Shrinking Margins & Government Eviction Bans Challenge Investors
Where is the ROI?
by Rick Sharga
Single family rentals (SFRs) have been one of the fastest-growing segments of the housing market for the last decade. Formerly a well-kept secret and the purview of local mom-and-pop investors, the category sprung into the nation’s consciousness during the Great Recession, when institutional investors entered the fray, buying thousands of foreclosure properties and converting them into rental homes.
Popular opinion at the time was that large institutional investors like Blackstone would dominate the market, but exit it relatively quickly, with a business model designed to make modest profits during the holding period, while banking on longer-term home price appreciation for the bigger profits later. This theory also held that the phenomenon of renting single family properties would be relatively short-lived, and last only as long as it took these renters to repair their credit or improve financial positions that had been devastated during the foreclosure crisis. Both of these assumptions proved to be very wrong.
Instead of shrinking, the number of SFRs has almost doubled over the last 12 years, and ownership is still heavily skewed towards small-to-mid-sized investors. According to a recent Freddie Mac report, almost 90% of SFRs are owned and managed by investors who own between one and 11 properties. And the demand for these homes continues to increase as tenants who prefer renting to owning look for alternatives to apartments, and for opportunities to move out of urban markets into suburban areas which often boast stronger school systems.
So, should all investors be focusing on single family rentals? Like most things related to real estate investing, it depends.
Supply and Demand
The challenge for investors hoping to become SFR landlords is that there’s almost nothing to buy. Institutional investors originally built their SFR business by acquiring bank-owned properties or other foreclosure homes, but mortgage default rates are historically low due to the government’s foreclosure moratorium and the CARES Act mortgage forbearance programs. While some investors are banking on a wave of post-pandemic defaults once the government programs expire, that seems highly unlikely for reasons too numerous to delve into here.
Meanwhile, the inventory of existing homes available for sale is at the lowest numbers ever recorded by the National Association of Realtors®. So, there is very little to buy, and demand is exceptionally strong, driven by demographics and extremely low mortgage interest rates. Investors find themselves competing with traditional homebuyers for this limited number of properties, which drives prices up and makes achieving ROI targets more difficult.
The good news for SFR investors is that their ROI tends to be more cashflow-based and less based on the “buy low, fix inexpensively, sell high” approach employed by fix-and-flip investors who need below-market pricing to make their models deliver the kind of returns they’re looking for. This means that SFR investors are often better positioned to compete with homebuyers, as well as other investors, for properties selling at or near full market value—an advantage in today’s housing market, where prices have risen by double digits year-over-year.
Where’s the ROI?
Institutional investors initially focused on markets with the highest numbers of foreclosures like California, Florida, Arizona, and Nevada. As the distressed inventory was purchased, home prices rose more quickly than the investors anticipated, and in many cases, homes became too expensive to rent out at a profit.
Much of the investment by these larger firms since then has been done in less expensive markets in the Midwest and Southeast, where properties are lower-priced. Those lower prices, coupled with today’s low interest rates, offer investors of all sizes the opportunity to improve their yields.
According to a report from ATTOM Data Solutions, higher prices have had an impact on SFR ROI over the past year. The average anticipated annual gross rental yield (annualized gross rent income divided by median purchase price of single-family homes) among the counties in the report is 7.7 percent for 2021, down from an average of 8.4 percent in 2020. In fact, the yield declined in 87 percent of counties ATTOM analyzed. However, it’s not all bad news for rental property investors—there are still markets delivering high yields. The ATTOM report identified Counties Schuylkill County, PA (26.1 percent); Bibb County, GA, (18.1 percent); Baltimore City/County, MD (16.2 percent); La Salle County, IL, (14.1 percent) and Chautauqua County, NY (13.7 percent) as the five counties with the highest yields.
Among the top 50 rental returns for counties analyzed in 2021, 25 are in the Midwest, 15 in the South and 10 in the Northeast. Todd Teta, chief product officer at ATTOM, noted that “Returns on single-family rentals still generally remain strong, and there are pockets, especially in the Midwest, where yields top 10 percent. There also are some signs that things could improve in 2021.”
Among larger counties, the highest potential annual gross rental yields in 2021 according to the ATTOM report are Cuyahoga County, OH (9.9 percent); Dallas County, TX (8 percent); Tarrant County, TX, (8 percent); Franklin County, OH (7.9 percent) and Bexar County, TX (7.9 percent).
COVID-19 Increases Investor Risks
Of course, no article would be complete without a COVID-19 component, and the SFR market is no exception. As noted above, the ownership of single family rental units is skewed heavily towards small, “mom-and-pop” investors. Most of these property owners have financed the purchase of their rental units, and many are highly leveraged.
The combination of high unemployment rates, missed rental payments, and a ban on evicting non-paying tenants in order to lease properties to paying tenants can prove to be a toxic mix for these mom-and-pop landlords, whose mortgages are often not protected by the mortgage forbearance program in the government’s CARES Act, and also are not necessarily eligible for protection from foreclosure.
RealtyTrac published a Rental Property Risk Report which analyzed over 3,100 counties across the country to determine in which markets SFR property owners were in most danger of default due to the conditions
outlined above. Of the largest counties, 53% were considered to be at above-average risk. Among these large counties, Florida, New York, and California counties accounted for 44% of the 25 most at-risk counties.
There are two considerations in all of this data for SFR investors: First, it’s important to take into consideration the risk/reward ratio of the counties you’re thinking about buying SFR properties; second, there’s a possibility that SFR property owners in some of the high risk areas are going to find themselves in financial distress, and may need to sell off some of their assets to avoid foreclosure. In today’s low-inventory environment, those may be good markets to investigate for affordable properties.
The good news is that the long-term prospects for the SFR market continue to look very positive. Household formation will surge once the pandemic has passed, and a large number of new households will be renter households. In the meanwhile, the SFR market can still be lucrative for savvy, disciplined investors.
