In our REIT Rankings series, we analyze REITs within each of the commercial and residential sectors, focusing on property-level fundamentals and the macroeconomic forces driving overall supply and demand conditions. We then analyze REITs based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.
(Co-Produced with Brad Thomas through iREIT on Alpha)
In the Hoya Capital Single-Family Rental REIT Index, we track the three single-family rental REITs (SFRs) which account for roughly $25 billion in market value: Invitation Homes (INVH), American Homes 4 Rent (AMH), and Front Yard Residential (RESI). Single-family rental REITs comprise roughly 2-3% 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 (TCNGF) which also owns a large portfolio of US SFRs.
Single-family rental REITs also 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.
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 quantity and magnitude not seen since the young Boomers began to flock to the suburbs the late 1970s. In their 2019 State of the Nation's Housing report, Harvard University's Joint Center for Housing Studies (JCHS) projects that the number of households in their mid-30s to mid-40s will increase by 2.9 million over the decade, an age cohort that is especially critical to single-family housing demand. Aided by this demographic-driven growth, along with the realization of several millions of "deferred" household formations that were delayed for economic reasons, JCHS projects annual household growth from 2018-2028 at 1.2 million households, which is 20% higher than the prior 5-year average.
This robust demographic-driven demand comes at a time of historically low housing supply. 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 core inflation over the past half-decade, averaging more than 3% per year. Amazingly, the US is building homes at a rate that is less than 50% of the post-1960 average after adjusting for population growth. We continue to believe that the combination of historically low housing supply and strong demographic-driven demand has provided a favorable macroeconomic backdrop for not only single-family rental REITs but of companies involved across the US housing industry over the next decade.
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 that combine both scale and diversification. 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.
Achieving "scale" is far easier said than done. Density within markets is critical for SFR REITs and under the stabilized ownership model, market density is 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 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 over the last two decades.
A theme we'll discuss throughout, we expect the lines between homebuilder and SFR REIT to be increasingly blurred in the next decade these companies develop an internal development channel to fuel external growth. Initially, in a phase we call SFR 1.0, the SFR REIT business model depended on the bulk acquisition of distressed housing assets, and REITs used foreclosures as a primary source of new home acquisition. In SFR 2.0, the business model evolved into a stabilized ownership model, focused on achieving efficiencies and growing via one-off acquisitions in a model similar to the smaller apartment REITs that lack internal development teams. In SFR 3.0, we see SFR REITs mirroring the model of the larger apartment REITs with internal development teams capable of supplementing the acquisition-fueled external growth channels. AMH is leading this next evolution in the business model with their rapidly growing Build to Rent program.
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.
Finally, you can't introduce the single-family rental sector without mentioning the enormous impact of real estate technology in enabling the formation and fueling the future growth of the sector over the next decade. The "prop-tech" industry includes data and technology companies including Zillow (Z), Redfin (RDFN), CoreLogic (CLGX), and RealPage (RP) that have helped to streamline the buying, selling, and managing of real estate properties which have enabled the "institutionalization" of the single-family rental market, which we see as a positive development for both renters and investors alike.
One of the youngest REIT sectors, single-family rental REIT emerged in the wake of the housing crisis and became a full-fledged NAREIT sector beginning in 2015, the same year that data centers garnered recognition as a REIT sector. Following two straight years of strong performance between 2016 and 2017, single-family rentals had a tough year in 2018 as the sector was weighed down by operational struggles and questions surrounding the ability to grow externally given the persistent NAV discounts. The sector dipped 11% last year compared to the 4% decline in the broad-based REIT index.
Amid the broader 'REIT Rejuvenation' which we discussed in our 3Q19 Real Estate Earnings Recap, the SFR sector has returned to its winning ways in 2019. The SFR REIT sector has jumped more than 40% through the first ten months of this year, significantly outperforming the 25% gains in the broader REIT average and the 30% gains in the Hoya Capital Housing Index. This year's gains have been powered by strong fundamental performance as these REITs have reported accelerating rent growth, occupancy levels near record-highs, and turnover rates near record-lows which we'll analyze in more detail below.
After trading in lockstep for most of the past three years, the performance of Invitation Homes and American Homes have diverged this year. Invitation Homes has led the charge in 2019 on the back of superior operating performance with gains of just shy of 50%. American Homes, meanwhile, has gained roughly 33% while the small-cap Front Yard Residential has climbed 24% after a post-earnings dive following 3Q19 results.
