By Sudha Reddy
April 29, 2022
It is widely known that there is a dearth of entry-level housing—both for rent and for sale—in the United States.
It is widely known that there is a dearth of entry-level housing—both for rent and for sale—in the United States. COVID-19 accelerated the demand for both types of housing in suburban markets, and this trend is not anticipated to dissipate in the near term. Indeed, as interest rates rise, even more households can be expected to consider renting their homes.
The build-to-rent (BTR) market is part of the solution and will help meet the rising renter demand in many of the country’s largest metropolitan areas. There is strong institutional interest in participating in all segments of the value chain, including acquiring BTR communities once they have stabilized. The housing market stands to benefit from an increased supply of larger-floor-plan rental homes. And the key to increased supply is continued institutional investment in the BTR space.
Single-family rental housing—owned by individuals and investors—has always existed. However, the sector emerged as a viable real estate product type during the global financial crisis of 2007–2008 when early investors recognized the opportunity to aggregate distressed houses at substantial discounts to peak pricing and rent them out.
Some of these early investors believed the investment strategy constituted purely a trade, allowing the investor to take advantage of the dislocation in the market and wait until market conditions improved before making a successful exit—that is, buying low and selling high. Others believed that the single-family rental strategy could result in an industry that provided individual and institutional investors with much-needed measurable yield, like its multifamily counterpart. These same investors also recognized that individuals and families caught up in the foreclosure crisis would need homes to live in and preferred houses to apartments.
Now that the economy has substantially recovered from the financial crisis, a growing cohort of individuals is renting houses by choice because of the flexibility that renting provides. Others are renting houses because they lack the downpayment required or simply cannot qualify for a loan given current high interest rates and home prices.
In the past, rental housing was primarily built with smaller floor plans—primarily one or two bedrooms, with a small percentage of three-bedroom units. As a result, an individual or a family wanting to live in a larger space had the option of renting one of a limited number of homes in a market or buying a home.
Today, renters have more options, and an increasing number of residents are choosing to rent rather than buy. This has led to a growing single-family rental sector that now includes a new construction component commonly referred to as build to rent. BTR is adding much-needed rental inventory across the country to a housing market that has rarely had single-family houses purpose-built as rentals.
As the country enters an inflationary environment in which interest rates are expected to rise at least in the short term, more individuals and families are expected to face affordability problems and forgo the homebuying market in favor of home rental. The BTR sector will be a critical solution for these individuals who want to rent a house.
The single-family rental sector has evolved over the years, as have investor mind-sets regarding the format. Two main questions have been top of mind for early investors in the sector: how do you efficiently acquire homes in multiple markets and states, and how do you efficiently manage homes scattered across markets? Operators of single-family rental housing have wrestled with these topics as they have proved out the business model.
As some operators enter their second decade of operations in the sector, they can cite historical results to provide comfort to prospective investors. For many investors, these results have been enough to prompt them to begin deploying capital into the traditional single-family rental model. Others are still not convinced or cannot find suitable operators with experience in the sector. Many of these investors have shifted their focus to the growing BTR sector, where many parallels to the multifamily sector can be drawn.
Investors in build-to-rent properties are attracted by the exceptional long-term fundamentals that come with the single-family rental sector, including longer-term tenancy, increasing rental rates, and high occupancy. On the flip side, they are also attracted by the high operating and financing efficiencies that come with traditional multifamily properties.
A growing cadre of investors believes that BTR is the perfect hybrid because it combines the best that traditional single-family rental and multifamily properties have to offer in one investment strategy. Investors appreciate the efficiency and simplicity of operations created by a single location while gaining exposure to the highly coveted single-family renter demographic.
The BTR label has been used broadly by the investment community to describe rental housing that is less dense than traditional multifamily housing and purpose-built in a single location. Rarely has a distinction been made between the size of the rental units or resident profile of various BTR communities.
There are two distinct categories of BTR. One, commonly referred to as horizontal multifamily, involves essentially less-dense multifamily projects—usually one-story cottage-style buildings—that have apartment-style floor plans and a small yard. These types of projects have been in high demand by renters looking for less density and extra space for their pets. However, they cater more to the apartment renter.
