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Looking at Single Family Home REITS



April 08, 2014 – Comments (1)

Board: Real Estate Investment Trusts

Author: Reitnut

Here's a post I did for "Block Party" a few weeks ago, in case anyone is interested:

Home ownership certainly offers real benefits. A home of one’s own can provide a favorable environment for raising a family; it allows those who are not astute in making investments to build equity for eventual use in retirement; and, unlike apartment rent payments, mortgage interest is subsidized by US tax laws. But a home isn’t normally a great investment. A blogger for recently cited the conclusion of Robert Shiller, the well-known economist who has spent years studying housing markets: “Over the long term, home values remained relatively the same when adjusted for inflation. From 1900 to 2000, the national average of the real rate of appreciation on home values was only 0.2%.”

Nevertheless, we have witnessed the recent birth of a number of new REITs dedicated to investments in single-family homes. The first such REIT was Silver Bay (SBY), organized in December 2012, followed by American Residential Properties (ARPI) and American Homes 4 Rent (AMH), in May and July of last year, respectively. The newest such REIT is Starwood Waypoint Residential Trust (SWAY), having recently been spun off by Starwood Property Trust (STWD). These REITs seek to buy homes cheaply, often via defaulted home mortgages, and rent them to tenants. Are these REITs good investments? Is buying and renting homes a good business, or just a good short-term trade?

Homes bought cheaply enough can be quite profitable. There are more stories than there are kibbles in my dogs’ food bin about homes bought at the bottom of a housing cycle by enterprising speculators, usually with substantial debt leverage, and sold later in the cycle at profits that would make a pawnbroker blush. But can anyone build a business doing this? For numerous reasons, I am skeptical.

The value of a single-family home isn’t easy to know. Unlike traditional forms of commercial real estate, few home dwellers pay rent, and “comps” are often elusive – and homes can be quite illiquid. Home prices are often determined, at the margin, by the emotions of would-be buyers. Are the local schools and the neighborhood improving or deteriorating? Is the landscaping appealing, or a turn-off? Replacement cost is often a very uncertain indicator of value. And mortgage rates (more on this below) will have a huge impact on the price of a home. Thus with home values so uncertain and changeable, how can the single-family home REIT have confidence that it’s investing in a home cheaply? And how can those who invest in such REITs make such a determination?

A car salesman once told me that, more than ever before, buyers base purchase decisions on monthly loan or lease payments, and not the car’s price. I suspect this is increasingly true of home buyers – the monthly mortgage payment is the key to a purchase decision. So what will happen to the housing market – and to home prices – when the 10-year Treasury note yields 4.75% and a 30-year mortgage comes with a 6.5% handle? Last year’s 100 bps increase in mortgage rates seems to have already caused some cooling in the housing market.

Another major issue involves the cost to properly maintain a home, or a portfolio of them. With commercial real estate we can look at REITs’ public disclosures of ongoing capital expenditures needed to keep their properties up-to-date and competitive; although this is an area where more disclosure is clearly needed, at least we have some data. I don’t believe there is any reliable data on the ongoing and recurring capital costs needed to keep a home attractive. Even regular maintenance expenses, such as lawn mowing and repairing window screens, are hard to forecast. As a result, it will be difficult indeed to project future free cash flows of single-family home REITs.

It is quite likely that those – both REITs and opportunistic buyers – who bought home rentals early in the recent cycle have made, and will continue to make, substantial profits from rental income. And they will probably see the values of their investments continue to rise for some period of time. But whether the shares of the REITs who have done so are a good long-term investment is an entirely different question. I have a great deal of respect for B. Wayne Hughes and Barry Sternlicht, the former known for his invention of Public Storage (PSA) – AMH is his newest creation – and the latter being the well-known commercial real estate guru who heads up Starwood Capital and, more recently, STWD. But nobody is forcing me to invest in any of these new REITs and, unless new facts come to light, I don’t intend to do so.

