Unlocking the Build-for-Rent Market
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 and
slow 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 are often measured in years versus months. Although each project is different, most Build-for-Rent projects in market today require 6-12 months of development time and 4-6 months to construct each house resulting in the first tenants being in place ~18-24 months following the start of land development. Zoning and entitlements typically add 6-12 months and can spike to several years (or more) in restrictive development markets. Contingencies are another key risk factor as many developers have insufficient reserves. Best practices are to account for at least 10% of development costs, 5% of construction costs and 3% of soft costs.
- Project acceleration. Accelerating stabilization is a key element to managing the NOI. Two best practices stand out – phasing and pre-leasing. Phasing refers to the practice of rolling stabilization. Where possible, creating site plans that allow for secondary construction entries will enable developers to build out the project from one entrance to the other while putting tenants in place once each construction phase is complete. This tactic allows for the generation of rents months earlier, while also reducing the pressure of having to lease-up an entire project at once. Similarly, pre-leasing properties in the construction phase minimizes the time a completed property sits vacant. This tactic is commonly used by new home builders who often contract the homes months in advance of the construction completion.
Financing Build-for-Rent Projects
Capitalizing Build-for Rent projects can be both costly and complex as the risk factors often fall outside the expertise of lenders. These nuances of financing Build-for-Rent projects require a specialized lending practice that is not yet established in the market. Many lenders have siloed expertise within a phase of the development (e.g., Construction, Development, Permanent Financing), but Developers need a partner who can underwrite the entire project under a singular loan.
Financing terms vary significantly throughout the life of each project. The lack of liquidity in the acquisition and development phases drives financing costs higher and requires greater equity contribution. Many projects are capitalized with equity through these stages as debt is typically limited to 50-60% of the total cost structure. Rates are highly dependent on the complexity of getting the land to a build-ready state. Once a project is eligible for construction permits, traditional construction lenders’ loan-to-cost (LTC) levels materially increase to 70-85% with coupons falling. Meaningful equity contributions of ~20% over the life of the project are crucial to a successful launch and align interests of all parties involved. The increased availability of debt solutions enables developers to maximize their profit. Ultimately, finding the right partner often means establishing a programmatic relationship with a financier who understands development and the process from land acquisition to stabilization.
An Arbitrage Investment
Strong demand and a dearth of supply make Build-for-Rent a compelling opportunity and the financial outcomes are outsized. While Build-for-Rent projects remain as a small percentage of new home development activity, the rich margins are likely to result in heightened land costs and increased viability of land parcels that were previously infeasible. At present, the resulting financial outcomes for builders executing Build-for-Rent projects can be materially higher than Build-to-Sell strategies.
Paul Stockamore and JP Ackerman are the founders of Techo Real Estate Capital (TechoREC.com). Techo is a capital provider to real estate developers focused on creating or preserving Attainable Housing. The Techo team is a team of developers, entrepreneurs, and investors with decades of experience investing and operating institutional real estate platforms. Techo’s funding programs are flexible and competitive solutions that enable mission-aligned developers to address the persistent undersupply of Attainable Housing.
Get in touch at hello@TechoREC.com
