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Valuations in the Single Family Rental Space

Here’s What’s Happening with Rental Investments by Kevin Ortner Housing prices continue to march upwards. But what’s driving prices in the SFR space? What is responsible for this boom, and should we expect more of the same in the months ahead? As Renters Warehouse CEO, I have seen a lot of changes in the housing market over the last year. Here are a few things that stand out. There’s good news for investors who own rental property: the single-family rental property market has continued to thrive, despite the events of the last year. Nationally, 5.6 million homes were sold in 2020 –and the median cost of a home shot up 15%, increasing from $300,000 in 2019 to $340,000 by the end of 2020, according to the National Association of Realtors.  Both home values and rents alike have soared over the past year, and it is still very much a seller’s market. Demand is high, and there’s just not enough inventory to keep up.  Still, we cannot assume that home appreciation will continue at its current pace. It is safe to conclude that at some point appreciation will start to level off and growth begin to slow. At some point, we could start to see home value appreciation that is a lot more modest, rather than the extreme increases that we have seen over the last few months. If this holds true, then you will want to keep in mind that you are paying for future appreciation today. It may be a slow housing price appreciation climb over the next 18-24 months. No one knows exactly when appreciation will begin to slow down, so investors should not assume that the next month will be the same as the last.  There are a number of factors that are at play, all of which are impacting housing prices. Here is a look at some of the things that we have noticed in recent months. A Housing Shortage Currently, there is a shortage of housing inventory. In fact, the U.S. housing market is short 3.8 million homes according to recent data from Freddie Mac.  While builders have started to increase output in the past year, up 18% from 2019, lumber shortages have made home construction considerably more expensive. A global lumber shortage caused by lower production in 2019 is one contributing factor. The soaring cost of lumber could easily add $24,000 to the cost of a new house.  And it is not just lumber that is on the rise, other costs are increasing as well, including labor. Labor costs, largely due to worker scarcity, have increased more than expected during the first quarter of the year. New Homes Cost More to Build Many builders have been telling us that we are starting to hit the affordability ceiling, with buyers and builders starting to max out. When this happens, it could put pressure on prices to slow.  Builders are building what can be sold. Values in almost all tiers of housing have risen, with housing prices increasing in most markets. In 99% of metro areas tracked by the National Association of Realtors, prices in the first quarter of 2021 increased over the same period last year.  Of course, these price increases are pushing out the first-time buyer. This is leading to an increased demand for rentals as more people opt to rent rather than buy.  For investors, there is still opportunity in affordable rental homes. There are a great number of renters who have lost their jobs or are still on extended furlough. With the hospitality and service sectors being especially hard hit and many places closing their doors for good, there are a great number of jobs that are at risk. While there will be opportunities for new jobs in many places as things slowly ease back to normal, we still have a way to go. These workers will still need accommodation, and affordable rentals will continue to be in demand. The Institution-alization of the SFR Space While SFR has long been an asset class that has been dominated by small investors, for a few years now we have been seeing this space slowly start to tilt toward the institutional investor. There are a few reasons for this. For one thing, institutional investors have the money to secure the best deals for themselves. They can buy materials at-scale and for a better deal than small scale investors, helping to mitigate costs. Large and medium builders are buying up the small guys, or, in some cases just pushing them out. They can lock in lumber prices with a longer timeline than the small builder. This allows them to have a bigger market share and control the pricing as well. Some are building more homes and making a bigger profit. Then there are the impact fees—the cost of doing business, and low rates that give institutional investors an edge. Institutional debt is almost always free. This, of course, is helping to drive prices even higher.  Additional factors are compounding to make SFR more challenging for the everyday investor. Eviction moratoriums have provided protection for tenants who cannot pay the rent, but often at the expense of landlords—forbearance for landlords is spotty. In many areas, it is also becoming increasingly difficult to manage a rental home, due to local legislation and changing laws. Landlords today need to continually keep on top of things to ensure that they are in compliance. These days, it is just not that cost effective to manage one or two properties.  Institutional investors, though, have cheap debt and the processes in place that allows them to buy and manage homes at scale, making these investments far more profitable –and feasible. We are seeing a flood of capital into these investments that is going to consolidate the SFR space. Are Investors to Blame? Many people have bought into the narrative that investors are to blame for rising home values; that investors keep would-be homeowners out of the housing market. Of course, the reality

