Wayne Hughes, a titan of the REIT industry who founded Public Storage (NYSE: PSA) years ago, formed American Homes 4 Rent (NYSE: AMH) in 2011 with the goal of consolidating this fragmented industry. Blackstone (NYSE: BX), one of the largest real estate investors in the world, created Invitation Homes (NYSE: INVH) the following year with the same goal (Figure 1). While both stayed private for a few more years, Silver Bay Realty Trust (bought by Tricon Capital in 2017) became the first publicly traded SFR REIT in December 2012. AMH and INVH eventually followed Silver Bay by going public in 2013 and 2017, respectively.
By 2013, institutional investors accounted for almost a third of existing-home purchases nationwide; according to RealtyTrac, such investors purchased over 500,000 homes from 2011 to 2014! Most were purchased at significant discounts to replacement cost at foreclosure sales and auctions on courthouse steps. The largest players focused on the markets where home prices declined most significantly such as Phoenix, Las Vegas, Atlanta, the Inland Empire of California, and Florida.
Because this was the first time someone had attempted to institutionalize this industry, management teams were forced into “on the job training” for marketing, leasing, and property management systems. At the time, we were skeptical if this was an actual operating business or just a “trade”. However, consolidation of several participants has occurred, and major advancements in operations have produced two viable publicly traded companies: American Homes 4 Rent and Invitation Homes. Both Boards of Directors are led by industry veterans, giving more credence to the long-term potential of this industry. As mentioned earlier, Wayne Hughes (formerly of PSA) is the Chairman of AMH, while Bryce Blair (formerly CEO of apartment REIT AvalonBay (NYSE: AVB)) is the Chairman of INVH.
After avoiding the sector for over five years, we have finally become comfortable that the proper systems are in place to run the business for cash flow and capitalize on the growing propensity to rent. While apartment REITs will benefit from this cultural change as well, SFR REITs have several unique attributes that could position them for outsized cash flow growth over the next few years which complements our overweight position to apartment REITs.
At first glance, single family rentals and apartments appear similar; however, there are distinct differences in tenants and operations. As illustrated by the renter demographics (Figure 2), apartments typically cater to young singles, whereas an SFR renter tends to be slightly older and more likely married with children. Therefore, the different product offerings cater to the differing needs of these two tenant bases.
Typically, apartments are categorized as either urban or suburban, and offer studios, one bedroom, and two bedroom units with average size ranging from 500 to 1,200 square feet (or sqft). Apartments also come with many amenities such as a pool, gym, and clubhouse.
In contrast, single-family rentals are mostly suburban with three bedrooms or more and average over 1,500 sqft. Instead of pools and gyms that are desired by unmarried tenants, the most sought-after SFRs have family-oriented communities that are zoned to highly-rated public schools.
Operational intensity is another distinguishing feature between the two sectors. An SFR portfolio typically requires a higher amount of upkeep and attention due to having more roofs, outside walls, and yards. In addition, there is more distance between units, so an SFR maintenance tech often has to travel miles to the next unit rather than a few footsteps, and an SFR leasing agent has to leave a central office to show homes across the city. Finally, there are homeowners’ association dues and rules that must be paid and adhered to.
Though the SFR REITs have been working diligently for the past five years to mitigate some of the disadvantages when compared to apartments (for example, “advanced door entry systems” that allow home tours without a representative), SFR REITs operate their companies with a much lower net operating income (or NOI) margin than apartment REITs.
On the other hand, the SFR sector shares many demand drivers with apartments, such as a relatively low homeownership rate, increasing household formations, rising interest rates, and even tax reform.
The national homeownership rate has declined significantly over the past ten years. From Q4 2007 to Q2 2016, the homeownership rate dropped from 68% to 63%, the lowest since 1965. As of December 31, 2017, the rate has bounced slightly off of the bottom to 64.2%. However, among millennials, the homeownership rate is only 36.0%. The millennials are the most important cohort for predicting future trends as they are the largest generation. We do not expect their propensity to rent to materially change in the near future due to the burden of large student debt loads and the trend toward delaying life events such as marriage and having a child. However, as millennials age and eventually start families, SFRs could gain an outsized share of rental demand due to its “family-friendly” features.
