Where is Build-for-Rent Headed?
The Market is Still Fundamentally Strong
By Adam Stern
For context, my firm provides Advisory and Investment Sales Services for regional builders looking to break into or expand in the Build-For-Rent segment, and showing them how to take residential projects and fit them into the Build-For-Rent mold in order to sell their neighborhoods as rental communities to long term buy-and-hold operators.
Let’s start with a view of where things just were and where they are right now before delving into what lies ahead.
The Past and Present
The housing market in general is coming off a white-hot run where everything from resale homes to new construction homes were flying off the shelves shortly after they were listed. But the market changed in Q4 of 2022. There was a tangible and abrupt shift in the buying patterns of investors in the institutional Single Family Rental (SFR) industry, from the largest publicly traded REITS to smaller private equity and privately funded SFR investment firms.
I would estimate buying velocity is down now by as much as 80% from a year ago. Firms that were continually buying particular homes in certain markets have shifted to buying opportunistically. This means they are not so much buying homes that fit a fixed set of criteria, but are now looking for homes that both fit that criteria and have a special circumstance that could lead to a lower than market acquisition price.
Those firms that have made the shift are now competing with smaller fund buyers (who were generally always buying opportunistically) for that very inventory. So, professional investment firms active in buying both existing homes and new construction homes overall represents a relatively small segment of the real estate market. These firms, until recently, were very actively funneling capital into the housing market, and are now waiting to see where the market is going before resuming business as usual.
Where the Market is Headed
Some of those firms from large to small that have been actively pursuing both existing home acquisitions and new construction single-site projects (what is traditionally known as Build-For-Rent), seem to be shifting the majority of their focus to just Build-For-Rent.
While the overall pace of acquisition in the institutional SFR sector cools, the desire of firms to see Build-For-Rent projects from builders is actually increasing.
It’s a very strange time in this still relatively new and nascent market niche. The economy is slowing, inflation is high and interest rates are high, but inventory is still very low in many markets around the country.
Builders are looking at investors to be a second option for them to sell their inventory to while still hoping for strong retail sales. Investors are being very solicitous to see that very inventory, but to make a deal work, both sides of the transaction need to squeeze to make deals come together.
Investors need to accept lower overall returns for projects in order to make the option viable for builders, and builders need to be good with thinner margins in order to pen a deal to sell all units in a subdivision to investors. It cannot stay like this forever. So, the question remains… Where is Build-For-Rent headed?
The highest value opportunities being sought by larger scale investors are single-site subdivisions in prime markets that are large enough to house an amenity like a pool and have an onsite leasing office. If a sub-market within a certain Metropolitan Statistical Area (MSA) is proximal enough to the major population centers in that market, meaning being drivable within 30 minutes to major employers, and close to shopping and retail thoroughfares, those communities have been and will continue to be highly sought after.
For a while, there has been talk about the Build-For-Rent trend moving to smaller markets outside of top large markets with populations over 1 million people. I have seen and even attempted to sell projects that fit this mold. It is very difficult to get firms interested in projects in smaller markets unless they are already sold on owning in that market. It is an arduous road.
What is happening now on a limited basis and is more likely be the case in the years ahead, is we will see some differentiation in strategies from fund investors where they will do the heavy lifting to get comfortable with certain smaller, tertiary markets and affirmatively start looking for opportunities there. Builders in markets like these will either have to find those firms or set themselves up as evangelists for their particular markets and look to draw firms in with opportunities.
This is why Strata SFR was set up to be an Advisory firm to builders first, and an Investment Sales organization second. The task of taking a project that is already under way, building it out, and then structuring the subdivision for sale as Build-For-Rent is a critical first step. Only then does a builder have a chance at either working with a firm like ours or trying on their own to make a market for those communities with a Build-For-Rent investor audience.
The Case for Smaller Projects
Behind large single site subdivisions in major and tertiary MSAs are smaller projects that generally are not big enough for an on-site leasing office or amenity. These types of projects, generally ranging from as little as 20 units to high double digits, are a hard sell to most larger fund investors.
If a project sits in proximity to other assets or communities of a current rental operator, they can be very attractive, as that operator can look to add doors and scale up their footprint in a particular area. This is only attractive so long as the performance of their current portfolio of homes in the area is strong, and the new units will not directly compete with their already operating inventory. We generally like seeing these smaller projects in good locations in large markets where the potential buyer pool is large and where any firm operating rentals in the area would be a potential take-out buyer.
These smaller projects in tertiary markets without large scale investors already owning there generally won’t be attractive to big funds.
Scatter Site Acquisitions
In the mix of what some people consider Build-For-Rent, but is really more akin to scatter site one-at-a-time acquisitions of homes through the MLS, are homes built on spec by home builders being offered to Single-Family-Rental/Build-For-Rent investors in bulk. There were thousands of these types of units being circulated at the end of 2022 and investors were looking at discount levels of 20%+ to make the numbers pencil in at a 6% Cap Rate.
For builders, this was an opportunity to get big chunks of inventory off their books at much reduced profit margins and in some cases at break-even points. Many fund investors are buying these types of homes directly from home builders well below peak pricing. Many home builders will take their chances on the retail market through the spring and see where new home sale prices shake out. Investors by and large understand this and will be waiting, looking to scoop up excess inventory at large discounts to peak pricing after the spring and summer markets come and go.
While the Build-For-Rent market has certainly shifted more in favor of buyers and to price levels that are more similar to early 2021, the market for Build-For-Rent is still fundamentally strong.
Rent growth is predicted to slow but not go negative in most of the largest markets in the US. Newly married couples and young families will find it harder to afford houses due to high interest rates, and those families with a need for more space and desire to live in good quality suburbs, will continue to drive demand for Single-Family-Rental homes. And as long as that fundamental need does not change, the pace at which new construction units will come to market will remain high and continue to pick up steam.
The pain being experienced by builders across the board may very well be satiated by looking toward Build-For-Rent as an exit solution. Builders that understand how to look at residential subdivisions through the prism of both Build-For-Rent and retail sales will be better off than those who rely solely on the retail home market as their sole way to unload Inventory.
