By Lea Overby, Steve Romasko, Radhakrishna Gowrishankara
Research Analysts, Nomura Securities International, Inc.
The heady rise and subsequent collapse of the residential market left a vast swath of distressed mortgages and vacant houses across the country. As a result of this dislocation, house values dropped to levels below replacement costs, and rental yields became very attractive. While the single-family rental market has historically been dominated by smaller owner/operators, the surge in available product and high returns enticed institutional investors into the arena.
The largest seven of these firms have invested $20bn in single-family rental properties, amassing sizable portfolios totaling over 115,000 homes. In spite of this rapid growth, these institutional investors own only a small fraction of the market. According to the most recent American Housing Survey, an estimated 14mn houses are designated as rental properties, accounting for 11% of the US housing stock, leaving considerable room for expansion.
As they have begun to seek additional leverage, institutional investors have turned to the securitized products market. Between November 2013 and August 2014, five of the seven firms have issued eight deals totaling $4.4bn, and the remaining two have indicated that they plan to come to market in the next few months. Total 2014 issuance is likely to reach $6bn, and by the end of 2015, we estimate the total size of the market will increase to $12-17bn.
Because the performance of these transactions rests on expected rental streams, like commercial real estate, as well as home price appreciation, as in the residential market, we believe these transactions will appeal to a wide cross section of securitized products investors. Given this potential for broad appeal as well as the “newness” of this sector, we provide an introduction to single-family rental market, focusing on the sponsors, deal structure, and expected performance. To date, these transactions have been structured very similarly to Single Asset/Single Borrower CMBS deals, consisting of a single loan to one borrower. However, recent commentary suggests multi-borrower deals may be forthcoming as institutional investors implement lending platforms to smaller owner/operators.
Following the subprime crisis, institutional investors rapidly expanded into the single-family housing market, with the largest seven firms acquiring a portfolio of 97,510 homes as of year-end 2013. Initially, the firms acquired these properties through foreclosure auctions, broker sales, and portfolio sales from government agencies and financial institutions. The firms have targeted properties in areas affected by the subprime crisis, with the largest state concentrations in California, Florida, and Arizona. The typical property is smaller than the national average of 2,169sf, and the firms have invested an average of $151,000 per home, significantly below median home prices of $222,900.
As the residential market has stabilized, opportunities for discounted purchases have declined, causing the initial explosion in growth to stabilize. The firms increased their holdings by 18% during the first half of this year, and several indicate near-term growth to remain at a rate of 8-10% per quarter for the remainder of the year. While these firms continue to explore acquisitions, they are also adjusting their strategies to increase yields by pushing occupancy and rent levels across their current holdings, investing in non-performing loan portfolios, and providing lending platforms to smaller owner/operators.
Investment from the three biggest investors, Blackstone, American Homes 4 Rent, and Colony Financial, makes up almost 80% of the total. While many of these firms have tapped the equity market for funding and are organized as real estate investment trusts, the single-family rental businesses of Blackstone and Colony remain private. In May 2013, Colony Financial retraced its initial efforts to launch its single-family rental business, as it believed the offered price did not fairly reflect its portfolio value.
In addition to differences in scale, institutional buyers likely have different investment time horizons and yield expectations that will determine their business strategies. High-yield (short-term) investors in the sector generally seek unlevered, double-digit returns and largely rely on near-term home price appreciation to realize these gains. These investors will generally look to exit opportunistically, either by taking the company public or by selling the portfolio.
In contrast, long-term players generally look to realize mid- to high-single-digit unlevered returns and see continued demand for single-family rentals that are professionally managed. They believe that the large inventory of distressed assets will provide a steady supply of properties with attractive rental yields, while an improving economy and job market would likely spur increased demand from household formation. Further increasing demand, the dislocation in the housing market may have dented both the desire and ability for households to purchase new homes, resulting in a larger portion of rental households. These firms are likely to buy homes that are of better quality and located in desirable neighborhoods that are likely to appeal to the permanent renter. For example, American Homes 4 Rent targets homes that are both newer and larger than other players in this sector.
As the initial pace of acquisitions has slowed, each of the firms has focused on improving rents and occupancy levels within their existing portfolios. Over the course of 2014, combined occupancy rates have improved from 68% to 85%, while average monthly rents have increased 2% to $1,292. While the firms have made significant strides in stabilizing their portfolios, we believe that, longer term, their ability to push rents will be largely dependent on conditions in the multifamily market, as well as the availability of credit for new home purchases.
Examining rent levels across their portfolios, we believe that these institutional investors are largely targeting a renter base that does not have access to or desire for a home mortgage. By comparing the expected monthly ownership costs with advertised rents for a random subset of properties, we found that asking rents are relatively high, and in many cases, the renter would be better off purchasing the home rather than paying rent. If credit conditions ease, those who now rent by necessity may choose to purchase, affecting demand for these houses. However, given their locations in stabilized neighborhoods and larger size, single-family rentals will likely remain an attractive alternative for long-term renters.
