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The Rental Hedge: More Production Builders Add Rentals In Hybrid Business Model

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As the homeownership rate creeps lower, a number of builders are testing rentals

When Gilbert, Ariz.–based Higley Homes built its first community of 185 single-family homes in 2012, its three owners—all newcomers to home building—offered half of the three- and four-bedroom, entry-level dwellings for sale and the other half for rent.

"The strategy, for us, was very compelling because it offered a little more downside protection," says principal Matt Blank, a former hedge fund stock analyst. "We could sell them to individuals, or we could sell them [to investors], or we could rent them out. We had three different angles."

The trio sold 34 homes, at an average price of $205,000, within four months of Higley Park's grand opening. On the rental side, 40 of the two-story houses leased up at the same time.

That's all it took for the partners, including Blank's brother, Sam, whose background is in real estate equity, and Darryl Berger, a private real estate investor, to get out of the for-sale business and focus solely on building new homes for rent.

Higley Homes isn't the only home builder whose head has been turned by a seemingly chronic upswing in the rental market. Miami-based public builder Lennar—No. 2 on our most recent BUILDER 100 list—is renting a community of 80 freshly built, two-bedroom, detached houses in Sparks, Nev., and is building or planning $6 billion worth of apartment buildings, and in July formed a $1.1 billion joint venture to develop apartment communities in 25 metropolitan markets.

Ryland Homes is countering what it calls "the slow absorption" of townhomes in the crowded Chicago market with plans to rent out 108 brand-new quads in 27 buildings in suburban Matteson until the market improves and the builder can put them up for sale. Caviness and Cates Communities builds 400 homes a year for sale and also rents out apartments in the 85 multifamily buildings it has constructed since 1998. Toll Brothers has found some success with garden apartments and high-rise multifamily, even as its overall focus remains on for-sale product. And a smattering of small- and mid-size builders are solidifying the hybrid model in a growing number of local communities, building some for-sale and some for-rent homes as the market continues to teeter rent-ward.

Economic Driver

In fact, 5.8% of the 535,000 single-family homes started in 2014 were built to rent rather than to sell, the NAHB estimates. That's up from 2% in 2006.

Even with the growth spurt, NAHB's chief economist David Crowe says the number is "so small that it's hard to tell whether that's really a big wave or just a dabble."

Either way, notes Lawrence Yun, chief economist for the National Association of Realtors, builders "are just following where the money is. The builders are saying, ‘Maybe there will be more home buyers in the future, but right now, there are plenty of renters and the rents are rising, so why don't we follow the money?'"

For Fayetteville, N.C.–based Caviness and Cates, "it's a good model," says co-owner Chris Cates, whose company's one- to three-bedroom garden apartments in North and South Carolina rent for $800 to $1,200 a month. "I don't see the negative of it."

In fact, the rental market has delivered its share of positive news over the past few years. As the rate of homeownership has fallen to a 20-year low, the 2010s are on track to become "the strongest decade for renter growth in history," according to "The State of the Nation's Housing," a Harvard Joint Center for Housing Research report released in June. Among the 22 million new households that will form from 2010 to 2030, 13 million will rent and 9 million will buy, the report predicts.

That's reason enough for some home builders to reach into the rental market, says New York–based Stanley Morgan research analyst Haendel St. Juste, who thinks homeownership—which historically has been embraced by 65% of Americans at any given time—eventually will whittle to a stable 63%. The Harvard report puts that number even lower: By 2030, it predicts the homeownership rate will drop to 61.3%. Regardless of which number is correct, St. Juste says, "We think the rental segment of housing can win."

Susan Maklari, a senior equity analyst with UBS Securities in New York, agrees. She points to the difficulty many potential home buyers—particularly young, first-time buyers—are having with qualifying for mortgages. The Mortgage Bankers Association estimates that lenders deny nearly 30% of mortgage applications, for which they require more documentation, higher credit scores, and tighter debt-to-loan ratios than before the housing boom of the mid-2000s.

Plus, Maklari notes, more young adults are lingering longer as tenants than in the past, when a greater share of them would rent for a brief time and then purchase their first homes at a younger age. And while the millennial generation—those born after 1980—still are the largest group of home buyers, the share of first-timers in the marketplace has fallen to its lowest level since 1987, according to the National Association of Realtors.

Some home builders have responded to that unique market condition by scrapping their entry-level product lines while they wait for the millennials to make their move. Neither Higley Homes nor Caviness and Cates, for example, build new product for first-time buyers.

