Residential US: No fixed abode
After years of institutional capital pouring into US multifamily, today’s savvy investors are moving beyond luxury apartments to class-B assets and workforce housing. Christopher O’Dea reports
Institutional investors in US multifamily property are looking beyond the urban towers and megaprojects to overlooked parts of the sector that offer better yields and less volatility.
The investment case is straightforward. Large apartment projects in gateway cities – which only became economically viable after the global financial crisis – reached a saturation point in 2016, and this glut will keep vacancy up and rents in check through 2018. In contrast, garden apartments, workforce housing, and class-B assets are attracting capital from domestic investors and foreign investors familiar with residential rental accommodation.
Demand for rental is strong across the US, reflecting employment growth and household formation. In fact, investors say, the market is returning to equilibrium, in which about one-third of US households were renters, a balance that was aggravated over the past two decades by government policies that encouraged home ownership, even for those who could not sustain the financial burden.
During that time, Americans developed a preference for living in or near cities. The urban lifestyle of dining, entertainment and employment appeals to all age groups, and has supported construction of residential property targeted at younger Millennials in first or second jobs, as well as older Baby Boomers decamping suburban homes for the bright lights and big cities. As affordability has become a concern due to rising rents on expensive new apartments, an opportunity has opened for refurbishing seasoned multifamily assets and adjusting rents towards prevailing levels.
Rental housing for Middle America may present the greatest opportunity. Garden-style and workforce housing properties (commonly aimed at essential workers, such as police officers, nurses and teachers, who might otherwise struggle to afford close to their place of work) tend to have high occupancy and investor-friendly characteristics. A shortage of apartments suited to the salaries of the service workers who keep the economy humming bodes well for investors.
Those trends have moved capital beyond the coasts, attracting interest from investors and encouraged single-family housebuilders to enter the sector. Investment managers say it will take time to educate foreign investors about the structure and return profile of US multifamily property, but some are already considering adding these to portfolios pursuing core strategies.
US multifamily property enjoys a positive macro backdrop. “Demand for rental housing remains strong across all age groups,” says Tim Wang, director and head of investment research at Clarion Partners, which manages $8.8bn (€7.9bn) in multifamily assets among its real estate assets under management of $43.1bn. Household formation and job growth are the macroeconomic factors that bear directly on demand for multifamily housing property, Wang says, and both of those are positive.
About 1.3m new households are being formed annually, with approximately two-thirds arising from natural births and one-third from immigration, Wang says. Unemployment has continued to fall, to 4.4% in April. Wang expects a large delivery of new multifamily units this year to restrain rent increases to about 2-3% nationally. But permits for new multifamily building suggest new deliveries will drop by 25% in 2018. “We believe rent growth will re-accelerate after this year,” Wang says. “That’s our view because there’s no shortage of demand,” he adds. “The question is how much will new supply actually moderate going forward?”
New supply has been concentrated in large cities because of the urbanisation trend. Developers need to build luxury projects aiming for top rents in order to justify their high construction costs, Wang says. Building materials and labour costs have risen between 3% and 4% annually, well ahead of inflation, while land costs have also climbed as the number of available sites has declined. That has raised the replacement cost of residential property, fuelling an uptrend in rents.
The development of new units at the highest price points has created opportunities for investors in properties that are affordable to a broader range of renters. Wang says the widening difference in rents between existing A-minus/B-plus assets and brand new, luxury properties means “investors in those assets have the ability to push rents higher at a faster pace or in larger increments compared to brand-new buildings”.
Such properties can be upgraded one unit at a time instead of vacating an entire floor, as is often done in an office-building renovation. This preserves cash flow and allows the asset owner to keep rents in line with the market as tenants turn over. Upgrades required to justify a rent increase, such as hardwood floors, new appliances, granite countertops, are inexpensive, and when the process is efficiently managed, the incremental return can reach the high teens, Wang says. And because the rental stream from the bulk of the property is not interrupted, he adds, “on a risk-adjusted basis, it’s a very attractive addition to the total return”.
Outside of the top 10 urban markets, “the overall apartment market is very, very healthy,” says James Martha, head of TH Real Estate’s workforce multifamily strategy. “From an investor’s perspective, apartments have been a terrific investment sector,” he adds. And with demand for rental housing strong, “there’s still plenty of runway aside from the downtown high-rises in a few of those top 10 markets”.
Workforce housing is a significant opportunity set in the US. “Workforce housing, the class-B product that targets Middle America, represents the hump in the bell curve for rental demand,” Martha says. So far in this cycle, “it’s been a little bit of an ignored space”, he adds. In a market dominated by glass towers, “it’s not a sexy product you can brag about in a brochure”.
Although the assets are typically 15 to 25 years old, and suburban rather than urban, workforce housing offers investors an attractive investment proposition. “It tends to have a little bit lower highs and a little bit higher lows, so you have less volatility,” Martha explains. “If you develop in the urban areas and you’re at the right point in the cycle, you clear the bases. Workforce housing is not that kind of product,” he says. “You tend to hit singles and doubles as opposed to hitting home runs.”
TH Real Estate, which has more than $2bn under management in US workforce-related assets, has been investing in the sector for 25 years, through CASA Funds, a series of closed-end funds or closed-end apartment special accounts. Over that period, a shortage has developed. Workforce housing, which encompasses property that people who earn incomes at or near the median for a city or metro area can afford to rent, has been created when class-A property is replaced by new housing stock commanding the highest current rent. That process has been short-circuited in the past 20 years, as developers built condos for sale, and then urban luxury apartments. “We had a lack of class-A product that could trickle down to feed the class-B workforce housing stock 15 or 20 years in the future,” Martha says. “Which is where we are today.”
