In our REIT Rankings series, we introduce and update readers each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.
In the Hoya Capital Single-Family Rental REIT Index, we track the three single-family rental REITs (SFR) which account for roughly $24 billion in market value: American Homes 4 Rent (AHM), Invitation Homes (INVH), and Front Yard Residential (RESI). Single-family rental REITs comprise roughly 2-4% of the broad-based real estate ETFs (VNQ and SCHH). Not included in our index is micro-cap Raven Housing (RVEN) and Canadian firm Tricon Capital which also owns a large portfolio of US SFRs.
Single-family rental REITs are one of the youngest REIT sectors, emerging in the wake of the housing crisis. As home prices plummeted, large private investors purchased distressed homes and non-performing loans by the thousands, often sight-unseen from other financial institutions and foreclosure auctions. Through spin-offs and IPOs, a handful of these portfolios were spun into REITs, beginning with AMH in 2013. Initially, the business model depended on the continual acquisition and sale of distressed housing assets, and REITs used foreclosures as a primary source of new home acquisition. The business model ultimately evolved into a stabilized ownership model more akin to typical apartment REITs. AMH is leading the next evolution in the business model, in which the lines between homebuilder and single-family renter operator begin to get blurred: the in-house and external development of new "build-for-rent" homes.
Despite the challenges of maintaining and managing a portfolio of unique single-unit properties spread across a wide geographical area, single-family rental NOI margins are only slightly below the typical apartment REIT. At scale, typical operating margins for SFR REITs are around 65% compared to an average of around 70% for apartment REITs. SFR REITs generally spend more on maintenance and turnover costs but do not have to incur common area expenses, which average around 20% at apartment REITs. A topic that we'll discuss more below, property taxes are the single largest (and growing) expense item for SFR REITs, reflecting the relatively unequal tax burden shared by renters and owners.
The roughly $5 trillion US single-family rental (SFR) market is highly fragmented, with REITs owning roughly 150,000 of the estimated 15 million SFR rental units across the US, which is roughly 1% of the existing SFR stock. SFR REITs focus on markets that have experienced the strongest economic growth during this recovery, most notably in the Sunbelt and western regions. Many of these markets were hit particularly hard by the housing bubble, which allowed institutional investors to buy distressed properties in bulk. The key evolution in the SFR business over the last several years - and a trend that we expect to continue - has been the focus on achieving market-level scale and density rather than broader geographic diversification. The two major SFR REITs are among the only institutional operators that hold portfolios which combine both scale and diversification.
Achieving "scale" is far easier said than done, however. Density within markets is critical for SFR REITs. The industry has experienced a continuous wave of IPOs and consolidations over the past three years as these REITs recognized that, with the stabilized ownership model, market density was essential to achieving efficiencies in leasing, acquisition, and maintenance. We estimate that 500-1,000 units per market are needed to achieve minimum scale, but that 2,000 units or more are needed to reach a "critical mass" whereby the REIT can localize operations within that market and achieve cost efficiencies on par with apartment REITs. INVH owns nearly 5,000 homes per market, while AMH owns 2,000 per market. Single-family rental REITs SFR REITs own a mix of affordable and middle-tier homes, generally, in this "starter home" category that has seen the most limited amount of new home construction given the poor economics for homebuilders.
To that point, over the last decade, the single-family rental market has become the de-facto “starter home” as rising home values, lack of housing supply, and tight credit conditions have made homeownership a mounting challenge. A theme that we discuss extensively in our research, new home construction - particularly in the single-family category - has been historically depressed over the last decade. This underbuilding has resulted in persistent housing inflation, manifesting in significantly higher rents and home values. Remarkably, housing inflation (CPI: Shelter) has accounted for roughly half of total core inflation over the past half-decade, averaging more than 3% per year. A shortage primarily rooted in sub-optimal public policy at the local, regional, and national levels, the US is building homes at a rate that is less than 50% of the post-1960 average after adjusting for population growth.