Over the past three years, total US household formations has averaged 1.1 million, 43% above the long-term average. However, most of the growth can be attributed to population growth, which means there is still pent up demand that can be released through an increase in the headship rate (or the percent of adults who head a household). Despite being the largest generation, millennials have not been starting new households at the same rate that other generations have in the past. As of 2017, 16% of millennials lived with their parents, as compared to the historical average of 12% for other generations at the same age. If that number declines, every 100 basis point (bps) reduction could result in 445,000 new households. In our opinion, the key to unlocking this demand is strong wage and job growth, and we could be seeing the early signs of improvement. From June 30 to December 31, 2017, wage growth averaged 3.3% and the unemployment rate dropped to 4.1%, the lowest since 2000.
Historically, higher employment and wage growth has increased inflation and, eventually, interest rates. Saving up for a down payment has already limited renters from moving out to buy a home, but higher mortgage rates would make it even more difficult to buy a home. Currently, the consensus economist estimates for the US 10 Year Treasury yield are 2.9% and 3.2%, respectively, by year end 2018 and 2019, which compares to 2.7% as of January 31, 2018. Mortgage rates tend to track the movements in the 10 year US Treasury, since the average mortgage is typically paid off or refinanced within ten years. To illustrate the influence of mortgage rates on affordability, a 50 bp increase in mortgage rates on a $300,000 traditional loan results in about a $100 higher monthly payment. Increasingly, prospective buyers could be forced to rent unless wage growth accelerates.
The recent tax reform bill is also expected to provide incremental demand for rental housing. For years, the government has been favoring homeowners in the tax code. However, the new legislation doubled the standard deduction, limited state and local income and property tax deductions to $10,000, and lowered mortgage interest deductions to loans of $750,000 or less. It is estimated 95% of US tax filers will choose to take the new standard deduction. Without the need to itemize deductions, the majority of homeowners and renters will finally receive the same tax treatment, thus eliminating many of the tax benefits of owning a home.
The US has a housing shortage. Since 2009, US total households have grown 20% more than total housing units due to the lack of new construction of affordable homes to buy. During the Great Recession, the construction labor market fell by 30% from peak to trough, and many in the industry never returned. As of December 2017, the construction labor market has only regained 70% of what it lost, despite the increased construction activity. Additionally, the existing inventory of for-sale homes is at 3.2 months, which means it would take just over three months for the for-sale market to clear. In contrast, six months is considered normal for a market in equilibrium. With such little existing supply, home prices are expected to continue to rise, further lowering affordability and pushing more people toward renting.
Due to its new “institutional” status, the SFR sector has the potential for outsized internal revenue growth by improving operations. Most mom and pop investors manage their properties for occupancy, which is only one piece of the revenue puzzle. The entrance of the REITs into the space brought revenue management systems that not only optimize rent growth and occupancy, but also help with exposure to lease rollover (which helps reduce revenue volatility by spreading out the lease expirations). The introduction of these systems has led to above average same store revenue growth over the past two years as the SFR sector averaged about 4.5% versus 3.9% for the apartment sector. We believe this outperformance can continue in the near-term as apartments are somewhat burdened by excess supply in many cities and the SFR REITs are continuing to enhance their revenue management systems.
The SFR REITS also have the opportunity to increase margins through cost controls. In Q3 2017, the year-to-date average NOI margin for SFR REITs was 63.9%, which is a 170 bps improvement from 2016. Maintenance improvements include enhanced productivity through efficiently scheduling routes and the use of programs that monitor the supplies within trucks and orders replacements when necessary. Despite these and many other enhancements, NOI margins are still below the 68.0% average for the apartment sector.
The broad geographic dispersion of SFR portfolios may prevent the sector from surpassing apartments, but the SFR REITs still believe there is room for outsized revenue improvement. Specifically, over the next few quarters, AMH and INVH plan to focus on deploying their in-house maintenance platforms nationwide instead of through third party vendors, as well as finding additional sources of ancillary revenue. For example, INVH is pushing its “Smart Home” technology platform, which should save residents money by reducing heating and lighting costs, while generating an additional $18 per month in rent. In a bizarre twist of fate, some of the technology and operating strategies the SFR REITs have developed are actually being considered by apartment REITs!
