- Some RE pros question the viability of the single-family rental business, but tight mortgage underwriting standards and low savings rates should sustain rental demand and a role for SFR REITs.
- SFR REITs are boosting profits by fine tuning their operating policies and practices and gaining greater scale in metro markets.
- SFR REIT valuations currently anticipate profit growth, but further gains in occupancy, operating refinements, modest house price appreciation (HPA) and steady new household formations should eventually raise profit outlooks.
Launched after the collapse of the housing and mortgage markets, the business of single-family house rentals is now well off the ground and nearing cruising speed and altitude. By some estimates, the handful of new publicly-traded firms, offshoots of larger financial firms and institutional investors who participate in the industry have purchased nearly 400,000 homes over the past five years. The opportunity arose because banks and the housing market could not cope with the flood of foreclosures. Those investors who stepped up early were able to buy at bargain prices, making it profitable to rent out houses and perhaps sell at a profit later, after the rebound in house prices.
Traditionally, it has not been easy to make money in this business. Although the universe of residential rental properties is large - by some estimates, 14 million units - it is dominated by small investors and individuals and small scale investors, many of whom hold properties that they inherited or left behind in a move-up. This presents both opportunity and challenges for SFR REITs. On the one hand, professional management and the application of technology should give SFR REITs an edge. On the other, mom-and-pops may be motivated by factors other than making a profit in their leasing decisions, which could hamper rental rate increases.
It does not take a genius to recognize that it is tougher to manage a portfolio of scattered single-family properties than a single apartment complex. Consequently, skepticism has been voiced about the viability of this business. But time will tell: Either these new businesses will take root and grow or they will end up liquidating their portfolios. While conceding that the business is operationally intensive, industry insiders seem more confident about the business's long-term potential.
The following financial model for a single residential investment should help to illustrate both the opportunities and challenges associated with investing in this sector:
In this example, a REIT pays $150,000 for a single-family property that is 15 years old with 3 bedrooms, 2 baths and 2,000 sq. ft of living space. Half of the purchase price is borrowed (at a current assumed rate of 3.5%). It receives rental income of $1,150 per month ($13,800 per year). Direct operating costs, including O&M, real estate taxes and homeowner association fees are estimated at $500 per month ($6,000 per year). Real estate taxes are $1,800 per year and homeowners' fees are $300. The property generates $650 in net operating income per month or $7,800 per year. The net yield on the property, calculated as net operating income divided by the purchase price, is 5.2%.
After deducting administrative (i.e. overhead) costs and interest expense, the net profit is $351 per month ($4,212 per year). In this example, net profit is effectively equivalent to funds from operations (FFO), a commonly used measure of REIT performance. A REIT pays no taxes and is required to distribute 90% of its REIT taxable income in order to maintain its REIT status. In this simplified model, the return on equity of 5.6%, calculated on the assumed equity investment of $75,000, is therefore a good approximation for the REIT's dividend yield.
This example was derived from REITs whose occupancy rates are currently in the low 80s, below the normalized level of around 92%. (It usually takes six months or so to buy, renovate and lease a single-family house.) Since the REIT in this example carries a higher-than-normalized number of vacant homes, the expense line items are higher on a per leased house basis. They should therefore decline as occupancy improves. The REIT's net profit margin and return on equity should likewise increase modestly over time (until the REIT achieves normalized occupancy levels, perhaps a year or so after it stops acquiring properties).
Yet, the assumed expense levels in this model offer no insight into the quality of operating and maintenance services, including whether this REIT is spending enough on maintenance. This property may be in good shape, but maybe not.
As with all REITs, this FFO-centric model does not take into account maintenance capital expenditures for big ticket items, such as re-roofing or replacing an HVAC system. Depreciation expense provides an estimate of such costs, but it is not included here (or in the standard definition of FFO). Assuming that $50,000 of the house's $150,000 purchase price represents the cost of the land and an estimated useful life of 30 years (with a $30,000 salvage value), the depreciable property base would be $70,000 and depreciation expense would be $194 per month or $2,333 per year.
If this estimate of maintenance capital expenditures were incorporated into the model, investment returns would obviously be lower. Still, it can be argued that by sprucing up this property early on, expected maintenance costs ought to be low for at least a few years. Straight line depreciation rates may also overstate future expenses because a significant portion of the structure often lasts well beyond 30 years. Furthermore, the model does not take into account the benefit of higher occupancy rates in reducing per leased unit costs (as noted above) or the potential profit increase from raising rent, both of which might offset some of expected future maintenance capital expenditures.
SFR REITs seek to overcome their operating disadvantages (vis-à-vis apartments) in several ways: First, they try to minimize operating costs wherever possible. One SFR REIT executive recently referred to this as an effort to save nickels and dimes. Constant attention to other details of the business, including (1) buying the right houses in the right locations at the right prices, (2) making cost effective renovations (i.e. those that reduce future maintenance expenses) and (3) finding tenants who pay their rent on time, take care of the property and stay a long time, are all important.
