slow near term. There are a significant number of sellers that are now waking up to the fact that there are many buyers around and are listing their properties. Hence why existing inventory in the US year to date is up 17.5%. This will cool near term some of the regional house price appreciation numbers being produced & further weigh on these stocks.
Additional disclosure: I have spent that last 15 months heavily involved in the Single Family Housing Space, including launching my own partnership as well as meeting many investors and management teams in the space.