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ROI Starts with Understanding the True Value of the Property You Are Going to Purchase

The Bottom Line for Investors is Still the Bottom Line by Rick Sharga Perhaps nothing is more important to the success of a real estate investor than properly valuing a property. Over-paying for an investment property is one of the most common mistakes made—particularly by inexperienced investors—and can often be the difference between making a reasonable return on an investment and financial ruin. To a certain extent, investors buying properties to rent have a little more latitude than fix-and-flip investors, since they probably have a longer time horizon, and are less dependent on making a short-term profit on a sale. But, particularly in the case where a property is financed, the costs of over-paying can add up over time in terms of higher interest payments and lower monthly cashflows. And ultimately, when it’s time to sell the property, the profit will be smaller since the purchase price was higher than it should have been. But ultimately, most properties go up in value over time, so the rental property investor can make an error in valuing a property and still come out ahead in the long run. This is especially true in a housing market like today’s, with high demand and low inventory driving home prices to unprecedented levels. According to a recent report by RealtyTrac parent company ATTOM Data Solutions, median home prices nationwide rose 16 percent year over year in the first quarter of 2021 and were up at least 10 percent in most markets across the country. During what has now become a nine-year U.S. housing-market boom, equity has continued to improve because price increases have widened the gap between what homeowners owe on mortgages and the estimated market value of their properties. Freddie Mac recently noted that homeowner equity had increased to a record $23 trillion, as overall housing stock values rose to over $33 trillion. The ATTOM report said that the percentage of homeowners considered “equity rich,” (homeowners whose mortgage debt was less than 50 percent of their home’s value) had risen in 41states from the fourth quarter of 2020 to the first quarter of 2021. On the other end of the spectrum, homeowners who are seriously underwater on their loans (owing more than 125 percent of their home’s value) decreased by 49 percent during the same period. But the ATTOM report did suggest that some markets might be better than others for investors looking for good deals. For example, there are parts of the country where there are still a large number of homeowners who owe more than their homes are worth and might be candidates for short sales with their lenders. The top 10 states with the highest shares of mortgages that were seriously underwater in the first quarter of 2021 were all in the South and Midwest, led by Louisiana (13 percent seriously underwater), West Virginia (10.5 percent), Illinois (10.4 percent), Arkansas (9.2 percent) and Mississippi (9.1 percent). These are also all states where home prices are still affordable enough that an investor can buy a property, rent it out at a reasonable rate, and generate positive cashflow—something not as easy to do in some of the higher priced states like California, where the median property price is now over $800,000. Clearly, even though home prices don’t always go up in a straight line, the odds are in an investor’s favor if they plan to hold a property for any significant period of time. A small overpayment by a rental property owner—especially in one of the lower-priced markets noted above—can look somewhat trivial a decade later when a property has doubled in value, assuming the landlord has charged market-priced rent and kept the property occupied most of the time. For fix-and-flip investors, valuations can be a lot less forgiving The two most common mistakes made by fix-and-flip investors are overestimating the value of a property and underestimating the cost of necessary repairs. A 10 percent swing on these estimates, especially in an expensive market, can wipe out most or all of the profits. Flippers are also sometimes victimized by market timing—paying top dollar for a property expecting home prices to continue rising, only to see a market correction. In today’s red hot housing market, the temptation is to spend whatever it takes to buy a property, since prices have now gone up nationally for over 110 consecutive months, and demand continues to outpace supply. But it’s important to watch trends carefully, and to remember that local market conditions don’t always play out the same way the national headlines might suggest. Just to use two items from recent news headlines to put this into perspective, consider supply chain disruption and inflation—both results in one way or another of the COVID-19 pandemic. Flippers need to factor in material costs to their repair estimates. It seems unlikely that many of them planned on lumber prices increasing by almost 300 percent in the past year, but that’s exactly what happened. They probably also didn’t factor in appliances being on back-order for six months or more, yet real estate investors, homebuilders and homeowners alike are all still waiting for that new washer and dryer. For an investor with relatively high cost financing, extra months waiting to market the property can mean lower profits. As for inflation, many market analysts warn that if inflation continues to rise, mortgage rates are likely to follow. Most housing market experts agree that an increase in interest rates by as little as a point could seriously weaken demand among prospective homebuyers due to the historically high price of homes—affordability has been propped up by low interest rates and would suffer significantly if those rates suddenly went from 3 percent to 4 percent. Usually, this scenario results in home price appreciation slowing down, or even prices falling slightly. That’s good news for a flipper getting ready to buy a home, but not good news for a flipper who just bought one and now needs to sell it at a profit. Due to competition