A highly fragmented market, the average SFR owner manages just 1-2 properties. Relative to apartment markets, this fragmentation makes it more difficult to acquire a substantial number of units to achieve scale. That said, there are several dozen institutional-quality portfolios and, considering the importance of scale, we expect continued consolidation among these portfolios and could see one or more additional portfolios covert into publicly-traded REITs over the next several years. Three of the five largest SFR portfolios are operated as publicly-traded REITs.
Single-Family Rental REITs comprise roughly 3% of the Hoya Capital Housing 100 Index, which tracks the GDP-weighted performance of the US Housing Industry. Americans spend an estimated $1.3 trillion per year in direct and imputed rent, accounting for roughly 30% of the $3.5 trillion per year spent on an annual basis on housing, home construction, and housing-related services at the GDP level. Housing is the single-largest annual expenditure category for the average American at roughly 33% as measured by the Bureau of Labor Statistics. Because of the high percentage of housing assets held in the private markets, indexes weighted based on market capitalization like the S&P 500 (SPY) are significantly underweight the residential housing industry relative to their importance to overall spending at the GDP level.
SFR REITs have surged more than 35% so far in 2019 as rent growth has reaccelerated, driving strong revenue and NOI growth through the first half of the year. Blended rent growth averaged 5.1% year-over-year, rising an average of 25 basis points from already-impressive results in 2Q18, continuing a reacceleration that began in the middle of 2018. The relative "ease" at which SFR REITs have been able to push rent growth has been most impressive, highlighted by a continued rise in average occupancy during the period and another quarter of record-low turnover. Invitation Homes was the clear standout in the second quarter as some of the cost-related issues that troubled the sector last year started to creep back up in American Homes' results.
Riding the bullish trends we discussed above regarding persistent housing inflation, residential REITs as a whole have significantly outperformed the REIT average during the post-recession period. Within the residential category, SFR fundamentals continue to be among the strongest in the REIT sector as rising home values, limited supply, and robust demand has produced rent and NOI growth near the top of the REIT sector. According to NAREIT T-Tracker data for the second quarter, the SFR sector has seen same-store NOI outpace the broader REIT sector by a wide margin on a TTM basis, rising 5.3% compared to the 2.6% growth across the broader REIT sector.
A trend that we also highlighted in our recent update on the multifamily sector, Apartment REITs: Roaring Rents, a “perfect storm” of factors - rising wages, solid job growth, elevated mortgage rates last year, and lack of total housing supply - has rejuvenated the residential rental markets. The Zillow ZRI Rent Index shows that rent growth in both the single-family and multifamily category jumped to the highest rate since 2016 despite moderating home price appreciation. Over time, home prices and rents do exhibit a high correlation and we expect to see rent growth close the gap on home price appreciation over the next several years.
On that point, critics of the SFR sector point out that rent growth has historically lagged home price appreciation, which, over time, erodes investment returns. As home values outpace rents, attractive acquisition opportunities become fewer and farther between. REITs were net sellers in 2018 for the first time since the sector emerged earlier this decade. SFR REITs have turned their focus from large portfolio acquisitions to smaller, more precise acquisitions in their existing markets. With an improved cost of capital this year, we expect SFR REIT acquisition activity to increase, but believe that the activity will be focused on densification within their existing markets.
Home price appreciation has forced SFR REITs to get creative with external growth plans. AMH continues to push ahead with built-to-rent projects using internal development pipelines and partnerships with homebuilders (XHB and ITB). It sees 100 bps higher all-in yields from in-house development and 50 bps in incremental yield from built-for-rent purchases from homebuilders. We continue to note the trend of "built-to-rent" as a growing share of total housing starts. We've noted in the past the emergence of entire built-to-rent homebuilding communities, and see the lines between homebuilders and single-family rental operators as beginning to get blurred. For now, we think homebuilders and SFR REITs have a synergistic relationship and foresee more build-to-rent partnership deals between builders and SFR operators.
