Sometimes it astounds me how long a simple idea takes to become accepted, particularly if it seems to run contrary to prevailing wisdom.
I first started to write my By George! articles back in the spring of 2010. In retrospect, that was kind of the bottom of the hole when it came to residential real estate.
Here is an excerpt from one of the articles in October of 2010. In some ways, it could have been written last week.
Making a Difference: Strategies for Today
George Casey: “By George!”…Builder Magazine, October 2010 (Excerpt)
Sometimes I think I read too much.
When you read what others are writing it is easy to get caught up in the prevailing wisdom of the moment. I don’t know if I end up any wiser, though. All I know is that the media always seems to be six months or more behind what is really going on out in the real economy.
Sometimes it just makes sense to walk around, talk to people, listen to conversations, and look at the data, too. It helps you to get a grip on what reality is and what ought to be done to make a positive difference for you or your company.
I think that is called strategic planning.
I look at the data on housing sales, starts, consumer confidence, the various builder sentiment indices, the various pricing tracking indices and all that stuff. What it seems to tell me is that we are bumping along at a very slow rate of both home sales and new home production.
The headwinds to ownership are pretty formidable right now with the no-job blues, abundant foreclosures, and ever-tougher mortgage underwriting standards canceling out some of the best mortgage rates and home affordability metrics in over a half-a-century.
It is kind of like steak at 99 cents a pound, but the butcher won’t open the cabinet and sell you any and, even if he was willing, you are not sure you really want to buy.
Maybe soup would be better for you right now.
So my operating presumption is that what we see is what we are going to continue to get for quite a while. Whether it is six months or six years, I don’t know.
What I do know is that there is some level of demand for shelter, that there is apparently an oversupply of for-sale shelter in many markets, that the rental market seems to be doing better as people either can’t or won’t buy housing the way they used to, and that there is a base level of demand for new single family homes at between 300,000 and 400,000 homes per year. This is one of the lowest production levels in the past half-century, but it is at least something.
If this is reality, you had better figure out how to make money in it, because it may not get much better for a while. The dream of it “coming back” soon now seems like delusion, at least for now.
So here are some observations and thoughts.
First, when I talk to some of my real estate broker friends, they continue to say that there seems to be a strong demand for rental single-family houses. Whenever they get one, particularly in a good school district or a good neighborhood, they get rented at good rates and fast. That makes sense when you think about it, given the situation we are in.
Second, the same brokers tell me that there seems to be a deep demand from investors for houses coming out of foreclosure whenever they are available. Mostly cash purchasers, they seem to be happy renting them out for someplace between a 5% and 8% cash on cash return. That makes sense, too, given the rates that CDs and Treasuries are paying.
Third, in the better neighborhoods, the selling prices of new homes are now beginning to sell at the regular premium to re-sales, albeit at lower prices than 4 years ago and even though the resale prices are in many markets really the foreclosure or short sale prices.
So here is a question: is there a business model for builders to build homes and then sell them to investors who want to own rental single-family houses?
It seems like in some markets this might make sense, particularly when end sales are getting messed up in turbulent financing and negative consumer confidence when it comes to purchasing. I think that people still want to live in nice houses in nice neighborhoods and that, for a while, renting may be the preferred way for a segment of the population.
The supply, demand, and sentiment for rentals seem to be lining up. It is a different business model, but these are different times. I am not sure how the economics work in your marketplace, but in doing a back of the envelope analysis, it looks like it does in some.
Over the past several years, I have watched companies such as Waypoint Homes (now Starwood Waypoint), American Homes 4 Rent, and other deep-pocketed investors move from just acquiring foreclosed existing single-family homes to figuring out how to do neighborhoods of new single-family homes for rent. Builders said it wouldn’t work long-term.
But it did. The group-think of home builders blinded them to a new opportunity that was there and actually fell into their wheelhouse.
Several months ago, I lauded Lennar and Toll for beginning to look at rentals as part of their product portfolio. In particular, I noted Lennar’s experiment with a full single-family for-rent community in Nevada.
Several other smaller home builders have started to do communities of single-family for-rent also. Some are selling the completed communities to institutional investors while others are holding them in-portfolio. The test-phase is starting to spool-up.
Recently, industry observer and thinker John Burns noted that about 10% of the nation’s housing consists of single-family homes being rented: about 12.7 mm houses. Further, he noted that about 29% of rentals consist of single-family homes. He thinks this is a wide-open opportunity for builders of new homes.
My contacts in the community development industry continue to show high interest in having new single-family homes for rent as part of the product portfolio for a community. This is incremental demand and absorption of land for them and makes good financial sense.
In reading through the commentary on the latest round of public home builder quarterly results, it seems that many are facing issues of absorption, oftentimes discounting excessively to get sales velocity (and thus creating a gross margin problem). Those who don’t discount and keep the gross margin up suffer with absorption and less leverage on their fixed overhead.
Either way, net income suffers.
Two generations ago, builders built both for-sale and for-rent product. Some was single-family and some was multi-family. The goal was to move through a piece of land quickly by servicing multiple pieces of housing demand. If you could sell, you made good money. If you couldn’t, you either rented it out yourself or you sold it to a rental property owner/manager and made a little less. But you provided shelter and moved with the market. Sometimes you hit it right and got all for-sale deals. Other times, you didn’t and ended up with mostly all rentals.
It all seemed to work out.
I think that the “Back to the Future” moment I have been talking about over the past several years may now be finally upon us.
Sure, in some highly constrained markets where there is huge pent-up demand for for-sale housing way in excess of supply (see coastal California), this may not apply. But for the rest of “normal” America, I believe that it does.
But it takes builders understanding a different Pro-Forma.
When doing single-family homes for-rent, absorption rates are usually significantly higher. This has the obvious effect of cutting interest expense. But it also has the effect of reducing real estate taxes for the project life, reducing HOA subsidies for a project’s life, reducing maintenance cost and time on publicly dedicated infrastructure, and getting higher overhead efficiency. In addition, houses built for-rent do not need the high internal sales costs (including outside commissions) that for-sale communities do.
On the direct cost side, simplicity and consistency of product, the reduction of the need for options, and the ability to offer higher velocity to trades with less variation in product configuration should lead to better pricing.
Finally, the infrastructure needed to deal with homeowners through a build process and in subsequent warranty (including litigation exposure) drops with rental homes versus for-sale,
On the other hand, the sale value of rental homes to third party investors is less than that to retail purchasers, probably by about 10-12%. However, the fiddling around with incentives, mortgage qualifications, etc. is eliminated, also.
My quick “back of the envelope” tells me that on a net income basis, homes built for-rent and sold to institutional investors are pretty close to a push, with time risk mitigated as a bonus.
This was the thinking of builders 50 and 60 years ago. Being able to build both for-sale and for-rent allowed one to hedge cycles and cut down on the need to boom-bust the labor force of the builder, leading to higher efficiency overall.
I commend those who have pioneered the resurgence of this mixed model for homebuilding. It taps a significant piece of demand that builders have forgotten about. It gives a more solid underpinning to organizations. And it lessens the risk profile for builders in a meaningful way.
It also provides a different way to think about land valuations and utility.
Five years has been a long time for the seed to germinate and begin to become action. If you are not looking at this business model, don’t say I didn’t tell you to do so.