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The “Why” of Valuation

Building Valuation Discipline by Michael Greene and Alex Villacorta Business school classes often demonstrate concepts like “the wisdom of crowds” or “the Winner’s Curse” by asking students to guess the number of jelly beans in a jar. Miraculously, the average guess of the class is typically quite close to the actual number of beans, while the range of guesses is distributed broadly. Never in question, however, is the precise number of jelly beans that represents the RIGHT answer. There is a finite and knowable amount of jelly beans, and whoever is “closest to the pin” has the best estimate. One would expect that valuing a home would work similarly. While it may be challenging for an individual appraiser, broker, or automated valuation model (AVM) to nail the value of a home, at least we can know ex post facto who made the closest estimate. It is as easy as determining who was “closest to the pin” when the home trades. But is it? What makes the definition of accuracy in the valuation space different from counting jelly beans is not only the “what” but the “why.” That is to say that the business objective the valuation supports is highly relevant to how one should measure that valuation’s accuracy. For example, a mortgage lender wants to know what value for the home is supported by its surrounding market, so that it does not face idiosyncratic risk from an overvalued individual asset relative to its MSA-level risk models. In this case, an accurate point estimate of the price at which a home will transact is less important than the most probable minimum value supported by enough comparable properties to imply a liquid resale market. A home seller or their agent would like to know what the highest bidder might be willing to pay for their home to formulate a listing and marketing strategy. Especially in times of tight inventory or when in possession of a unique home, this number is likely to be different from the mortgage lender’s number. Similarly, a retail home buyer wants to buy the house of their dreams as cheaply as possible. What matters to that buyer is not the intrinsic value of the home, relative to its neighborhood comps, but figuring out how to bid one penny more than the seller will accept (or competing bids). For these retail market participants, the most probable point-estimate of transaction price is what matters. An investor would like to know the after-repaired resale value or rental rate to determine whether the property will deliver the returns they expect. This requires not only an understanding of the home’s value today, but also both the average price and market depth of peer assets in the neighborhood with similar hedonic characteristics but an upgraded fit and finish. Customizing Valuation Discipline to Business Needs The consumers of home valuations face an increasingly broad array of product choices around which to build their valuation discipline. In the last decade, the availability of cheap computing and storage power has unlocked previously unimaginable datasets for use in automated valuations (AVMs). Richer data has allowed for better attribution of value to an expanded list of property attributes and as a result has led to significantly tighter error bands. This increase in accuracy has been so significant over the last decade that AVMs have evolved from offering limited use cases around free-to-the-consumer marketing to offering credible, underwrite worthy valuations at the asset level. Recently, the industry has focused innovation around clever combinations of man and machine, with a spectrum of options from condition-informed AVMs to hybrid appraisals. The physical constraints imposed by the COVID 19 pandemic have accelerated the adoption of these “cyborg” valuations by realtors, lenders, and investors, funding further vendor innovation. It is no longer sufficient to rely on industry-accepted best practices when choosing how to value homes. Instead, each practitioner must create a valuation discipline that maps their company’s unique “whys” to the “whats” that the market is offering. As Peter Drucker said, “what gets measured gets managed.” While human providers of appraisals and BPOs are typically measured against client outcomes, such as revision requests, automated or computer-assisted valuations lend themselves to systematic measurement and comparison. In constructing a valuation discipline, this is an enormous advantage to those of us steeped in interpreting these data, but presents dangerous pitfalls to those who are not. Vendors and Appraisal Management Companies (AMCs) aim to serve as many market participants as possible, each of whom, as described above, wants something different. In competing for business, these vendors aim to achieve good scores against universal benchmarks across national averages. For automated solutions, these may include accuracy (usually measured by median absolute percentage error, or MdAPE), systematic bias, hit rate, or large error risk (measured by percent of valuations within 5, 10, or 20 percent of the ultimate sale price), each of which is more or less important to a different client. In the case of human-powered valuation, revision request frequency and turn time become important considerations, and everyone is sensitive to cost. A client’s “whys” determine which of these benchmarks should define their evaluation process. Which Model is Best For You If you are the buyer or seller of an individual home (or their agent) looking for a quick independent source of value to corroborate your comparable market analysis, an “accurate” AVM, as defined by a low national average error rate (MdAPE) is probably less useful to you than a “not wrong” AVM, defined by a low probability of major error (PPE5 or PPE10). After all, what is the point of being right on average if the client is only buying one house? By contrast, an institutional investor using AVMs to conduct macroeconomic research and backtests may favor an AVM with no systematic bias and a high hit rate, rather than one that has a low probability of major errors. Being right on average is precisely this investor’s goal. Along the same lines, a mortgage lender looking to determine