Forward guidance was generally better than expected, with Invitation Homes raising its full-year NOI estimates by a robust 80 basis points from 4.5% at the midpoint to 5.3% on both higher revenue and lower expense growth expectations. Same-store revenue and NOI growth are expected to rise by more than 4% this year while AMH and INVH forecast an 8% average rise in Core FFO growth for the full year. RESI is still a few quarters away from being able to offer comparable metrics given the firm's recent shift to a fully internally managed and owned SFR REIT.
However, cost concerns – particularly rising property taxes– have again become a concern in the second quarter as both REITs reported a surprising jump in property tax expense growth and an unwelcome rise in the "cost to maintain" metrics. Core NOI margins improved for INVH to above 65%, but margins were disappointing for AMH and were particularly poor for RESI. The average annualized cost to maintain rose 6% on a year-over-year basis in the second quarter. Helping to keep rising costs in-check, however, are ever-lower turnover rates, a reflection of tight rental conditions but also likely a result of strong renter satisfaction.
Again, the focus for most investors remains on efficiency metrics, which had seemingly stalled out in mid-2018 after several years of solid improvement, but were improving for several quarters before 2Q19. While not a huge concern at this point given that the trend has generally been positive, investors will be watching these metrics more closely in the next quarter. Core NOI margins and overhead metrics have been trending in the right direction as the sector has matured over the last half-decade.
We think it's reasonable to see NOI margins stabilize in the upper 60%-range, depending largely on the future growth rate in property taxes. On the 2Q19 earnings call, INVH noted that it expects property taxes to "grow higher than inflation...but not at the rates that we have seen in the last couple of years as home price appreciation has been so strong." We're actually a bit more bullish on the future path of single-family property taxes, as we believe that the changes associated with the tax reform package in 2017 may result in a shifting of property tax burden slightly away from the single-family markets and towards the multifamily markets due to the cap on state and local tax deductions (SALT) which has already significantly increased the tax burden on many single-family homeowners in coastal markets.
Whether they’re renting or owning, the maturing millennial generation will enter the single-family housing markets in full-force in the 2020s in a magnitude not seen since the 1970s. The bullish case for the single-family rental sector is perhaps best summarized by INVH's Dallas Turner on the 2Q19 earnings call:
The facts around industry dynamics in our value proposition are simple: Household formation in our markets is robust, supply is limited and home price appreciation continues to outpace inflation. In a market where attractive housing options can be difficult to find, we offer a solution that allows residents to live in high quality homes in desirable neighborhoods at a fair price.... Over 65 million people or one-fifth of the US population is aged 22 to 34 years and we believe many in this cohort could choose the single-family leasing lifestyle as they form families and age toward Invitation Homes average resident age of 39 years.
A number of structural impediments to supply growth, including restrictive zoning, rising construction costs relative to home prices, and lingering dislocations caused by the financial crisis, have resulted in an extremely slow recovery in new home construction and, more broadly, residential fixed investment as a whole (existing and new homes). As noted above, amid the lingering housing shortage, long-term SFR fundamentals remain highly favorable. On a rolling ten-year average, housing starts as a percent of the population and residential fixed investment as a share of GDP are both at or near historic lows dating back to the 1950s. As a result, housing markets remain historically tight as the vacancy rate for both rental and owner-occupied units remains at or near historic lows, putting continued upward pressure on rents and home values.
Additionally, we to believe that the two large SFR REITs are uniquely positioned to benefit from the broader trend of institutionalization within the single-family housing industry - a trend that we believe is in the very early innings. In a business where analysts question whether 50,000 homes constitutes “sufficient scale” for profitability, we question the viability of “iBuying” firms and funds focusing on one-off acquisitions and home flipping, which we see as a very capital-intensive and low-margin business. Below, we outline the primary reasons that investors are bullish on the SFR REIT sector.