Happy residents, happy investors. The strong share price performance of the single-family rental REIT sector has been attributable to solid operational execution by the two stalwarts of the sector, which have generally "beat and raised" throughout the 2019 fiscal year. 3Q19 was another solid quarter with AMH and INVH delivering average same-store revenue growth of 4.2% and NOI growth of 3.5%. Invitation Homes was again the clear standout in the third quarter, as the company boosted full-year NOI guidance a tenth of a percent to 5.4% while both companies boosted full-year same-store revenue growth projections on strong rent growth.
According to NAREIT T-Tracker data for the third quarter, the SFR sector has seen same-store NOI outpace the broader REIT sector by a wide margin on a TTM basis, rising 4.5% compared to the 1.9% growth across the broader REIT sector. 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.
Questions were raised last year after several quarters of soft reported NOI margins and rising expense growth, primarily from property taxes. While 3Q19 was generally another solid quarter of strong revenue growth and ever-lower turnover rates, some of those questions did start to creep back into the conversation on analyst calls as same-store expense growth jumped to 5.3% year-over-year from last quarter's 3.2% rise. Core NOI margins were flat for INVH at just shy of 64% while AMH reported a 90 basis point dip in margins to just shy of 62%. RESI, which is in the final stages of the internalizing process of the property management of their portfolio, reported a "kitchen sink" type of quarter with a 900 basis point decline in Core NOI margins. The SFR business isn't easy, and we think that RESI will see it's fair share of operational hiccups over the next few years.
Leasing trends are the metrics that we watch most closely as forward-looking indicators not only for the SFR REIT sector but also for the housing industry as a whole. Blended rent growth averaged 4.3% year-over-year, rising an average of 5 basis points from already-impressive results in 3Q18, continuing a trend of reacceleration that began in the middle of 2018. As we discussed last quarter, 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. Encouragingly, even RESI reported solid leasing results with 3.9% year-over-year blended rent growth despite an otherwise challenging quarter of transition.
The Zillow ZRI Rent Index shows that single-family rent growth across the nation has bounced back firmly since bottoming in mid-2018 even as home price appreciation continues to cool. Interestingly, while we originally theorized that we'd see a cooling-off in rent growth due to the sharp turn lower in mortgage rates over the past ten months, we have seen continued strength in the rent growth data. The tightening of the spread between single-family rent growth and home price appreciation is welcome news for SFR REITs, as moderating HPA generally helps from both an expense control and an acquisition perspective.
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 key expense line items like property taxes and insurance are linked to property values. As home values outpace rents, attractive acquisition opportunities also become fewer and farther between. REITs were net sellers in 2018 for the first time since the sector emerged earlier this decade. However, as projected last quarter, with an improved cost of capital this year, SFR REITs were net buyers in 3Q19 for the first time since 4Q17. SFR REITs have turned their focus from large portfolio acquisitions to smaller, more precise acquisitions in their existing markets as the focus remains on densification and achieving scale.
Home price appreciation has forced SFR REITs to get creative with external growth plans, and as discussed above, we see the lines between homebuilders (XHB and ITB) and SFR REITs being increasingly blurred over the next decade. AMH continues to push ahead with built-to-rent projects, forecasting up to 2,400 delivers in 2020 from a combination of internal development and partnerships with homebuilders through their National Builders Program. AMH 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. 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.
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 fourth 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.
Based on dividend yield, single-family rental REITs rank at the bottom of the REIT universe, paying an average yield of 1.5%. SFR REITs payout just 35% 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 5.5% but does so by paying out a higher percentage of their available free cash flow.
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.
While we continue to see a very favorable supply/demand dynamics in the single-family rental REIT sector over the next decade, the wild-card will be whether or not these REITs can crack the code to unlock sustainable and accretive external growth. We continue 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. We continued to see real estate technology as the wild-card that could allow the SFR REITs to drive property-level efficiencies and help to fuel external growth via acquisitions. 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.
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.
We continue to believe that the success of the SFR REIT industry is closely intertwined with the growth and success of the real estate technology industry. The "prop-tech" players including Zillow, Redfin, CoreLogic, and RealPage, along with hundreds of smaller start-ups have helped to streamline the buying, selling, and managing of real estate properties which have enabled the "institutionalization" of the single-family rental market, which we see as a positive development for both renters and investors alike.
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