Today, most property in the US workforce housing segment are assets that have been redeveloped, repositioned or recapitalised – or which require capital to undertake those activities so projects can be re-leased at higher current rents. A common format is garden-style apartments featuring two to three-story attached apartments around a community core with amenities such as pools or gyms.
Such projects have accounted for a smaller share of new apartment construction. They comprised only 31% of rental units delivered in 2016, compared with 78% of new units 15 years ago, according to Greg Willett, chief economist at MPF Research, a division of RealPage.
“Particularly in this cycle, the mindset of the development world has been to build very densely within the footprint of urban areas,” he says.
That has left garden apartments in high demand. “They are jam-packed,” he says. With occupancy of 95.5% compared with 94.6% for high rises, units are not vacant for long, enabling owners to raise rates frequently as tenants turn over, leading to “solid rent growth”, with rents for new residents climbing at an annual pace of 4.4% for the garden sector compared with 1.7% for high rises. The result, Willett adds, is that “garden-style communities are performing well at this point in the cycle”. An analysis by Real Capital Analytics shows that cap rates remain well above the broad multifamily sector (see figure).
Returns tell a clear story. In general, workforce housing can produce a cash yield of about 5% , with the potential for 200bps to 300bps of appreciation over several years, Martha says. But for non-US investors, the terminology of the multifamily rental market is one aspect of the “education process that’s needed to explain the multifamily business,” he adds.
Garden and workforce apartments, for example, are not interchangeable terms. “Although, we tend to see more workforce housing in garden-style product, there is also workforce housing in mid-rise and occasionally high-rise product,” he says. And there is some class-A garden-style product existing or being developed that would not be considered workforce housing. “The generalisation of associating workforce housing with garden product is likely tied to development cost and replacement cost.”
TH Real Estate is working with investors to help them transition from comparing the limited housing investment options in their domestic markets to the array of US multifamily options. “We have a global platform, and we’re definitely talking to investors about our various multifamily products,” says Giacomo Barbieri, head of TH Real Estate’s investment in the metro New York City area. Northern European and Asian investors have expressed the most interest, he says.
While focusing initially on urban gateways, TH Real Estate is working to demonstrate the value of seasoned multifamily assets as a way to diversify a portfolio. The company is also considering diversifying the multifamily exposure of its core investment strategies – which have been geared towards gateway cities and urban assets – to include workforce housing.
“We’re looking at it,” says Martha. “It will be a small percentage – likely a 15% to 20% exposure – but it’s a nice complement to our urban/high-end strategies. This allows us to diversify our exposure by expanding some of the markets, and perhaps, some of the age or definitions of the multifamily allocation.”
Mom and Pop go to Wall Street
Investment managers began systematically acquiring single-family homes on behalf of institutional funds in 2011. That capital has transformed the sector from one comprised of mom-and-pop local investors to one where national firms have brought the cost of owning and operating single-family homes into line with other sectors, creating platforms to expand margins through top-line revenue growth or further cost improvements.
The consolidation of this market bears similarities to the institutionalisation of the multifamily sector in the 1990s, and is proceeding rapidly, according to an analysis of the single-family market by GTIS Partners. The New York City-based firm manages its $550m (€492m) in single-family assets through StreetLane Homes.
Technology has played a big part in the evolution of the sector, GTIS reports, allowing operators to track the business lifecycle of each home in a single software platform, from underwriting and buying units to scheduling renovations, and marketing through automated listings across channels. Leasing is accelerated, and commission costs reduced, by lessening the reliance on agents. Tenants submit repair and maintenance requests through online portals that route work to technicians, reducing maintenance costs.
The technology allows investment and operating activities to be performed at scale across many locations. Those capabilities made it feasible for operators to handle a large volume of distressed acquisitions early in the financial crisis, and amortise investments over a larger asset base. The result was that cash-flow yields, and early investment gains, were sufficient to fund continuous development of better management processes.
Potential investment returns are attractive. Gross rental yields on single-family assets in StreetLane’s target markets range between 10% and 12%, above multifamily yields in comparable locations. After accounting for vacancy, taxes, and operating costs, the asset-level net-operating-income cap rate ranges between 6% and 6.5% for one-off acquisitions, GTIS says. That pencils out to a gross-to-net spread of roughly 550-600bps. In multifamily, comparative transactions have gross rental yields in the 7% to 8% range with a gross-to-net spread of 300-350bps, equating to a cap rate of 4-5%.
Those numbers have already prompted formation of several single-family real estate investment trusts from institutional portfolios. In February, Blackstone Group listed its 50,000-unit single-family platform, Invitation Homes, in a $1.54bn initial public offering that priced at a 15% premium to net-asset value, or an implied cap rate of 5%, according to GTIS Research. Also in 2017, Tricon Capital acquired Silver Bay Realty Trust in a $1.4bn all-cash deal that will create the fourth-largest publicly-owned single-family rental company in the US, with more than 16,800 units in 18 markets across the Sun Belt.
Tricon targets the US middle market, which it defines as 11 million households earning $50,000 to $95,000 annually, which typically can pay monthly rent of between $1,000 and $1,600. The segment tends to be stable, longer-term renters, Tricon says, leading to a tenant turnover rate of 28.3% in 2016, compared with turnover for sector peers of 35% to 40%.
GTIS believes there is scope for private institutional capital in the single-family rental sector. The 10 largest institutional holders own only 200,000 units, GTIS notes, less than 1.5% of all rental homes. Back in 1990, GTIS says, the top 10 multifamily operators controlled 634,000 units, or 3% of the market, a share that grew to 1.2m units over the ensuing decade. Today, the top 10 still control about 1.3m units – a position that amounts to 6.3% of total units, according to the National Multifamily Housing Council.
For institutional investors, the evolution of the US single-family rental sector clearly offers an opportunity to participate in a new asset class.