The other type of BTR—commonly referred to as dedicated rental or build-to-rent communities—has larger floor plans and resembles true for sale–style housing in either a detached or attached format. Typically, these types of BTR communities have units with three or four bedrooms and cater to families or empty nesters seeking a renter lifestyle.
Both styles of BTR communities have been successful and meet different resident demands.
Financing for BTR continues to evolve, and an increasing number of debt and equity providers are entering the space. Several large real estate private equity funds specializing in opportunistic and value-add strategies have entered the BTR sector and are funding sponsors with homebuilding, multifamily, and single-family rental experience to develop, build, and stabilize BTR communities. As these BTR communities are stabilized, they are seeing robust demand from institutions of all sizes that are seeking stable cash flow for their core and core-plus capital allocations. These institutions are essentially validating BTR as an asset class that has staying power and is valued similarly to multifamily
Debt providers are becoming increasingly comfortable with the BTR space and the different types of structures accompanying various communities. Lenders with experience financing the scattered-site single-family space seem to be most comfortable providing acquisition lines of credit to borrowers who are acquiring BTR communities in phases once homes have received a certificate of occupancy from the local municipality. Alternatively, construction lenders familiar with homebuilding or multifamily construction are more comfortable providing construction loans to BTR borrowers. Each type of lender is focusing on what it knows best; a small group of lenders have been able to do both.
Upon stabilization of the communities, traditional multifamily lenders—including government-sponsored enterprises (GSEs)—are entering the BTR market, providing long-term fixed- and floating-rate options to borrowers. The key requirement for these lenders is that BTR communities need to be contiguous with no fractured ownership structures. These lenders will become the lifeblood of the BTR sector, providing the much-needed validation and long-term stable capital it needs to continue increasing liquidity in the space.
As is in the case in traditional real estate sectors, BTR deals can come together at several stages—unentitled raw land, entitled raw land, fully developed finished lots, acquisition in phases at certificate of occupancy, and fully stabilized communities. Each of these structures carries its own risk profile.
Because BTR is a hybrid of multifamily and single-family housing, different stakeholders are entering the space in different manners. For example, traditional homebuilders heavily focused on building communities for the ownership market have been increasingly comfortable creating these same communities for investors who will lease and manage them as rentals. Often they will sell them to investors in phases, similar to their for-sale business with little change in business model. The benefits include eliminating price risk by locking in a contract sales price, eliminating market risk by selling to one owner, maintaining a comparable gross margin, and cycling capital more quickly.
Some traditional multifamily developers are entering the sector and assembling land positions where they will oversee horizontal development, vertical construction, and lease-up before they either exit or hold for the longer term. They see the benefits of adding a product type to their toolkit.
A key highlight of the BTR investment strategy is the operating model, which is more akin to traditional multifamily model than the more challenging scattered-site single-family rental business model. The single location is the key to BTR for many investors who are accustomed to multifamily underwriting and property management. There are some key differences between multifamily and BTR—most notably the slower turnover rate for BTR, which is generally half that of multifamily. While this is of benefit for the overall model, it frequently leads to higher turnover costs because homes have been occupied longer and require replacement more frequently. This is a key item that needs to be underwritten properly.
Many national and regional multifamily property management firms are entering the BTR space, as are some managers of scattered-site single-family rental properties. The ability of investors to use high-quality property management firms they already have a relationship with is another key element helping increase the number of investors entering the space.
Investors in all asset classes regularly seek to identify risks and mitigate them as best they can, and real estate investors are no different. The single-family rental sector in its infancy in 2009–2015 was perceived as fraught with risks and unknowns. Many investors had questions. How will you acquire and manage homes across multiple metro areas and states at the same time? How do you control costs when you are buying and renovating homes one at a time? How will you exit the investment?
The question regarding exit was among the most difficult because no investor had exited a portfolio in bulk. Those questions have largely been answered now that portfolios have traded in bulk between investors and back to individual homeowners and investors.
With BTR in the early stages of its formation, many operators have been asked about exiting stabilized communities. A small number of early BTR operators began selling their stabilized communities in 2020 and 2021, proving that investors would value these assets like class A multifamily housing based on prevailing market cap rates in the low 3 percent to low 4 percent range. Now actual comps exist to prove that institutional investors seeking a stable yield are actively acquiring BTR communities upon stabilization. These comps will begin to provide stability to this new segment of single-family rental housing.
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