The SFR REITs have the opportunity to become the industry consolidator due to their scale, superior operating ability, and access to capital. Since 2011, most of the sector’s growth has been by acquisitions through distressed sales (foreclosures and real estate owned by banks), the Multiple Listing Service, or portfolio transactions. Over that time, however, home prices have increased an average of 40% through October 2017. As a result, the REITs have been forced to become more disciplined, heeding signals based on their cost of capital. Currently, acquisitions are in the 5-6% economic yield range (after capital expenditures), while the sector is trading at an implied cap rate (annualized NOI divided by the market implied value of real estate) near 5%, which means acquisitions could be accretive to future Net Asset Value (NAV) per share estimates.
In an attempt to achieve higher yields, American Homes 4 Rent is testing the feasibility of rental home development through two promising options. In the first, AMH commits to buying 10-20% of homes in newly constructed communities from builders for the purpose of rentals. Option two, albeit riskier, is through an internal development program where AMH purchases land and builds to their own standards and specifications.
AMH’s development yields are near a 50 bps premium for the first option and a 100+ bps premium for the second. While the higher yields reflect higher risk, the purpose-built design of the homes should also add incremental value through efficiencies and durability. These homes will have the advantage of using all of the SFR REITs’ operational expertise in the design and construction, including damage resistant materials, energy efficient layouts, and other features that minimize maintenance costs. AMH currently expects to contribute about $400 million toward development homes in 2018, while INVH has yet to announce a development program.
Though the growth in NOI for the SFR REITs appears attractive, it is not without risk—the biggest of which is how capital expenditures will trend in the long-term. Properties acquired within the past few years incurred $10,000-$25,000 per unit in the front-end to upgrade appliances and for deferred capital expenditures such as flooring, carpeting, paint, plumbing, and cabinetry. The initial upgrade program at purchase has likely lowered near-term maintenance. For example, the SFR REITs averaged 6.7% of NOI for capex for the nine months ended September 30, 2017, which compared to 8.1% for the apartment REITs. This may be able to continue for a few years, but it may begin to trend upward as the homes age. The average age of homes for INVH and AMH are 22 and 14 years, respectively. Our financial models already assume a higher capex reserve to account for the risk of increasing costs in the future.
The future political environment could also pose a risk to the sector’s performance. Examples include a return of more government subsidies that encourage home ownership, student loan forgiveness, and economic policies that change the trajectory of interest rates. Additionally, any event that would damage the value of home prices could have a duplicative negative effect by decreasing asset valuations, while also making it more difficult to maintain occupancy and increase rental rates (since home purchases would become more affordable).
Until 2017, we had avoided the single family rental REITs in the Chilton REIT Composite. Our main concern was the long-term cash flow per share growth potential. After a few years of intense due diligence, meetings with management, and scouring financial statements, we believe that the companies and the sector as a whole have laid out a pathway for long-term value creation for shareholders.
The sector should continue to benefit from favorable demographics, technological advances, and additional synergies through scale. Additionally, AMH and INVH share prices are down 4.8% and 4.6% respectively, year to date as of January 31, 2018. We believe the market has created an attractive entry point for investors into both names. The sector currently meets two crucial investment criteria that should be attractive to both traditional REIT investors and generalists. First, as of January 26, 2018, the SFR REITs trade at a 19% discount to NAV, which compares to a 9% discount for all REITs, and the long term average of a 1% premium. Second, the combination of internal and external growth initiatives should produce above average cash flow growth over the next few years. The sector is expected to produce 12.6% compounded AFFO (Adjusted Funds From Operations) growth in 2018 and 2019, as compared to 4.2% for apartment REITs, and 5.4% for REITs as a whole.
Blane T. Cheatham, CFA
Matthew R. Werner, CFA
Bruce G. Garrison, CFA
RMS: 1917 (1.31.2018) vs 2000 (12.31.2017) vs. 346 (3.6.2009) and 1330 (2.7.2007)
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