Tom Barrack, the founder of real estate giant Colony Capital LLC, recently appeared on CNBC and made some interesting comments about the single family rental market that I think are worth considering from an investment standpoint. Colony Capital is one of the big private equity firms, along with Blackstone (BX), that has been an active buyer of single family homes, which it intends to spruce up and rent out.
At first glance you might think that the single family rental market would be a solid business model, provided you have experienced people making the operational decisions and savvy financial people ensuring an adequate return on capital can be realized. However, much has been made in the financial media about how the likes of Colony and Blackstone have caused sudden and dramatic price increases in the markets they have entered (mostly those that saw housing prices fall the most, and therefore presented great entry points for those firms who had the capital to buy foreclosed homes). In markets like Las Vegas and Phoenix, price increases have been stunning, with 25-30% one-year increases not uncommon.
There are two ways of looking at these developments. The bearish case is that private equity investors have bid up prices of these homes too much, and the returns they will ultimately achieve from renting them out will be unimpressive. This view seems to be winning the day right now, as several single family rental real estate investment trusts have gone public recently [Silver Bay Realty (SBY) and American Homes 4 Rent (AMH) to name a couple], and they are mostly trading around or even below book value per share. Typically companies that earn a decent return on equity trade at a premium to book value, so investors clearly doubt the viability of the business model right now.
Mr. Barrack, on the other hand, offered a more bullish view on the sector during his CNBC appearance. Now, you can say that since his firm has purchased tens of thousands of single family rental properties, he is simply talking his own book. But given Colony Capital’s track record, I don’t think Tom Barrack’s opinion is something investors should simply dismiss. Besides, he really has little to gain at this point in his career from disingenuously talking up the single family rental market. Ultimately, the renters will determine how well his firm’s investment performs.
Barrack believes the single family rental market will provide attractive investment returns, provided companies due their homework and don’t overpay for their properties. Given how far home prices fell peak-to-trough in the markets where private equity investors have focused, the mere fact that their buying activity has pushed up prices does not ensure that future returns on rentals will be sub-par. It is widely believed that many areas of the country saw home prices reach absurdly low levels (below replacement cost by a wide margin), so it is entirely possible (and I would argue likely) that private equity involvement has merely accelerated the timetable for when these homes returned to a more realistic market value. And assuming rental market demand remains solid, there is likely plenty of money to be made.
On that end, Barrack pointed out that there is a wide disconnect between the valuations of the single family rental REITs (again, at or below book value in many cases) and the large apartment rental REITs like AvalonBay Communities (AVB) and Equity Residential (EQR), which both trade at 1.8 times book value. In his view, the single family rental companies will be able to prove they can earn solid returns over time, and as a result, he believes their stocks will trade closer to the valuation levels of apartment REITs. If that is the case, there is quite a bit of potential in the single family rental market, not just for the private equity firms themelves, but for smaller investors as well who want to play the trend via the stock market.
This investment thesis makes a lot of sense to me, although I admit I have just started digging into these relatively new single family rental companies (my research is hardly complete at this point). That said, it”s hard for me to articulate why the underlying business fundamentals and return characteristics of these two markets would be materially different from one another. After all, is there really a big difference between buying a 50-unit apartment building and buying 50 single family homes and renting those out? Other than slightly higher costs associated with managing 50 separate properties instead of a single, larger one, it seems to me that the business models are very similar and could very well yield similar results.
Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time