The Buzz Behind Build-to-Rent
Analyzing the Differences Between BTR and SFR
By Michael Cook
Build-to-Rent (BTR)’s breakthrough in the Single-Family Rental (SFR) asset class is officially old news.
In 2018, Toll Brothers teamed up with BB Living to create one of the first builder/operator partnerships. Other homebuilders quickly followed, developing their own line of BTR products by either creating their own property management division or partnering with established operators to manage a steady flow of homes built specifically for rental.
Even one of the leading brokers in the SFR space jumped on the bandwagon, raising a $1 billion BTR fund. The Wall Street Journal predicted the number of BTRs built annually would double by 2024.
If Institutions Are All In, Is There Room for Smaller Players?
Of course. Just like traditional SFR, smaller players need to find opportunities to get into the game where larger institutions either cannot or choose not to play. The big guys are focusing on deals where they can put large amounts of capital to work, so they tend to avoid these three areas of opportunity:
1. Tertiary markets that lack strong home price appreciation metrics or solid gross yields;
2. Smaller developments (sub 100 lots); and
3. Challenging municipalities.
How Far is Too Far?
While tertiary markets generally fall outside of the top 20 on most investment lists, they often provide solid returns for local players with deeper on-the-ground knowledge of the market. From start to finish, even modest BTR projects will take years to develop. So, when considering these markets, focus on either gross yield or appreciation (if a market had both it would be a top 20 market). Regardless of the market, focus on the long-term fundamentals. Job growth, path of development, supply of housing, and proximity to retail or local demand drivers should be chief considerations.
Bigger Isn’t Always Better
Smaller developments lack the economies of scale required for larger players and are thought to be more trouble than they are worth. As such, these types of projects represent an excellent opportunity for smaller players to stake their claim in the space. Whether targeting individual infield lots or communities with under 100 lots, both represent areas of opportunity. Importantly, bring a large-scale mentality to the small-scale project. Where possible, utilize the same local builder. Minimize the number of floor plans and designs. Lock in material costs early. Build the perfect BTR home over and over again to offset some of the disadvantages of smaller scale.
Embrace the Challenge
Each municipality offers its own set of challenges. Some make it easy to build, some make it hard, and then others make it their very own special version of hell. Larger players typically avoid the hard ones and almost everyone but the locals avoid the hellish ones. While not for the faint of heart (or light of pockets), the biggest challenge in these markets lies in simply getting the approval to build the community and then the homes constructed.
A strong ground game pays dividends in these markets. Sweat equity, networking, and simply camping out in the city planning office can be a good starting point. You may also consider partnering with a local partner with a proven track record of completing and exiting transactions. To be sure that you are covered, do not forget to increase contingencies and model six to twelve months more than you would on a normal deal.
Ok, But Is It All Worth It?
Every market has local players that have been making a living off of development for years. BTR requires a special skill set that combines the complexity of homebuilding with the expertise of a long-term property manager. Let’s look at the numbers to better understand the appeal of BTR for smaller players.
The most obvious benefit is in the significantly lower operating costs of BTR. As noted above, with warranties in place, first year operating costs should be close to $0.
Over a five-year hold period, our experience over 500+ homes suggests operating costs averaging $1,000 per year. That compares favorably to traditional SFR, where the costs over a five-year hold period can range anywhere from $2,000-$5,000 depending on the upfront renovation plan and the age of the traditional SFR home. Assuming a 5.5% cap rate, the maintenance benefit represents a value of ~$18k ($2,000-$1,000)/5.5%).
So, an investor willing to pay $225k for a BTR home should only pay $207k for a fully renovated traditional SFR with similar specs, and much less for a similar size older home with minimal renovations.
This operating cost difference is driven by the fact that you cannot renovate everything profitably. The potential for plumbing issues or foundation repairs, as an example, grow exponentially as the home ages. But, any preemptive fix generates exactly $0 in increased rent and an uncertain amount of cost avoidance. Traditional SFR investors need to balance cosmetic renovations that contribute to higher rent and fewer days on market with cost saving renovations to structural items (roof, foundation, electrical, etc.) that provide smaller upfront benefits.
New Home Smell Premium
BTR homes command higher rents than traditional SFR. Renters have shown that they value a perfect home more than they value even a nicely renovated home. The rental stock in many areas, even renovated, will likely have inferior appeal. Whether it is funky layouts, smaller bathrooms, or fewer electrical sockets, homes built pre-2000 were not designed for the way we live today.
The premiums vary and decline over time. The first renter in a new home will likely pay a 5-10% premium, while subsequent renters will pay 2-5%. For BTR communities, that premium can get up to 20%, but it still declines over time. For simple math, let’s assume a 5.5% cap rate again and a 5% rent premium on an average rent of $1600. Assuming a new home rents for 5% more or approximately $1680, you would take $80 per month straight down to the bottom line. In total value, you would see an additional ~$17,500 ($80 x 12 / 5.5%). Continuing with the math above, now our $225k BTR home compares to $189.5k traditional SFR home ($225k – $18k – $17.5k).
Volatility – An Investors Worst Nightmare
The final, and perhaps most important, benefit of BTR is the reduction in cash flow volatility. Tenants stay longer and pay more, resulting in higher income over time. BTR tenants also generate less bad debt. On top of that, the operating costs of the asset are much more predictable. With warranties for any major work and insurance for disasters, the potential for a “midnight surprise” is limited to a broken appliance or minor damage, which could likely be charged back to the tenant.
In traditional SFR, larger institutional players limit their volatility in several ways. When looking at the buy box (universe of homes within a determined set of purchase criteria), they attempt to limit volatility by eliminating homes that are older than 1990 or homes in flood zones or homes in areas with known foundation issues, etc. Importantly, that does not mean these are bad homes. This simply means that institutions place more value on consistency of cash flow than on the discounted price of homes outside of the buy box.
In real estate, risk or volatility is measured via cap rate. BTR’s lower volatility merits a lower cap rate. Let’s continue with our example above. If we just look at the net operating income (NOI) of each home, the new home should be priced at $225k and the traditional SFR home should be priced at $189.5k. This accounts for the higher rent and lower operating costs in the new home.
If you could buy a new home for essentially the same price as an old home, you would buy the new home every time because (over time) you expect the expenses to increase on the old home much faster than you expect income to grow. In the new home, you would expect to see the opposite. Expenses should be low, predictable, and stable for at least the next 10 years, while rent should price at a premium to market for about that same timeframe.
Our BTR home generates ~$12,400 per year ($225k x 5.5% cap rate) vs. the traditional SFR home at ~$10,400 ($189k x 5.5%). As discussed, given the volatility of traditional SFR, it should likely trade at a higher cap rate to reward the investor for the additional risk. Depending on the community, that premium could be 50 – 200 bps. Assuming 50bps, our new price for a comparable traditional SFR home should be ~$173k ($10,400/6.0%). This means an investor should be willing to pay a ~25%-30% premium for BTR homes vs. traditional SFR homes. Importantly, for that premium they should expect similar returns with fewer heartaches.
While this math is far from exact and varies by market, it helps directionally explain the buzz behind BTR. If you can find the right opportunity, even the little guy can capture a significant premium over traditional SFR.