Single-Family Rental Securitizations
Initially, single-family rental investors relied mostly on cash and short-term debt facilities to finance their acquisitions; however, over the next few years, we expect the firms to tap longer-term financing and to increase leverage to levels in line with apartment REITs. Taking advantage of the low cost of securitization, which is as much as 125bp lower than short-term credit facilities, five major players have issued eight ABS deals totaling $4.4bn through August 2014. Given this favorable pricing, as well as the continued growth in their portfolios, we expect that issuance is likely to rise to at least $12bn by year-end 2015. Using a slightly more aggressive assumption for portfolio growth and total funding through ABS, we estimate issuance may reach a higher volume of $17bn over this period.
The first eight securitizations are sequential pay deals that are collateralized by floating-rate loans to single borrowers. The loans are structured with an interest rate cap that equates to a 1.20x or 1.25x DSCR at the cap, while underwritten DSCRs range from 1.95x to 2.88x. The loans have little to no amortization and mature in five years, after taking into account the available extension options, with the borrower expected to refinance the loan at the end of the extended term. Generally, each loan has been underwritten at 70-75% of Broker Price Opinions (BPOs), with the exception of IHSFR 2014-SFR2, which was structured with a trust LTV just shy of 80% and includes a retained 5% principal-only subordinate class.
We find some evidence that collateral and tenant quality has marginally declined and sponsors have been able to extract some concessions to loan covenants. For instance, successive issuances from both Invitation Homes and Colony American Homes have lower debt yields, higher rating agency LTVs, and increased barbelling. Further, tenant leasing requirements have weakened, and newer securitized loans have no amortization and no LIBOR floor. Both rating agencies and investors have taken notice of this deterioration. In spite of higher credit enhancement on later deals, these deals typically trade at wider spreads.
Assessing Deal Performance and Ratings
Each of the three agencies that rate these deals—Moody’s, Morningstar, and KBRA—has provided detailed commentary regarding its methodology, as well as risks to the asset class. Each bases its methodology on a hybrid of multifamily and single-family concepts, since monthly debt service is paid primarily from rental income and final repayment at maturity is driven by home price appreciation.
To assess performance during the loan term, the rating agencies evaluate the stability of the monthly rental streams by using projected market rents and vacancies, as well as expenses and other sources of income. Due to a lack of historical data on single-family rental performance, the methodology typically relies on multifamily trends.
In determining value, the rating agencies generally consider the acquisition cost, adjusted for improvements and home price appreciation. The firms also use the most recent appraisal, with a haircut depending on the quality of the appraisal. For example, Moody’s increased the acquisition cost of each property by 50% of renovation costs and 50% of home price appreciation in the given MSA. The firm also applies a 15% haircut to the Broker Price Opinions because the valuation was not based on a full appraisal. To determine recovery value, the rating agencies primarily rely on home price appreciation under the assumption that the properties are likely to be sold back into the residential market in a stress scenario.
With only a few months of history, the single-family rental deals appear to be performing in line with or slightly above rating agency expectations. Only the first deal, IHSFR 2013-1, has sufficient history to discern performance trends. However, given the strong similarities between the various deals, we believe that this is indicative of the health of the sector, and we expect the latter deals to show similar performance.
The IHSFR 2013-1 portfolio was structured with an initial period of heavy lease rollover, which caused vacancy rates to ramp up from 0% at origination to a high of 8% in February 2014 and contractual monthly rents to decline. However, the strong DSCR of 2.10x at origination easily cushioned this decline, and recent reports indicate that this deal is now performing slightly above expectations. Vacancy rates are likely to stabilize around 4-6%, well below rating agency assumptions of approximately 10%, and average rental rates have steadily increased from an average of $1,312 at origination to $1,329 as property managers have been able to push rents.
Risks and Outlook
While the initial performance of single-family rental deals has been in line with expectations, risks regarding strength of sponsorship, valuation, and collateral performance may arise as these deals season. The primary concern regarding these deals is the limited history of institutional ownership of single-family rental housing.
All of the rating agencies express concern about the quality and longevity of the operators, noting that skilled management is necessary to maintain stable cash flows, especially in light of the geographic dispersion of the portfolios. Both S&P and Fitch highlight operational infancy as a key factor contributing to their decision not to rate the deals as AAA credits. The business models of each of these investors continue to evolve, and, as a result, we believe that the timing of repayment for these deals is uncertain, especially in light of loose prepayment restrictions and multiple extension options.
In addition to the viability and structure of the business model, the use of home price appreciation models to derive collateral value has been a topic of considerable discussion. Because it is likely that these homes may remain rental properties for several years, some believe that the portfolios should be valued primarily on the basis of rental income, while loan amounts are based on underlying single-family property prices. As a result, this differentiation may increase refinancing risk at maturity, should the market shift its view on the valuation of these properties. However, expectations for rental growth, fairly low LTVs, and the option to sell underlying homes back into the residential market should help to assuage these concerns.
In spite of these uncertainties, we believe that these deals provide an appealing alternative, allowing traditional RMBS and CMBS investors to gain exposure to the rebounding housing market. Given high DSCR levels, low interest rates, and initial performance, we believe that the likelihood of term default is extremely low. Further, the strengthening residential market and solid multifamily market, as well as demand for higher-yielding securitized assets, will enable these institutional investors to refinance at the end of the extended loan term. In addition, strong issuance through next year is likely to increase liquidity in the sector, providing investors with attractive risk-adjusted returns versus other comparable sectors within securitized products.