I dislike leaving this Block Party post on a sour note, and so I will try your patience for a few minutes longer by briefly mentioning, with kinder thoughts, another smallish sector in REITdom.

“Lab space” REITs are often categorized as a subset of the vast office REIT sector. These REITs own and lease space to companies and institutions that use it to research and/or develop prescription drugs. Tenants include large and small drug companies (both pharmaceutical and biotech), research institutes and other entities (some government affiliated) that need specialized space to carry out these activities.

There are two public REITs that focus exclusively on this niche: Alexandria Real Estate (ARE) and BioMed Realty Trust (BMR), with market caps of over $5 billion and almost $4 billion, respectively. HCP Inc (HCP), the healthcare REIT, also has a significant number of investments in this property type. ARE has delivered returns close to that of the REIT industry over a multi-year time period, while BMR’s return has lagged slightly. Performance will, of course, vary with the measurement period chosen. Both ARE and BMR have solid, and modestly-levered, balance sheets.

These REITs own properties that, for the most part, are located in “clusters” where lessees like to congregate; they tend to prefer being near major universities or research institutes. Many of these markets are supply-constrained, e.g., Cambridge. The tenants vary widely in size and profitability, thus putting a premium on the underwriting of promising science when space is leased to a smaller company that is not yet profitable. But the property owners have been able to limit their build-out capital expenditures, and thus avoid major write-offs if a tenant goes out of business. Leases are usually triple-net.

I like these REITs – and their properties – for several reasons, including: (a) the stable nature of life science R&D programs, making space market fundamentals somewhat recession-resistant; (b) limited competition for new developments – not many enterprising developers with a line of credit given them by their golfing buddies at the local bank can build these properties; (c) locating and keeping quality tenants is very important, and the two REITs specializing in this property type have extensive and long-term contacts in the life science industry; (d) property development here, as elsewhere, is risky, but new projects can often be largely pre-leased to one or more large tenants; and (e) the ageing of the US population, increasing life expectancies, and the ability of new meds to help control healthcare expense growth should provide a solid tailwind.

Perhaps the biggest risk in this niche is a possible decline in prescription R&D budgets, pressured by the massively expensive effort necessary to develop major new drugs. Funding of the NIH, due to federal budget constraints, is a recent concern. Tenant quality may, at times, also be an issue for investors.

I hope these brief comments will provide some perspective on the single-family home REITs and the lab space REITs. The prospects of the former look quite uncertain to me, but investments in the latter would seem to offer favorable long-term total returns and with only modest risk. But take these comments with many grains of salt – I haven’t seen a Bunsen burner since high school chemistry.


1 Comments – Post Your Own

#1) On April 08, 2014 at 2:03 PM, Teacherman1 (< 20) wrote:

Interesting post Ralph

Just a few observations from someone who "profited" substantionally in the 80's from a very large residential REIT that went bankrupt; when I was able to buy porperties in my area for about $0.25 on the dollar when the bankruptcy judge forced them to liquidate.

If they are investing in areas they don't really know, they can get hit hard in any downturn. They bought a lot of "dogs" along with the good stuff, because they were going on price and square footage, and didn't know the bad areas from the good ones.

You make your money when you buy, i.e. if they buy at the right price and have a good cushion, then they can weather the storm, but if they don't, they will get blown away by the strong winds of change.

They have to keep growing, because if they stop, they start to go backwards. It is like walking up a down escalator.

You need local people who have a vested interest to manage the properties, you can't pay strangers enough to look out for your interest.

If their model is to buy, rent out, and then sell them to the renters, they can make good money, if they try to just keep renting them, at some point they will go South.

If I were younger, I would keep a close eye on them and look for opportunities to "take them off their hands" when things don't work out the way they had hoped, but being into my 8th decade of life, I just don't have the will, energy, or need to do it again.  

JMO and worth exactly what I am charging for it.   

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