Another way to overcome the structural cost disadvantage of the business is to gain sufficient scale within each metropolitan area served. Most SFR REITs say that it is necessary to own at least 250 properties in a single MSA and preferably 500. Ideally, 1,000 units per market provides sufficient operating scale to allow SFR REITs to reduce costs (and, they say, improve quality) by bringing key business functions, like leasing and maintenance, in house and relying less on third-party subcontractors. Greater scale within each MSA also helps to keep per unit administrative costs low.
Besides the financial parameters, SFR REITs maintain profiles for both the houses that they acquire and the tenants that they seek. They tend to focus on lower-priced homes (in the $100,000-$200,000 range) with at least three bedrooms and two bathrooms. Ideally, these homes are located in master-planned communities, with good schools and low crime rates, near public transportation and employment centers.
Tenants must be at least 18 years of age, with gross monthly income of at least 2.5 times the monthly rent payment. By policy, tenant households are usually limited to two people per bedroom and no more than three pets (no alligators, please!) The REITs also verify employment and income and check criminal records, credit reports and rental histories. This information can affect the size of the security deposit. Some SFR REITs also require tenants to maintain a minimum level of renters insurance.
Under this income qualification policy, using the above example of an average monthly rental payment of $1,150 (or $13,800 per year), the required annual household gross income is $34,500. This is well below the U.S. median household income of around $52,000. The average single-family rental home offered by these REITs is affordable.
But turnover can be high. At these income levels, workers are more vulnerable to layoffs in tough economic times. Lower income households are also more prone to life changing events, such as separation and divorce or family expansion. Although the REITs want their tenants to become attached to the local communities and school systems, many tenants see these houses as a temporary stop on the path to home ownership and a bigger and more expensive home.
Thus, turnover rates are typically 30% (equivalent to an average stay of 3 years). Since SFR REITs spend $2,000 to $3,000 to spruce up a property for new tenants, minimizing turnover has a big bottom line benefit. (I am somewhat surprised that I have not yet found an SFR REITs that offers "rent-to-own" programs, where a portion of each rental payment is credited to a negotiated purchase price.)
Besides minimizing turnover, managing maintenance expense, as already noted, is a key determinant of profitability. SFR REITs require renters to take care of basic maintenance chores, such as mowing the lawn. Landlords are responsible for normal maintenance items and repairs; but tenants are responsible for any damages that they themselves cause. Minimizing the number of minor repairs through cost effective scheduling can have a big impact on profit margins and customer satisfaction.
House price appreciation (HPA): the other side of the coin. Besides the annual income from managing the properties, SFR REITS also benefit from HPA, which raises their net asset values. In 2013, home prices increased about 13.4% on average, according to the Case-Shiller 20-City Composite. In the states where SFR REITs are especially active, HPA was higher out west, with California at 18%-20%, Phoenix at 15.3% and Las Vegas at 25.5%. It was also strong in Florida, up around 16% and Atlanta, Georgia, up 18.1%.
SFR REITs realized average price appreciation of around 5% in 2013. This makes sense, because their portfolios grew rapidly in 2013. (So, for example, a property bought in June 2013 would have realized half of the year's price appreciation.)
So far in 2014, through April, the pace of house price appreciation has slowed. The Case-Shiller 20-City Composite was up 1.9%. This is not surprising, given the increase in mortgage rates off of the early 2013 lows. A more modest HPA rate of say 3%-4% is healthier for the housing market in the long run.
HPA can be a two-edged sword. If a REIT chooses to cash in, it loses the income from the property. But it can also reinvest the sales proceeds in new properties that may have greater upside potential. However, if house prices rise too fast, it may be difficult to invest house sales proceeds into new properties at equivalent net yields. Earlier this year, both Blackstone's Invitation Homes division and Silver Bay Realty Trust (NYSE:SBY) said that they would slow their purchases of homes because it had become more difficult to find houses that meet their investment hurdle rates.
Industry consolidation should drive SFR REIT growth. The SFR REITs are also positioned to benefit from industry consolidation and the desire of institutional investors who bought in several years ago to cash out. Bulk property purchases at fair prices (i.e. at a justifiable discount to current market values) are the quickest and most efficient way for SFR REITs to scale up their operations.
SFR Securitizations: A New Asset Class. Blackstone's (NYSE:BX) Invitation Homes division was the first to complete a securitization (Invitation Homes 2013 SFR1) backed by "REO-to-Rental" (aka single-family rental) properties. In November 2013, it sold $479 million of securitized bonds through Deutsche Bank. The top five tranches, totaling $437.6 million or 91.3% of the entire issue, were rated investment grade by Kroll Bond Rating Agency, Morningstar and Moody's. The first and largest tranche of $278.7 million, 58.2% of the issue size, was rated "Aaa."
The credit ratings agencies approached this transaction cautiously. The SFR REITs argued that an AAA-rating was justified because there was a substantial built-in cushion that ensured that bondholders would be paid by selling properties at a discount, if tenants defaulted on their rent payments. Fitch acknowledged the plausibility of that response, but said it was not "AAA" certain. Its top rating on SFR securitizations would be "A-." Fitch's view prevailed until the deal was restructured into a conduit, a move that strengthened the security claims of investors. This persuaded Moody's, Kroll and Morningstar to give the securitization the Aaa-rating.
