As build-to-rent institutional investors pause and reassess, home builders find themselves pressed to determine the best course of action with their pipelines. Despite the initial deal-making mania, investors are now taking a wait-and-see approach.
It has been a whirlwind for builders and build-to-rent since spring 2020. Approximately $60 billion has been raised by institutional investors, all earmarked for the home building industry. A new real estate asset class was created, giving home builders a new path to growth and innovation. Builders believed their BTR projects were derisked via creative relationships provided by investors who wanted to own their homes. The offers and ease of capital were irresistible as builders scaled while investors battled to obtain product.
In the third and fourth quarters of 2022, inflation and interest rates suddenly accelerated, and rents began to soften while borrowing costs soared. Economic uncertainty prompted caution and tightening, and BTR capital pulled back and withdrew.
The Reset
There is a reset today as institutional investors and builders navigate how best to move forward in BTR. Institutional capital is waiting on key economic metrics to stabilize, while builders determine how best to position their businesses. As rent growth softens and stabilizes, projected net operating income resets. The combination of lower projected net operating income along with higher cap rates leaves the bid-ask gap we are seeing today.
Institutional investors are not providing the creative joint-venture partnerships and ease of capital to builders these days. They do not want to be part of the land acquisition or development process. The focus today is on forward purchase agreements (FPAs), and buy boxes have shrunk. Many underestimated how long and tedious the predevelopment and entitlement process can be. They want to purchase homes already under construction or close to commencement. This shortens the investment horizon more suitable for needed returns, without development risk.
Not only have investors pulled back, but they also pulled out of deals. Builders with FPAs in hand found their investor/purchasers trying to renegotiate or pull out. JV agreements to supply equity and purchase completed homes also fell apart, leaving builders unable to close on their land and financing. Some highly publicized programmatic capital relationships were withdrawn as well.
Builders are left in limbo, many forfeiting earnest money on land as well as substantial dollars on entitlement, design, and predevelopment costs. Many paused with entitled land or finished lots secured, scrambling and delaying land closings with sellers, or delaying horizontal commencement.
With the economic uncertainty and pullback of institutional investors came debt financing apprehension. As lenders became aware of FPA instability, they began to underwrite deals as if there was no end buyer, even if the builder had contracts in place. With the softening of rents, rising cost of capital, and no value to end buyer contracts, BTR deals became tougher to finance. Smaller funding criterion, tighter terms, higher rates, and lower leverage. A project has to stand on its own with a stabilization plan, cash flowing enough to qualify for permanent financing as an exit for the lender.
Cautious Optimism
The good news is investors appear to be more active in recent weeks than in all of the fourth quarter of 2022. They need conviction that inflation is moderating and rates are stabilizing. They are actively seeking FPAs and have substantial funds to deploy.
Below are some strategies for builders when entering into FPAs:
- Negotiate a higher deposit. The norm is 5% to 10%, and don't hesitate to ask for 8% to 10%. After all, there is a risk of withdrawal.
- Consider timing of deposit. The sooner the better. I've seen builders with signed FPAs but the funding of the deposit has not yet triggered, and capital eventually withdrew.
- Have the ability to use the deposit as equity in the deal. This can be vague and is not always the case.
- Stabilize the project before entering into an FPA. By completing and renting homes, institutional capital is more willing to acquire the project at a better price. This is a sound strategy, especially since cap rates have increased, and is being utilized by apartment developers.
An Opportunistic Time
Although a housing shortage exists today, economic realities have discouraged investment in new supply. Where JV partnerships and FPA fell apart, opportunities exist.
I’m seeing projects fully or partially entitled, engineered, designed, or shovel-ready become available. These are not distress situations in poor locations with minimal demand; these are opportunities in good locations with favorable demographics. Projects are teed up for the right builder and partnership. Value through entitlements and predevelopment has already been created.
The timing is right for builders and developers to unite on withdrawn or paused projects. Get creative with co-general partner and limited partner relationships. It’s an opportunity to partner with builders who know the land, neighborhood, and community.
An Alternative
Institutional investors are professional, experienced long-term investors. They want to own cash-flowing homes and create portfolios with scale. After all, great historical wealth has been achieved through real estate investment.
Builders being entrepreneurs shouldn’t stake their businesses on the backstop of private equity investors. BTR as an asset class is formidable, and builders are in the driver seat. The new-home rental industry is set up for success and the benefits of real estate investment never run out of style. Builders should consider holding their BTR projects. It’s a great way to diversify a home building business and obtain cash flow, while the option of selling exists after stabilization.
BTR is projected to thrive in the long term. The goal is to provide quality, professionally managed affordable housing, which continues to be in high demand. It’s unknown whether the creative partnerships between institutional investors and builders will resurface in similar forms. Although capital is cautious, opportunities have emerged.
