SFR: Disruption, Impact, Innovation
Three Key Disruptions in the SFR Asset Class
by Stephanie Casper
In his highly acclaimed book, “Innovator’s Dilemma,” Clayton Christensen details how established companies focusing on incremental improvements or innovations to address their biggest customers’ evolving needs often miss the true innovation occurring around them. The disruption caused by the upstart innovators ultimately spells the demise of countless companies in Christensen’s book. Since its publishing, disruptors continue to impact incumbent companies and industries. Think Uber, iPhone and NetFlix.
However, in real estate, particularly the single-family residential space, I would argue that disruptions are the drivers of innovation in the asset class. There have been three key disruptions in the last 20 years that have dramatically impacted real estate, and in particular the single-family residential asset class: internet usage, the Great Recession, and the global COVID-19 pandemic. Out of each of these disruptions, innovation has emerged dramatically changing the complexion of single-family real estate.
Internet and Data Availability
In early 2006, shopping for a new home or residential investment property often meant perusing the real estate section of the local newspaper or spending weekends driving through neighborhoods in search of “for sale signs” and open houses. And to get additional information on comparables, property details, and property history, buyers had to rely on realtors and brokers. This was the process my parents followed when shopping for a home 30 years prior. My mother, not one to leave things up to the realtor, would drive by the address prior to the showing so that she could modulate her reaction instead of being surprised. On one realtor led showing, a 2-year-old, me, already clearly interested in single family real estate, asked, “Mom, isn’t this a sh*t house?” To my mother’s horror I had repeated her often uttered property assessment to the agent.
Zillow’s website launch in February 2006, complete with listings, aerial pictures and Zestimates, instantly democratized the property buying experience. Shoppers were now armed with information previously only accessible to realtors. Now, buyers could check out listings and neighborhoods from the comfort of their home computer, and finally in 2009 from their smart phones (thank you, Apple). Trulia, Redfin and Realtor.com soon followed. These sites have evolved such that virtually all information a buyer needs to make an assessment of a property, from pictures and price history, to tax information, to estimates of value and comparables, is available.
The rise of widespread data availability via just a few keystrokes not only enabled buyers and investors to make more informed decisions, but lenders also benefited as well. Tech-enabled lenders have been able to leverage web-based databases of transaction, mortgage, and property details to build decisioning and underwriting models that quickly assess potential borrowers, the viability of proposed fix and flip projects, and the anticipated cash flows of rental properties.
The Great Recession
As we all know, largely due to some “innovation” in lending, the incentives for originators and the capital markets’ execution for mortgage-backed securities, a single-family real estate bubble grew and ultimately burst causing The Great Recession. In 2007 and 2008 more than 5.3 million homes were foreclosed in the US. Virtually overnight the inventory of residential homes outpaced the demand resulting in a plummeting of home prices. This massive disruption in the residential market spurred innovation from institutional investors, in both equity and debt.
Historically, residential real estate investors were smaller individual owners, typically with ten or fewer properties. My grandfather, a retired firefighter in a small town in Massachusetts, was one. Anytime a house or lot in his immediate neighborhood came up for sale, he bought it all cash and rented it out. He even developed a duplex for rent on a lot adjacent to his home. This small town, small time execution in single family investment evolved due to the innovation brought about by The Great Recession.
As more and more REO properties became available across the country, institutional equity investors took notice and seized the opportunity. They began acquiring foreclosed properties at courthouse auctions and via partnerships with local boots on the ground. The scattered site single family properties were renovated, leased up and added to growing portfolios of rentals being operated like contiguous multifamily complexes. Early on, this innovative approach to holding large numbers of detached properties as rentals was met with skepticism. Naysayers preached that the economies of scale afforded landlords in a traditional multifamily property would not be achieved with single family detached homes resulting in much lower returns.