Despite the controversy, the financing was oversubscribed. The AAA-tranche was priced attractively (for the issuer) at 115 basis points.
Invitation Homes 2013 SFR1 was backed by 3,207 properties having a net book value (i.e. purchase price plus upgrade costs) of $542.8 million and an estimated fair market value of $638.8 million. This gave the securitization an effective loan-to-value, based upon the fair market value of the property, of 75%. Surprisingly, this was modestly higher than the average 70% LTVs on conventional mortgage securitizations.
In early April 2014, Colony American Homes, the SFR division of Colony Financial (NYSE:CLNY), completed a $513.6 million securitization backed by 3,399 properties. Average pricing on the transaction LIBOR plus 178 basis points.
In late May 2014, Invitation Home came to market with its second securitization, Invitation Homes 2014 SFR1. This time, it raised $993 million securitized by 6,537 properties. The top four tranches, totaling $801.8 million or 80.75% of the offering, were investment grade-rated. The top Aaa-rated tranche was $483.4 million in size or 48.7% of the total issue. Pricing ranged from LIBOR + 100 bp for the top tranche to LIBOR +260 bp for the Baa2-rated tranche.
Also in late May, American Homes 4 Rent (NYSE:AMH) completed its first SFR securitization, selling $481 million of bonds backed by 3,852 homes. The Aaa-rated Class A tranche was $269.4 million or roughly 56% of the total offering. The three other investment grade tranches, collectively $116.9 million or 24% of the total, were rated "Aa2" to "Baa2." The remaining 20% of the issue, or $95 million, was unrated. The duration-weighted average rate on the securitization LIBOR plus 154 basis points. Underwriters for the transaction were led by Goldman Sachs.
In mid-June, Colony American Homes completed its second SFR securitization. This time, it issued $558.5 million of securities backed by 3,727 homes. Its average pricing on the debt offering was LIBOR plus 164 basis points.
More of these transactions will be coming in the months ahead. American Residential Properties (NYSE:ARPI) is reportedly readying an offering of $300 million. Starwood Waypoint Properties Trust (NYSE:SWAY) has said it will come to market with its own securitization in the fall.
Deutsche Bank, the leading underwriter in this new asset class, said earlier this year that SFR securitizations could total as much as $5 billion in 2014. So far in 2014, $2.5 billion of SFR securitizations have been sold. With higher advance rates and better pricing on debt that is non-recourse, securitizations are clearly a better deal for SFR REITs than bank financing.
There should be no illusions about the risk of potential price fluctuations on top Aaa-rated tranches in SFR securitizations. Those rating agencies that have granted Aaa-ratings on this paper have noted that there is no historical experience on cash flows for this asset class upon which they can base their ratings. Their Aaa assessments are therefore driven mostly by low LTVs (less than 40%). Given that many of the properties collateralizing this debt were purchased at discounted prices, the very low LTVs should provide adequate collateral coverage under almost any downside scenario. However, in extreme circumstances, such as a severe economic downturn, bondholders may have to wait to get paid. These AAA-rated securitizations should be a good hedge against the risk of both a sharp economic downturn and a spike in interest rates; but investors must be able to be patient and wait to get paid, if required to do so.
SFR REIT Year-to-Date Stock Price Performance
There has been a material divergence in performance so far this year among the five publicly-traded SFR REITs. Shares of Colony Financial (CLNY), which is a diversified financial REIT, American Residential Properties (ARPI) and American Homes 4 Rent (AMH) delivered returns of 10%-19% through June 27, which is roughly in line with the Dow Jones U.S. REIT Index's 14.5% return and better than the Dow Jones U.S. Total Market Index's 6.1% return. Silver Bay (SBY) and Starwood Waypoint Properties Trust (SWAY) have both underperformed the market, with returns of +2.0% and -7.7%, respectively.
Average forward valuation multiples for the publicly-traded single-family rental REITs do not look especially cheap at this time, but this is because they are all still in early development. It is noteworthy that on average, consensus estimates anticipate that these REITs will be profitable going forward (on an FFO basis) and that their earnings are expected to grow rapidly in 2015. Earnings growth expectations are more modest for Colony Financial (CLNY), which operates in more established financial segments. At this stage, the share prices of SFR REIT stocks are anchored by their equity book values. Forward earnings multiples are high, because earnings are expected to grow rapidly, as lease rates normalize, until the SFR REITs begin to pay dividends at rates consistent with equity REIT norms.
Tight mortgage underwriting standards and the difficulty that many potential home buyers saving for a down payment support the SFR REIT sector's viability. Over time, I think that three or four of these REITs will grow to dominate the industry, managing many more properties than they do now. The sector's performance will of course be affected by economic developments and changes in interest rates, so there will be ups and downs going forward. Investment opportunities may vary over time, but should always be present. As long as the U.S. economic recovery continues, interest rates rise at a measured pace (and do not spike higher) and mortgage underwriting standards are not loosened appreciably, this should be a good time to invest in SFR REITs.