"It's hard to make margins on that entry-level product right now," says Cates, who points to high land, lot, and labor costs. "And getting [first-time buyers] qualified for loans is tough. We've got plenty of people wanting to write offers, but getting them qualified is tough."

Others, it seems, are turning what might have been entry-level, for-sale communities into rentals.

"The inability of the American family to access the mortgage market" has led more would-be homeowners to the single-family rental market, Lennar CEO Stuart Miller said during an earnings conference call in March, shortly after the company introduced its for-rent Frontera at Pioneer Meadows community in Sparks. Rents for the two-, three- and four bedroom detached homes, which include touches like granite countertops and stainless steel appliances—usually reserved for for-sale properties—start at $1,399.

When to Rent

Miller has not said the Sparks project was initially intended as a for-sale community of first-time homes, but analysts say it would make sense for a builder to market entry-level homes-in-progress for rent once the company determines they are unlikely to sell because of an uncooperative market.

"If nearby comps aren't at a high enough price point because you paid too much for the land, or the people you'd like to sell to can't get mortgages, those are beyond your control," St. Juste says. "But what you can do is find an alternative use. You can look at what's our best outcome here—let it sit on the balance sheet, empty, or try to monetize it."

A home builder who steps into the rental market can transfer the experience and competencies from one industry—around land acquisition, construction, and purchasing—into the other, says Charles Elliott, manager of Toll Brothers Apartment Living, the builder's rental arm.

Toll Brothers built its first apartments for rent, in Virginia and New Jersey, in the late 1990s before "anybody knew how good the apartment business was going to be during the downturn," Elliott says, noting that the properties did "phenomenally well" in 2008 and 2009.

So in 2010, the luxury home builder renewed its focus on rentals, starting projects in suburban New Jersey, Washington, D.C., and Philadelphia. Next, Toll will expand its rental reach to the West Coast, Elliott notes, building high-density suburban infill and urban product in San Francisco and Los Angeles.

The mortgage-shy millennials who are likely to rent Toll's luxury apartments could be the builder's clients for life. "They're at a point in their life when renting an apartment make sense," Elliot notes. "A few years go by, they have kids, get promoted, and the time comes to buy a Toll Brothers house or townhouse. Then their kids grow up and go to college and they're empty nesters, and they want to live in a condo in the city. We're able to provide a whole broad spectrum of product that appears to that customer for an entire life."

Caviness and Cates also encourages its tenants to buy with the builder when they're ready to move up. The builder offers free appliances and assistance with closing costs, and it will let renters break their leases with no penalty if they're moving into one of the company's new homes.

Still, because of the builder's lack of entry-level product, Cates says, few of the company's sales are to current tenants. "We've priced ourselves out of that," he says.

Offering a mix of rental and for-sale product, though, could buffer a builder from the impact of another downturn—and even from the current sluggish housing recovery—by putting rental product in place that will move when demand for apartments outpaces home sales, and vice versa.

Toll and other builders also have the option of selling their rental properties—by the building or by the unit—if the demand for sales surges.

In fact, institutional investors seem eager to purchase single-family homes—whether they're new, existing, or distressed—that they can convert into rentals.

St. Juste estimates that real estate investors have bought more than 528,000 single-family rental homes since 2011. Although they traditionally have favored deeply discounted foreclosures, a dwindling stock of distressed homes has refocused investors on newly built, single-family houses—which they sometimes contract before construction starts.

Staying on the Sidelines

Most traditional home buyers are unlikely to shift their focus—even a piece of it—to rentals. Some, like Atlanta-based PulteGroup, have said they're not interested. Others might find the rental side to be too customer service oriented: Landlords, after all, have to have staff available around the clock to unclog tenant toilets, unlock apartment doors for residents with lost keys, and mediate noise complaints and other neighborhood spats. Plus, they have to find renters, repaint apartments, repair what breaks, and eat the cost of units that sit empty—for an average of two months—between tenants.

"It's a very different business model," Maklari notes.

Even for the builders who have successfully gone to the other side, the endeavor is still experimental, she adds, and many are keeping their successes and failures to themselves. "It goes out of their comfort zone," Maklari says. "They're not completely sure how it will go, or of some of the pitfalls, or how it will play itself out. Rather than openly discussing it and making it a whole kind of to-do, they'd rather just dip their toes in the water and see how it comes out before they make it a big conversation with investors and the public."
As for those who won't consider the possibility of building for-rent property, Maklari says she isn't surprised. "Builders like to build," she says. "They like to build it, sell it, and start the whole process again."
Elliott says rentals will always be Toll's second love. "Home building is always going to be our core business," he says. "Apartments will never take the place of home building, but it will be an important part of the business now and going forward."

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