What started out as a small group that included Invitation Homes, American Homes for Rent and Colony Capital, the number of large players in the space has exploded with single family rental now a solid 6th real estate investment asset class. As it turns out, the management of SFR rentals has outperformed expectations with less tenant turnover and lower CapEx and maintenance needs. Seeing an opportunity to gain yield in a prolonged period of low interest rates and capitalize on the counter-cyclical nature residential rental properties offer in an investment portfolio, the interest and demand for single family residential rental properties continues to explode.
Alongside the institutional equity players entering the space, institutional debt emerged to provide financing for those investing in the space. These lenders provided and continue to provide short and long-term financing for investors who are acquiring, renovating, and flipping, as well as “aggregators” who are buying and stabilizing rental properties, along with single and portfolio rental loans. Few investors in the space had access to debt financing prior to the Great Recession, and if they did, it regularly came in the form of hard money lenders or high net worth individual private lenders.
Today’s lending scene is crowded. A recent white paper, “Housing Mania 2.0” published by John Burns Real Estate Consulting, lists more than 50 national lenders, with many more local and regional players not counted among them. And, while institutional capital continues to pile into investing in single family rentals, mom and pops still own the vast majority of properties in the US. Current estimates show that more than 60% of all rental properties in the US are still owned by smaller investors. Now, due to innovation coming out of disruption, they can find financing options that best meet their needs.
COVID-19
The third and more recent disruption that is bringing about innovation in single family residential, and arguably the broader real estate markets, is the COVID-19 global pandemic. Innovation has come in the form of both technology adoption to facilitate the business
of real estate and real estate financing, and innovation in the form of evolving development that supports the overall market demands for single family housing.
Central to this disruption has been the physical distancing requirements interrupting the status quo of transactional real estate. As a result, new technology adoption, long lagging in the real estate space, has caught steam. Realtors, lenders, inspectors, notaries and all the surrounding services that go into buying and selling homes have had to pivot and look for ways to conduct business in a distanced or remote way. Virtual open houses and online 360 tours of properties, once novel, became the norm due to COVID-19. Lenders, like my company, have found ways to enable their customers to continue doing business by allowing virtual inspections for construction draws on flips. And some states, once the bastions of physical document recording, finally adopted electronic recordings (welcome to the 2000s).
Stay at home orders, remote work and school also shone a bright light on living arrangements and resulted in an acceleration of housing trends that were gaining steam prior to the pandemic. Americans began seeking more distance from neighbors, more space, and yards, thus generating an increasing demand for single family homes to purchase or rent. With household formations outpacing new home starts for a decade, historically low mortgage interest rates and renters seeking single family detached homes instead of traditional apartment homes, the demand for single family residential spiked, outpacing supply.
One way the investment community is addressing this market shift and the phenomenon that it is cheaper to build than it is to buy in many markets (and has been for a few years now) is by innovating through purpose built-for-rent communities. These developments address market supply shortages and provide affordable home options for buyers who are priced out of certain markets. They also provide attractive yields for investors seeking an inflation hedge. COVID-19 is not the genesis of the idea for these developments, but the shift it caused in market demands has propelled the concept to the forefront of the residential investment conversation.
Disruptions over the past two decades have resulted in innovations impacting the single-family residential sector, the opposite of Christensen’s thesis of innovation as the cause of disruption. Technology for individual and institutional use makes information more accessible. Data-driven investment and lending decisions lead to more successful outcomes. And, by keeping their fingers on the pulse of the markets through data, players in the single-family space can better understand emerging trends and market shifts and capitalize on new opportunities.
Finally, let us not forget the small-time buyer or investor. Had the previously detailed innovations occurred sooner, I have to believe that my mother would have been able to avoid the embarrassment that came from the mouth of her precocious two-year old. As for my grandfather, I suspect he would currently be building a small build for rent development in a suburb of Boston with construction financing from one of the many lenders in our space. It would, of course, be pre-sold to a Wall Street equity firm before any homes were vertical.
