August 23, 2016
The Family Office Alpha Report by Witherspoon Partners July Aug 2016
Being Single Can Have Its Benefits: Opportunities in Residential Real Estate
By Phoebe Outerbridge & Keith Danko
“I would say that housing came back very late after the panic in 2008 and ‘09… it has showed continuing growth and momentum. That continues to this day. Household formations fall off a lot in recessions. People double up and move in with their in-laws, but eventually hormones win out. [laughter]”
In a recent interview, Warren Buffet shared this outlook on housing. But where does the most value lie in residential real estate these days? Multifamily has been providing strong value for investors for several years, and there are indicators that support this play: vacancy rates are still below historical averages, achieving an operational scale is faster with one apartment building versus many homes to rehab and maintain, and in major metropolitan areas there is still ample supply.
Multifamily housing starts have skyrocketed in the last five years, but this may be catching up to both builders and renters. Surveys also point to millennials shifting away from apartments in favor of single-family housing, in line with labor markets tightening and moderately increasing wages for this cohort. As young people start families, they also tend to opt for more bedrooms which a home is more likely to provide than an apartment.Warren Buffet acknowledged “good housing statistics” in his interview, noting a transition away from apartment development and a strengthening of the single-family market. The logic is simple, starting with basic numbers: There are roughly 117 million occupied housing units in the US: 80 million single-family, 30 million multifamily (2+ units), and 7 million others. Ten years ago an oversupply of single-family homes paired with the collapse in housing demand set the stage for the housing crisis; post-crisis foreclosures and tightened lending practices in turn contributed to lower home prices, which have been recovering at a slower pace than multifamily/apartments.
Household Formation Brings Subtle Transformation
The rate of homeownership has been in decline since 2006 and according to the US Census Bureau is now at a 50-year low. At the same time, household formation is starting to outpace the housing supply. American households are opting for single-family homes—but as renters, not buyers. To wit: 61% of the 6.1 million net increase in single-family housing stock between 2005 and 2013 was comprised of rental units. For investors, these homes represent undervalued assets ripe for the picking.
There is a huge opening for institutional investors to acquire single-family homes, especially in secondary and tertiary markets of the US where home prices are more affordable than they are in the gateway cities, and to convert these homes to rental properties. Institutional investors or aggregators are able to manage the efficiencies and have the necessary expertise to source, purchase, renovate and manage multiple homes. Mom and pop buyers can face higher risks, including slimmer margins if cost overruns are incurred.
Inefficiency: The Mother of Opportunity
Despite the tailwinds for single-family rentals (SFR), it is still an inefficient market: Surprisingly, institutional investors account for less than 3% of single-family home sales. The number of homes estimated to be owned by SFR aggregators is a mere 160,000, the largest public players being American Homes 4 Rent, Colony Starwood Homes, and Silver Bay Homes.
Part of this inefficiency can be attributable to barriers to entry. Capex and renovation costs can be higher in the single-family rental market, and for a one-off operator it can be difficult to achieve the necessary critical mass to generate desirable returns. The largest public REITs like American Homes 4 Rent operate on a massive scale—their portfolio contains over 50,000 homes currently—allowing efficiencies and economies of scale comparable to those of multifamily real estate.
Publicly-traded single-family and apartment REITs have been performing well this year, but there are also smaller private SFR aggregators and businesses who have institutionalized and systematized their acquisition process, and who are able to achieve even higher returns. Public REIT returns are forecast to average in the 6-7% range in the next two years, which is up from 3% in 2015 but well below their 20-year average (12.9%), whereas some of the private aggregators are achieving strong double-digit returns (20%+). The public REITs offer liquidity, of course, but the smaller private aggregators remain capable of generating excess returns.
One difference that may contribute to those higher returns: the large SFR REITs are relatively agnostic to location, while the smaller aggregators are more selective in targeting metro areas with the best demographics. These metro areas tend to be more affordable than the coastal markets; construction in “class-A” urban locations is pricier.
In the majority of markets, vacancy rates for both multifamily and single-family rentals remain low, and the outlook for residential real estate is relatively positive. There are obvious benefits and efficiencies inherent in multifamily investing, but the conditions created by the mortgage crisis and subsequent recovery (related to supply and tighter lending), and the fact that single-family housing is still very much in the midst of the recovery cycle, are key reasons to consider the SFR market.
And should the next trend for millennials be a move from renting single-family homes to buying them, that will drive another leap in value for investments in the aggregators’ portfolios.