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Fast and Accurate Valuations Are Key for Real Estate Investors

New and Improving Tools Are Arriving Just in Time by Katie Brewer In a buyer’s market, the advantage goes to the purchaser who can make a wise decision faster than other potential buyers. So, for investors in today’s market, time has become the crucial obstacle to success. Some have called it a modern-day Gold Rush, and just as in olden days, prospectors who can sift through the national inventory of properties faster and spot the hidden nuggets more clearly are the ones who will prosper. The combination of historically low interest rates and shifting demographics has triggered a buying spree in single family homes that has accelerated during the coronavirus pandemic. As a result, inventories are low across the country. According to the Radian Home Price Index, there are currently 40 percent fewer homes on the market, on average, than any time over the past decade. High demand and low supply have inevitably driven prices skyward. During the month of April, the Radian Home Price Index rose 10.4 percent, with the median home in the U.S. now costing $277,365. But perhaps the most illustrative measure of the real estate market’s velocity is the time between the listing of a property and a pending purchase offer. According to Zillow, in April, nearly half (47 percent) the homes for sale in the United States were on the market for less than a week before going under contract and more than three quarters (76 percent) were on the market less than a month. Evaluating any property in days—or even hours—adds a level of risk that many would be unwilling to take in a normal market. Doing it at scale locally, regionally, or nationally requires either a prospector’s instinct or a technological edge. Most choose the technology. AVMs, AI, Machine Learning One solution is to use an automated valuation model (AVM) that applies mathematical models to a database of real estate information such as current and historical prices, number of bedrooms, and property improvements. With an AVM you can run estimated values on properties in a matter of moments. When a new property hits the market, an investor can quickly identify its essential characteristics and make a judgment about its suitability for their real estate portfolio. But AVMs are only as good as their data inputs. While they have the potential to deliver objective valuations without human bias, most models analyze data that has been collected in-person, and that can result in a distorted valuation. This is most consequential when the owner of the property is a member of a historically marginalized group. According to the Urban Institute, a Washington, D.C.-based think tank focused on social and economic policy research, AVMs have produced larger pricing errors in majority-Black neighborhoods than those in majority-white neighborhoods, “potentially contributing to the wide housing wealth gap between Black and white homeowners.” To correct for bias, AVM operators often look for ways to expand or augment the data sets their model is analyzing. The more data that is available, the more accurate the final analysis will be.  But a new approach, using artificial intelligence (AI), promises the fastest and most accurate analysis and valuations short of an in-person inspection. Modern AI can analyze an enormous amount of structured data such as price histories, property attributes and surrounding market data, but also unstructured data like photographs, floor plan sketches and text or speech.  Analysis of images in particular can help to establish the condition of a property and objects that differentiate value using consistent and repeatable tools without the in-person challenges. These tools can also evaluate newly built properties that have no price histories or recent comparables.  One of the most intriguing benefits of AI and Machine Learning (ML) is a model’s ability to refine and improve the process of identifying the best sales comparables to help establish a current price. Reinforcement learning allows models to improve accuracy simply through use and more data. And, unlike the human-based valuations, models can be independently tested in very large samples to ensure bias and other unintended consequences are limited or mitigated. Considering how many billions of photographs of properties there are on MLS listings nationally alone, the possibility of “better than in-person” accuracy through AI is a very real possibility.    The real estate Gold Rush shows no signs of diminishing. The Commerce Department recently reported that the median price of a new home sold in April of this year was 20.1 percent higher than a year earlier, the strongest annual gain since 1988. At the same time, the majority (54.6 percent) of homes in the middle price tier and almost half (48.0 percent) of homes in the top price tier went under contract in a week or less, up 60 percent and 71 percent year-over-year, respectively. Just like prospectors for gold, Investors looking for fleeting opportunities in this scorching hot market need faster and more accurate ways to judge the true value of their finds. Fortunately, new and improving tools are arriving just in time. 