However, critics continue to question the long-term viability of the REIT model for SFR ownership, particularly if home price appreciation continues to outpace rental revenues. Homeownership incentives and favorable attitudes towards direct investing in residential real estate as a long-term store of value can result in inflated valuations of single-family homes relative to its implied rental value. This can create a problematic situation for SFR REITs: Future acquisitions become less accretive as REITs are forced to pay higher prices for the same cash flow. Meanwhile, property taxes and other expense items are generally tied to rising home values. Since 2015, home price appreciation has significantly outpaced single-family rent growth.
It remains to be seen whether SFR REITs can continue to grow accretively given the potential persistent NAV discount and lack of distressed homes for purchase. In early 2018, supposedly "one-off" surprises to expense growth and total maintenance cap-ex costs appeared with greater frequency than many investors would like, further impairing valuations for much of the year. For now, unlike most other REIT sectors that have shown resilience through both boom and bust times, the investment thesis of SFRs owned through a REIT model is still unproven through a full business cycle. Below, we discuss the five reasons that investors are bearish on the SFR sector.
Following two straight years of strong performance between 2016 and 2017, single-family rentals had a tough year in 2018 before returning to their winning ways through the first eight months of 2019. Weighed down by operational struggles and questions surrounding the ability to grow externally given the persistent NAV discounts, the sector dipped 11% last year - the fourth worst-performing REIT sector.
Amid a broader 'REIT Rejuvenation,' the SFR sector has bounced back strongly in 2019 on strong earnings results and solid economic data showing, among other things, that household formations and income growth remain robust. SFR REITs outperformed the REIT average as well as the broader US housing sector, as measured by the Hoya Capital US Housing Index, which has climbed by 23% this year, led by the homebuilding and residential REIT sectors.
After trading in lockstep for most of the past three years, the performance of Invitation Homes and American Homes have diverged this year. For the reasons discussed above, INVH has strongly outpaced AMH over the past quarter and since the start of the year. Until weak results this past quarter, Front Yard Residential was running neck-and-neck with Invitation Homes, but has fallen off the pace during this earnings season.
Relative to other REIT sectors, single-family rental REITs appear moderately expensive based on Free Cash Flow (aka AFFO, FAD, CAD), but more attractive after factoring in forward-growth expectations. Now powered by data from the iREIT Terminal, we illustrate that SFR REITs are the fifth most "expensive" REIT sector based on Free Cash Flow. Over the past half-decade, however, REIT investors have been rewarded for "paying-up" for more expensive sectors as "cheaper" and higher-yielding sectors have generally underperformed. As it has for most of the past several years, the sector continues to trade at a persistent discount to NAV, though this discount has shrunk to a range of 0-10% across consensus estimates.
Based on dividend yield, single-family rental REITs rank at the bottom of the REIT universe, paying an average yield of 1.4%. SFR REITs pay out just 55% of their available cash flow, so these firms have greater potential for dividend growth and reinvestment than other sectors.
As these REITs mature, we expect their payout ratios to rise to levels in line with other REIT sectors. Front Yard Residential Corp. is currently the highest-yielding REIT in the sector, paying a forward yield of 5.4%, but does so by paying out a higher percentage of their available free cash flow.
Whether they’re renting or owning, the maturing millennial generation will enter the single-family housing markets in full-force in the 2020s in a magnitude not seen since the 1970s. Over the last decade, single-family rentals have become the de-facto “starter home” as rising home values and tight credit conditions have made homeownership a growing challenge.
A record-high share of new construction is being built specifically for renting. The lines between homebuilder and single-family renter operator are getting increasingly fuzzy. Single-family renting is a tough, capital-intensive, and low-yield business. Through market-level scale and operating efficiency, however, single-family rental REITs have cracked the code to profitably manage rental homes.
Ultimately, the 2010s will be remembered as a decade of historic underbuilding. Despite a US population nearly double the size of the 1960s, we produced 30% fewer housing units this decade. The implications of this housing shortage, we believe, will be a continued persistence of "real" housing cost inflation (rent growth) and a long runway for steady growth in residential housing construction. Until the shortage is equalized with more supply, we remain bullish on the residential REIT sectors, particularly the single-family rental operators as more Americans choose to "rent the American Dream."
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