Single-Family

Unlocking the Build-for-Rent Market

• by Paul Stockamore, JP Ackerman
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2021 May Be the Best Year Yet for Private Lenders…If They Are Careful by Paul Stockamore and JP Ackerman 2020 was a coming of age in the Build-for-Rent space. Amidst the turbulence, the strategy was brought to the forefront driving real estate principals to recalibrate executional strategies in the face of rapidly changing market dynamics. It was not the beginning of the build-to-rent trend, but the confluence of factors in 2020 hastened the momentum. Long standing consumer migration and housing trends were accelerated causing disruption in established real estate conventions. The pervasive uncertainty in the real estate markets in March 2020 ultimately proved to be the beginning of a transformation. Home prices approached new highs on the back of record low mortgage rates and a surge in move-up activity amongst homebuyers at each tier. The milestone year demonstrated that the real estate cycle was far from over, while also heightening challenges to property investors building their rental portfolios. Many investors are exploring alternative strategies to create housing supply through purpose-built single family homes. Build-for-Rent: A Hybrid of Multifamily & Single Family Rental The Build-for-Rent strategy is a hybrid of multifamily and single family rental designed to create additional housing supply to meet the increasing demand of families seeking high quality, affordable rental homes. The product is designed for the lifestyle of today’s renters while also delivering a more durable structure to withstand tenant use and turnover. The durability of these homes enables managers to reduce operational costs (specifically repair and maintenance) while also tapping into increased property management efficiency generated by a concentration of homes in a singular community. The result is operational costs more similar to multifamily levels than that of traditional scatter site management thereby driving up Net Operating Income (NOI). Given the macro factors driving the rental market and persisting institutional investment appetite, it is likely that cap rates will continue to compress, further increasing the reward for investors participating in this strategy. Emphasizing the “B” in BFR The homebuilding trade is an essential expertise to navigate the many pitfalls that exist through multiple years it takes to bring these projects to fruition. Build-for-Rent strategies generate significant increases in NOI, while also providing a housing solution that is both satisfying and affordable for tenants. The skill set required, however, is significantly different than those necessary for scatter site acquisition, renovation, and stabilization. The essential functions include land acquisition, site planning and entitlement, horizontal improvements, and ultimately vertical construction.  As property managers and developers consider Build-for-Rent projects, it is imperative to establish in-house expertise and solidify partnerships with third parties. Equity and debt providers are cautious about engaging inexperienced teams and may require increased returns to offset the risks. Underwriting Build-for-Rent Projects Identifying viable Build-for-Rent projects requires a thorough vetting and deep understanding of key underwriting assumptions. Among the many moving parts, there are a few that represent the greatest challenges to many projects: Gross yield. Defined as the annual rent divided by the home’s value, gross yield measures the viability of a rental property and should be at least 7-8%. HOA dues and additional tax assessments should be netted from the rents. Properties with lower gross yields are typically unable to generate sufficient NOI to remain viable as a rental long term. Note that gross yields vary significantly by market and tend to fall as price points rise making higher cost markets less attractive for Build-for-Rent execution. Monthly rents. There are many tools to complete a rental analysis (e.g., HouseCanary, Zillow), but the science is determining which comparable property is most representative of the project under evaluation. Overstating rents is one of the most common underwriting challenges, which can both make prospective investors wary andslow down the initial lease-up process. With new projects, many tenants are willing to pay a premium rent for newly constructed homes and communities. Institutional property managers have demonstrated a 5-10% premium to smaller operators who emphasize maximum occupancy, while new home builders have long proven the ability to generate a 10-15% premium when selling a new home. In a Build-for-Rent strategy, the two factors converge enabling Build-for-Rent properties to command a 10-20% premium above market, while maintaining a similar vacancy rate to institutional norms. Given the long timeframes for Build-for-Rent projects, many developers use appreciation in their models. These assumptions are risky. The best investments are those where no rental appreciation is required to be viable. In contrast, if rents are appreciating, cost hikes will likely follow. Best practices are to avoid appreciation or appreciate the cost structure and top line equally. Operational Expenses (OPEX). OPEX is one of most differentiated assumptions between Build-for-Rent and scatter site rentals. OPEX includes sales and marketing, turnover costs, property taxes, insurance, utilities, common area expenses (e.g., landscaping), other included resident services, property management, repair and maintenance, accounting and legal. Institutional managers report OPEX at 37-38% of net rents, whereas Build-for-Rent projects operate more efficiently (500-800 bps lower) through the reduction of costs associated with turnover, repair and maintenance.  Debt Service Coverage Ratio (DSCR). DSCR is a critical underwriting metric that speaks to the long-term viability and ability to finance the ongoing operations. Defined as NOI divided by the costs of debt service, DSCR should be greater than 1.25 to qualify for long term financing post stabilization. Most debt providers will ensure this is no less than 1.1 or more during the stabilization period recognizing that debt service costs should notably drop once permanent financing has been put in place. To drive construction and development underwriting, here are several best practices: Build a strong network of local experts in development and construction. Unlike scatter site acquisition where the properties have already been planned, approved, and constructed, new developments must be approved (sometimes lobbied for), improved, and built. During the early phases of a development, the as-is property value typically falls before new value is created. The “J curve” is a critical risk factor on which developers and financiers must focus. Timelines & Contingencies. Development timelines