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Valuing Your Rental Opportunities

How the Industry is Shifting to Help Investors Reduce Their Risk by Frank Guarnera After what has been a unique year to say the least, the future is looking like it may be ripe with opportunity and risk. Which is why it is so important to understand your assets now more than ever. As we may have some volatility or changes over the next year, it will be important to understand long term investment potentials. Anticipating this, the valuation industry has continued to evolve to provide solutions that can deliver valuable intel to help investors make more informed decisions. By integrating local rental data into traditional valuation products, it helps paint a clearer picture of whether an asset may be better suited as a short-term or long-term investment, or one to avoid altogether. Understanding the intrinsic value of a property is the cornerstone of the decision-making process along with knowing your Net Operating Income and Capitalization Rate. Several different products are available in the industry to provide important data in addition to the typical FNMA 1004+1007. The Desktop Appraisal Desktop appraisals, sometimes referred to as hybrid appraisals have been available to home equity lenders, servicers, and loss mitigation for several years. These products are fast becoming the preferred valuation tool with private lenders for fix and flip, long term lending and single-family rentals. While the products have a lower price point and faster turn times, the reliability and quality are on par with traditional appraisal products. Many of these desktop appraisals are USPAP (Uniform Standards of Professional Appraisal Practice) compliant and the data contained in them is much more user friendly than the traditional GSE format. The desktop appraisal bifurcates the appraisal process by leveraging a third-party data collector and the expertise of the local appraiser creating significant efficiency resulting in quicker turn times and lower appraisal cost without sacrificing quality. Valuable insight is also gained when these products provide additional forecasting data that considers both historical data trends and economic factors. This allows you to get a general idea of the expected appreciation/depreciation in an area. Combining all this data in an easy-to-read format helps investors make better informed decisions on these types of long-term decisions. Knowing the market value of the asset will help direct your investment strategy. Is this an asset I should sell now, rent for a period, and then sell, or keep as a rental property indefinitely? A desktop/hybrid appraisal can help answer those questions for less money and time than a traditional appraisal without compromising the quality. The Broker Price Opinion A Broker Price Opinion with a rental addendum has also shown to be a reliable source of information. In many situations, they are used as a low cost and fast resource to secure an inspection, property data, and rental information for the area. Leveraging the expertise of a local real estate agent, these are a valuable resource for anyone looking to secure more relevant data and get feedback from an agent in the area. By also receiving a BPO, you are gaining insight about the asset itself. With the rental addendum, you can pull in intel to perform a market-extraction which can help inform a reasonable capitalization rate for the area and your property. AVMs for Rental Market Trends Rental AVM’s have also continued to improve and can provide good insight of rental market trends. A robust dataset that can provide both historical and current rental trends can help establish what would be a credible rent price for an asset which will in turn, when combined with a property valuation, can help shine light on how good the investment may be based on the equity in the property and the future potential of the area. These will typically require you to do much of the deep diving but to the savvier investor, these tools have shown to be valuable. When it comes to identifying potential rental rates, there can be many challenges as the rental market is less liquid and transparent than the traditional real estate market. Rental data continues to become more reliable, but validation remains an important component of rental valuations. Getting a clear picture of what is occurring in the local market is a powerful indicator of what local market renters are interested in, willing to pay, and how long they stay. Further investigating vacancy rates and other value influencing features is paramount in reducing risk for long term investment strategies. Focus on what is going on in the local area regarding city migration and real estate development, inventory, economic conditions, and overall rates of appreciation. Do not let a lack of data be the reason you miss out on a great property or choose a strategy that does not yield the best return. Valuations continue to be an essential component with investment properties and there are a host of products to get you the information you need to make the best decision.    

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