This site refrains from talking about individual stocks, since we don’t give investment advice. However, a potential sea-change is underway, as a large portion of the inventory of foreclosed homes is being converted to rentals. Private equity firms are pursuing this opportunity eagerly, as the combination of low financing costs and tight rental markets in the US means that, at least on paper, investor believe they can earn attractive income, with potential for appreciation, either by eventually selling the houses to individuals or by taking the company public.
Given all the excitement over this conversion (it was voted the best opportunity over the next 12 months at a real estate conference I attended in the fall), it was interesting to detect a fair bit in the way of reservations in an article in the New York Times on the first IPO in this space, Silver Lake. Once it completes an acquisition, this REIT will own a bit over 3000 homes and plans to focus on Arizona, California, Florida, Georgia, North Carolina and Nevada.
I’ll confess to not having read the S-1 (I expect I will when I get caught up). I don’t consider this to be much of a loss since these homes were all acquired too recently to have reached stabilized yields, which is a function of not just rental levels relative to acquisition costs, but fix up and maintenance, normal turnover, and delinquencies/evictions. Historical financial data is not going to be a predictor of the future. What I find more interesting is how the Times piece, which hews to the journalistic convention of telling both sides of the story, winds up being less than convincing about Silver Bay and features more informed criticism than you’d expect for a piece of this sort.
Some of this admittedly relates to Silver Bay. It’s chief is the 35 or 36 year old David Miller, former Goldman investment banker, then as the Chief Investment Officer of the TARP. Given Neil Barofsky’s pointed criticism of Treasury’s lack of interest in fraud, and Elizabeth’s Warren’s finding that the TARP was buying back warrants too cheaply (which led Treasury to pay more after this unflattering finding), it’s hardly clear that he did as great a job there as his glowing press clips suggest (unless you consider his job to be serving Timothy Geithner in his capacity as bailouter in chief). And it’s not at all clear how doing “special situations” and valuing mortgage securities qualifies someone to run an operating business (my general experience with bankers is they think the ability to oversee a small number of highly paid and motivated lawyers, associates, and secretaries means they know how to manage complex operations).
One of the longer-established players stressed the need for hands-on management and local expertise:
Colony, for example, recently sent 50 people to bid on foreclosed properties at auctions in eight counties in the Atlanta area to ensure that the homes were carefully assessed, recalls Justin Chang, acting chief executive of Colony American Homes, a division of Colony Capital. “You can’t sit in your office underwriting on your computer — you can’t dial it in,” he says. “You need local men and women who really know those markets.”
This is the premise:
Industry experts say the potential profits are enormous. They compare the current home market to the commercial real estate market after the savings and loan bust of the late 1980s and early 1990s. Back then, early investors realized double-digit — and in some cases triple-digit — returns. Still, some question how long — and how far — these big investors can ride the market this time.
The big difference is that the S&L crisis led the FDIC to wind up with an enormous portfolio in its hands which it proceeded to liquidate in bulk sales. The earliest sales produced tremendous profits, partly due to the lack of price parameters, partly due to the fact that the Resolution Trust Corporation knew it had to allow the initial deals to be steals to entice buyers into the pool. By contrast, the Fannie/Freddie bulk sales program has been slow to launch and has become unnecessary; PE investors are so eager than servicers are selling homes individually. Local investors are even assembling small portfolios of homes that meet PE buying criteria and are flipping them. Some even think the market is sufficiently bid up that the remaining opportunity is short-lived in investment terms:
Some real estate experts question Silver Bay’s long-term prospects. And they wonder if the moment to plow into the housing market has already passed. The hedge fund manager Och-Ziff Capital, for example, is already starting to sell the single-family homes it bought since the recession began.
“This will be a workable business as a REIT for at least three to five years,” says Jay Leupp, a managing director at Lazard Asset Management. If the economy perks up and renters start buying, he said, “it may make more sense to liquidate the portfolio and transition into another business or simply return the cash to shareholders.”
Not mentioned in the article was that the use of a REIT may prove problematic; virtually all of the PE firms and other investors pursuing rental strategies who spoke at the conference mentioned earlier were cool on it; they thought a straight-up operating company IPO was preferable. The attraction of a REIT is that dividends paid to investors are tax deductible, but REITs must dividend 90% of their taxable income. For other REITs, this has not infrequently led to scrimping on capital investment and improvements.
And this is before we get to what most observers consider to be the fly in the ointment: single family homes have never been managed by large-scale, absentee landlords before. The PE mavens claim to have this solved, that they’ll concentrate their buying in a small number of locations, that they’ve hired reputable contractors for maintenance and emergencies, and (at least some) say they do careful, in person assessment of prospective tenants. They also contend that technology will help them lower the cost of managing (I’ve never heard this explained in any detail, BTW).
My own big doubt revolves around pricing power. The reason the rental market is so tight is precisely because the homeowners have left their properties much faster than the homes have been sold to new buyers and fitted up for rental. The high rentals are directly related to scarcity. As more PE firms put rentals onto the market, it has to alleviate the supply. At a minimum it will increase the time a home sits vacant before it is leased up again; it has the potential to lower rents from their current levels.
I’m not saying there won’t be a lot of money made. But I suspect just as the best play in the gold rush was supplying the prosepctors, here it is the various intermediaries who will clearly do fine. Focused, disciplined investors likely will as well, but at this stage, you can’t readily tell the poseurs from the real deal. And institutional investors (at least the ones I met) were skeptical of the promoters’ claims. For instance, most of the projections they’ve seen assume 5% annual rent increases. That simply does not map onto an economy where labor has no bargaining power and 2/3 of the jobs being created are low wage.
The Silver Lake IPO could still be a good short term play. It has the potential to trade at a premium to whatever one thinks its fundamental value is by being the only pure play in a hot new space. Personally, I’d rather play the ponies.