2020: A Year to Forget For Most, But Not For SFR
The SFR Industry Resiliency
By: Adam Stern, CEO, Strata SFR
There are some industries that tend to do better than average or even flourish during times of economic downturn. If we look back to past recessions in the US, those tended to be segments of the economy where demand does not much fluctuate based on changing prices; sectors such as basic household staples, healthcare, and consumer goods. The reason these sectors tend to outperform the rest of the economy during times of economic contraction is simple! People’s basic needs and their desire and ability to fill them, regardless of the economy, stay consistent. Other sectors do well for other reasons. Segments such as discount retailers and fast food do well because when times are tight, eating and buying cheaper is more appealing. Since the inception of the Single-Family Rental Industry in early 2008, back when the trend was still referred to as Foreclosure-To-Rental, it was speculated that SFR was going to be a “recession-proof” industry. The rationale made sense too. It was widely proposed that SFR would do well during economic expansion as higher home values would push many to rent as homes became less affordable to many, including cash-strapped millennials with high college debt, and at the same time create good returns for SFR portfolio owners as equity in homes increased creating the opportunity to leverage that equity to foster expansion. The flip side of that coin was if the economy tanked, it would mean higher unemployment and stagnant wages, driving many to rent, and in a shrinking economy, SFR investors would reap the benefits of lower home prices and higher returns.
All of this was speculation until this year. With the proliferation of COVID-19 and its resulting effects on the world economy, I don’t think anyone can argue that SFR has been a beneficiary of some stark economic, demographic and lifestyle shifts that have seen the trending toward people living in Single Family Rental Homes and especially those investing in SFR, to take a swing to the positive.
Reasons for the Win
How the SFR industry won in 2020 reflected a somewhat atypical recession cycle. The current situation, triggered by a worldwide pandemic, has changed the way many people live and work. It also coincided with one of the most divisive and hotly contested elections in recent memory. From top to bottom, there were many winners along the value chain in the SFR industry and few losers which I will outline briefly below.
Let’s start with the incumbent SFR industry players, those that have amassed huge portfolios by steadily buying SFR throughout the mid-2010s. Firms such as Tricon, American Homes 4 Rent, Invitation Homes and others have seen strong appreciation in stock prices as the industry has matured. These firms have proven to Wallstreet that scale and efficiency equate to predictable returns. The steadily increasing Net Operating margins of these various platforms, combined with strong earnings from streamlined operations, have attracted new and cheaper capital. This has allowed publicly traded SFR companies to be competitive in a tightening market. As 2020 unfolded, amid uncertainty caused by the pandemic, many firms pulled back on acquisitions which allowed them to focus on operations. This shift in buying habit did not seem to have hurt them though. If anything, it proved that these firms, through their sheer size and organizational prowess, are relatively safe bets for capital to ride out uncertain times.
Mid-Cap and Small Cap SFR firms have also seemed to fare well based on the strategies they chose in the years before the pandemic arrived. These firms, like the larger SFR REITs, focused on reinforcing operations and have chosen asset types and geographies that have held up well during the pandemic. They have seen strong income with little change to delinquency and vacancy rates. As such, many have remained well positioned to attract follow-on and newly raised capital from investors hungry for cashflow and yield. This in turn put them in a good position to expand upon their build acquisition infrastructure to deploy capital. Some segments of this category have struggled however during the pandemic. Firms that chose markets and targeted tenant bases that were exceedingly susceptible to the ravages of the pandemic, such as areas where tenants are in lower rent bands or where wages and jobs were adversely affected by the pandemic, have seen higher delinquencies, evictions (in areas where they remained legal), and stagnant or decreasing rent levels.
THE NEW WINNER—B4R
A huge winner in 2020 has been the new-construction rental sector or as many know it, Build-For-Rent. As overall inventory levels have reached historic lows in many markets around the country, combined with the seemingly insatiable appetite of renters for newly built, more modern rental housing, Build-For-Rent has seen an influx of investment capital through various avenues. These avenues include incumbent SFR firms and not too surprisingly, new entrants such as multi-family investment firms. Other types of real estate investment companies have come into the space as well. For example, those who have been able to leverage their current operations in other real estate food groups as a way to entice institutional capital to back their play in this asset class that is now competing with the other core commercial verticals.
To clarify, Build-For-Rent is the practice of buying land (raw or developed) and engaging with lot developers and builders to construct single family detached homes and townhomes for the purposes of holding as rental properties. There are several strategies players are implementing in this space. Building scatter site new construction homes for example is not a new phenomenon, as many investors bought distressed lots in broken subdivisions that resulted from the downturn and have been buying and building homes for rent on individual lots over the last decade. But the new strategy being employed by many SFR REITS, multifamily investment firms, and newly formed Build-For-Rent operators is the single site SFR subdivision. This new “thing” that many are figuring out has become the centerpiece of many a Build-For-Rent strategy and demands the expertise of many different disciplines in both real estate land development, construction, marketing, and operations.
Not many understand the size and scope of the Build-For-Rent segment as part of the overall Single-Family Rental Sector. So, it deserves some time and explanation. From top to bottom, many parts of this segment have been winning in 2020 in a big way. When you understand the makeup of this multi-faceted market segment, it is easy to understand why. There is a severe shortage in many of the most popular Build-For-Rent markets of buildable lots, and therefore those more localized real estate land brokers and raw land developers have found themselves in extremely high demand. The opportunity for land developers to align with investment capital to find their way to a prearranged take-out agreement for lots that have yet to be developed has been extremely strong in 2020. Developers that found themselves in the privileged position of owning developed lots ready for sale, have enjoyed somewhat of a Rockstar status, being pursued by national and regional home builders looking to increase their pipeline of lots in the for-sale space as well as firms looking to pick up finished lots for rentals. This new dynamic of having multiple buyer types has pushed lot prices up for everybody while creating downward pressure on profits for homebuilders and downward pressure on Cap Rates for investors.
For builders, the increase in demand for Single Family and Townhome rentals is a double-edged sword. On the one hand, this source of demand gives them multiple exit options, which is good. On the other hand, they must compete with Build-For-Rent investors. This means lot prices get pushed higher and margins get squeezed. And when a builder wins lot positions over both competing builders and B4R competitors, they have to balance their need to maximize exit time and profits with avoiding cannibalizing their bread and butter for-sale business by selling homes to investors vs selling homes to home buyers. And while the home buyer market is wide and varied in terms of product type and price point, there is a definitive “sweet spot” for B4R investors. And if a builder has a project in this sweet spot, they must carefully weigh their options when picking their exit strategy.
SFR—HERE TO STAY
If 2020 has shown nothing else, it has certainly highlighted the longevity and resiliency of the Single-Family-Rental industry as an institutional asset class that is here to stay. That argument, that this industry born of distress may not be an operational oriented stable asset class, is gone. If the jury was not in pre-COVID-19, it has certainly been decided in this year of strife and struggle. Professionally aggregated and operated rental homes as an industry finds itself in the pantheon of other industries that have stayed steady because they are essential necessities. In hindsight, the fact anyone doubted that this would be the case, since after all we are talking about housing, the most basic of needs, now seems obvious. The tailwinds that drove the success of the industry in 2020 from a lifestyle and demographic perspective are not going to be short-lived. People want clean, safe, affordable homes that consider things like area crime rates and school scores. The preference to rent vs own will only get stronger as the post crisis generations have not been brought up with the same pro-ownership sentiment as generations past. And when you combine that with higher individual college debt levels and shifting preferences toward mobility, SFR as an industry and asset class will take the momentum created over this past year much further as it forges ahead into the future.
