REIT Rankings: Single-Family Rental
In our “REIT Rankings” series, we update readers on one of the 13 real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives
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Single-Family Rental Sector Overview
Single-family rental REITs comprise roughly 3% of the REIT ETFs (VNQ and IYR). Within our market value-weighted single-family rental index, we track the three SFR REITs within the sector, which account for roughly $18 billion in market value: American Homes 4 Rent (AMH), Colony Starwood (SFR), and Invitation Homes (INVH).
Above we show the size, geographical focus, property focus, and quality focus of the three single-family rental REITs we track. SFR REITs currently focus in markets that were hit particularly hard by the housing bubble where they were able to buy distressed properties in bulk from banks. The “quality” is largely a function of the average age of properties within a portfolio (older houses require substantially more initial capex), and property location.
Single-family rental REITs are the youngest REIT sector, 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 site 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.
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 critical to achieving efficiencies in leasing, acquisition, and maintenance. We estimate that 500 to 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.
Ticker symbols have been coming and going within the SFR REIT space faster than anybody can keep up with. Just this past month, Invitation Homes and Starwood announced plans to merge and form the largest SFR REIT. The combined entity will own 80k single family homes and be the second largest residential REIT behind Mid-America Apartment’s portfolio of 100k apartment homes. If the merger between INVH and SFR is approved, there will be two SFR REITs remaining: American Homes and Invitation Homes.
Single-family rentals are nearly half of the total rental housing supply. SFRs have grown from just 10 million units in 2005 to over 16 million units today and could approach 20 million by 2020 based on current trends. Of the 16 million SFR houses, a tiny fraction – just 200,000 – are owned by institutional investors, and 130,000 owned by single-family rental REITs. A highly fragmented market, the average SFR owner manages just 1-2 properties.
(American Homes 4 Rent Investor Presentation)
Recent Developments And Quarterly Performance
Single-family rental REITs have climbed 6% over the past quarter, outperforming the broader REIT average. Over the past two years, SFR REITs have been among the best performers, returning more than 45%.
2Q17 earnings were generally in line with expectations. AMH met expectations while INVH and SFR slightly beat expectations. Across the sector, cash NOI growth averaged 7% and occupancy rose moderately to 96%. On average, full-year 2017 guidance was affirmed. Importantly, core NOI margins improved 170bps and total annual maintenance per unit decreased 1.5% to roughly $2,500. Home price appreciation remains roughly in line with rental growth on the national level, a necessary condition for SFR REITs to offer attractive investment yields.
Obviously, the most notable development over the last quarter was the announced merger between Invitation Homes and Starwood. The merger will be an all-stock merger-of-equals and the combined company will be the second largest residential REIT by total units behind Md-America’s portfolio of 100k apartment units.
The merger is another instance of consolidation within the SFR REIT space, the third REIT-acquiring-REIT merger in as many years. According to the Wall Street Journal, the merger was proposed after Starwood and Invitation Homes competed over the acquisition of homes in California. Starwood Chairman Barry Sternlicht remarked, “Combining is better than competing with each other forever.” The transaction benefits are detailed in the slide below.
As we’ve discussed, density within markets is critical for SFR REITs. Leasing, maintenance, and acquisitions/dispositions require ‘boots on the ground’ and we estimate that 500 to 1,000 units per market are necessary to achieve the operational efficiencies necessary to offer investment yields comparable to apartment REITs and that at least 2,000 are needed to reach a “critical mass” to efficiently centralize operations within a market. This merger was a significant step forward for the combined companies, which will generate 95% of their revenue from markets with 2,000 or more homes.
Compare that to the market density of American Homes 4 Rent, where only 50% of their properties are located in markets with at least 2,000 units. While most of AMH’s markets are above the 500-unit threshold, clearly AMH will have more difficulty achieving the efficiencies of the combined INVH. That said, it’s important to remember that, on average, AMH has younger, higher-quality homes that require less maintenance.
Also, keep in mind that higher density can also leave the firm more exposed to market-specific risks. In keeping with the theme of consolidation, we expect AMH will make strategic acquisitions of smaller private portfolios to improve market density, but will likely remain more geographically diversified than INVH.
Below is our REIT Heat Map, showing the YTD performance in relation to other sectors. We also highlight the strength in the S&P 500 (SPY) gains in the 10-Year Yield (IEF).
Long-Term Thesis And Supply/Demand Dynamics Of Single-Family Rental REITs
More than any other financial market, the financial crisis resulted in massive dislocations within the single-family housing market. Out of this dislocation emerged the institutionalization of the single-family rental market whereby well-capitalized companies, including newly formed public REITs and large private equity firms, purchased distressed properties by the thousands. Between 2009 and 2014, over 150,000 single-family homes were purchased by public REITs and private equity firm Blackstone.
Even after the devastation of the financial crisis, for most Americans, the desire to raise a family in a spacious house in a good school district remains appealing. The willingness or ability to actually own that house, however, is another story. Housing affordability has become a significant issue in recent years as home price appreciation has significantly outpaced income growth and mortgage credit remains out of reach for younger, less credit-worthy applicants.
In a twist of fate, a significant share of the renters in SFR homes are, in fact, former homeowners that were foreclosed on during the crisis. More than half of the foreclosed homeowners ended up moving into a SFR. At 63%, the homeownership rate is near its lowest level in the past 50 years. The homeownership rate in the US is slightly lower than the developed country average of roughly 65-70%.
We identify four primary reasons: lack of affordability, negative attitudes towards homeownership, demographics that are more favorable towards renting, and delaying major life events like marriage and children. We discuss these themes in greater detail regularly in our published research.
