Macro-Economics of the Single Family Rental Market

Executive Summary

Most Americans want to own the house they live in. There are economic and emotional reasons for this. Most renters rent because they can't afford to buy. The residential rental market mostly serves low income tenants because middle class Americans are able to buy. The housing crisis changed this. Many are locked out of the housing market. The result presents an opportunity for private equity investors.

Background

There are 3 reasons why people prefer to buy:

They like the control that ownership brings. A homeowner can paint their kitchen any color they like without seeking a landlord's permission.
Government policy favors home ownership. Mortgage interest payments are tax deductible. State and local property tax laws are often framed to favor home ownership.
A house purchase is a leveraged investment. A first-time buyer saves $20K to use as a down payment on a $100K home. Five years later they sell the house for $120K. This gives them $40K to use as a down payment on their next home. They doubled their money on a 20% increase in the value of the house.

The great recession exposed homeowners to leveraged investment's evil twin. A combination of falling house prices and cash-out refinances has left many with negligible or negative equity. Anyone caught in this situation will not be buying another house anytime soon. Tighter lending standards mean they are unlikely to qualify for a loan at more than 80% LTV. Few have the cash to make up the difference. Most are simply sitting in place waiting for prices to recover. Many gave up their homes to foreclosure or short sale.

The demand for rental properties in the United States will be higher than normal for a number of years. Former homeowners with limited cash or damaged credit will be unable to buy. Supply and demand rules suggest house prices should remain depressed for a similar period. This presents an opportunity for hedge funds and private equity.

Displaced homeowners will look for properties of a similar standard to the ones they vacated. If your last house was 3,000 sq ft overlooking a golf course you're unlikely to make your next home an 1,100 sq ft rental property backing onto a railroad. Most single-family rental markets around the country have far more of the latter than the former.

Investment Opportunity

We believe the single-family rental market is a 5 to 7 year investment opportunity. Private equity investors should focus on markets with high foreclosure levels, good employment prospects, positive population growth projections and low price-to-rent ratios. Their acquisition strategy should assume a 5 year holding period for the properties they purchase. They should focus on properties that match the general profile of owner occupied foreclosures and short sales in the markets where they are active. We see single-family rentals as an inflation opportunity/hedge. The Federal Reserve is currently purchasing $40bn in mortgage backed securities each month. This policy appears to be designed to introduce house price inflation. Underwriting criteria should be based on unleveraged yield and 5 year IRR projections that assume some level of house price inflation.

Exit Strategy

Three options exist for PE firms at the end of the 5 year term:

Sell their properties to retail clients
Convert the fund to a REIT
Bulk sell their properties to another fund or REIT

Funds that assume a retail exit are likely to have higher disposition costs than ones that convert or sell to a REIT. They also run the risk price erosion if they attempt to sell their properties too quickly. Funds that intend to exit via a REIT need to consider the data requirements described in the Fitch Ratings and Moodys reports on securitizing single family rental portfolios.