We discussed in further detail the trends we see from the millennial generation when it comes to homeownership in “Buy or Rent?” The economics of buying versus owning is unique to each individual’s circumstances, but for most millennials, renting appears to be the better option at these current home price valuations. The value of optionality cannot be overlooked. This large cohort of renters may shift out of multifamily housing into single-family rentals over the next decade.
Critics of SFR REITs question the sustainability of the business model and contend that the institutionalization of SFR was merely a result of a short-term dislocation of the housing market and that further potential growth will be far more difficult. The fundamental issue is that rent is not necessarily tied to home prices. Over the past several decades, we’ve seen times where home price appreciation has exceeded potential rent growth. Much of this appreciation is a direct result of the presence of these massive institutional buyers competing over homes.
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 expenses tend to increase with rising home values, for which the REIT would be on the hook. For other REIT sectors, this is less of an issue: as asset value rises, even if cash flow projections stay the same, investors are willing to value the firm at higher multiples based on higher levels of Net Asset Value.
Ultimately, it is our belief that, over the long term, home price appreciation should moderate to levels in line with inflation plus a risk premium, which will be roughly in line with rental growth. Under this assumption, the business model is not substantially different than multifamily REIT operators.
Our analysis of SFR REITs has shown that gross margins and capex are actually similar between multifamily and single-family REITs when they have been able to reach “critical mass” in specific markets. Critical mass appears to be around 2,000 units per market, which allows the REIT to internalize leasing, renovation, and maintenance operations.
Therefore, beneath the boom-bust cycles, the viability of the SFR REIT model is really an issue of operational efficiency: Can large portfolios of individual homes be managed efficiently? Do large institutional owners have a competitive advantage over smaller private owners? Is economic value created by the existence of these companies? For other REIT sectors, the answer has been a resounding “yes.” The young SFR REIT sector still has to prove its worth, but this past year has given investors more confidence that this REIT sector is here for the long term.
Valuation Of Single-Family Rental REITs
Relative to other REIT sectors, single-family rental REITs appear moderately expensive based on current and forward free cash flows. When factoring in the growth potential of the sector, SFR REITs appear more attractive.
SFR and INVH have significantly outperformed AMH over the past quarter. AMH now appears more attractively valued relative to the two combining REITs.
Sensitivities To Equities And Interest Rates
The single-family rental REITs are among the most equity-like REIT sectors. The sector is the second least sensitive to interest rates, and the most sensitive to movements in the equity markets.
We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. (click to read more information about our methodology). As a sector, Single-Family Rental REITs are Growth REITs, a function of their high growth rates, low interest rate risk, and low income yields.
Within the sector, we classify the three names as either Yield, Growth, or Hybrid REITs based on our calculations. All three REITs are Growth REITs, which means these REITs should be relatively immune from movements in interest rates, but are more exposed to broader economic growth conditions.
Dividend Yield And Payout Ratio
Based on dividend yield, single-family rental REITs rank at the bottom of the REIT universe, paying an average yield of 1.4%. Single-family rental 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.
Just months after Blackstone’s massive IPO of Invitation Homes, and two years after Starwood’s merger with Colony, the two mega-sized landlords plan to unite. The combined company will own 80k homes and be the second largest residential REIT by total units. We believe the move makes strategic sense; market density is essential for SFRs. Scale and focus in specific markets have allowed these REITs to keep capex and maintenance costs in check. Investors have applauded these REITs’ focus on reaching a critical mass.
2Q17 earnings were generally in-line with expectations. AMH met expectations while INVH and SFR slightly beat. Across the sector, cash NOI growth averaged 7% and occupancy rose moderately to 96%. Importantly, core NOI margins improved 170bps and total annual maintenance per unit decreased 1.5% to roughly $2,500. Home price appreciation remains roughly in line with rental growth on the national level, a necessary condition for SFR REITs to offer attractive investment yields.
Critics, though, have questioned the sustainability of the business model, particularly if home price appreciation outpaces potential rent growth. Single-family homes have historically exhibited irrationally low ‘cap rates.’ Investors considering SFR REITs have a lot to consider. Institutionalization of single-family rentals, on the scale that it exists today, has existed for less than a decade.
Other REIT sectors, all of which operated before, during, and after the financial crisis, have shown resilience through a full real estate cycle. SFR REITs are essentially writing their own rules as the industry matures, getting cues from investors and the broader market as to what works and what does not.
The rate of homeownership in the United States remains near multi-decade lows. Demographics, affordability, and attitudes towards ownership continue to suggest that the “American Dream” no longer requires homeownership. The institutionalization of the single-family rental market has coincided with the decline in homeownership. SFR REITs emerged from the market dislocations that occurred during the financial crisis.
Technology and productivity are the wild cards that may determine the fate of the institutional SFR industry. Logistically, managing portfolios of thousands of SFR homes was impossible less than a decade ago. If SFR REITs can continue to harness and develop cost-saving technologies that streamline the acquisition, disposition, leasing, maintenance processes, and be leaders in this field, we expect the SFR business to not only be sustainable, but for the SFR REIT model to exhibit a competitive advantage over smaller private equity players in the space.
We aggregate our rankings into a single metric below, the Hoya Capital REIT Rank. We assume that the investor is seeking to maximize total return (rather than income yield) and has a medium to long-term time horizon. Valuation, growth, NAV discounts/premiums, leverage, and long-term operating performance are all considered within the ranking. We view AMH as the most attractively valued REIT in the SFR sector.
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Disclosure: I am/we are long VNQ, SPY, MAA, CPT, CCP, OHI, PLD, GGP, TCO, PEI, STOR, SHO, SUI, ELS, ACC, EDR, DLR, COR, REG, CUBE, PSA, EXR, BXP.
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