October 7, 2013 - Post No. 30 - This week I am revisiting a subject I discussed about 6 months ago - companies purchasing huge numbers of houses to rent as a new investment vehicle.
In parts of Europe, especially Germany, there are companies that own literally tens of thousands of rental homes. This has been a successful investment for many decades. Will it be here in the USA? My opinion is a resounding No.
The most important reason I do not think this will prove to be a profitable investment is supply and demand. I always go back to supply and demand as the market cannot get away from its pull. Prices can disengage from the reality of value, - as in 2004-2007 and, once again today, for some property types and markets - but sooner or later the two will merge and result in an equilibrium market.
As I have stated for many years, just because a private equity firm or REIT buys a house, that does not create demand for it. Only an increase in population/households creates demand for housing. Granted demolition of existing units can help by reducing supply.
To use some numbers....Let's say in 2006 when the bubble burst and prices started to crumble we had a market with 100,000 occupied households (owners and renters) and 150,000 houses of inventory. Obviously there was a huge vacancy of spec units and even existing houses (due to foreclosures). Now 7 years later let's assume the number of occupied households has grown by about 1% per year. Let's round this up and say there are now 110,000 occupied households (again owners and renters - albeit today the proportion has probably changed drastically).
Instead of 50,000 vacant homes, we only have 40,000 vacant homes. The norm would probably be 5,000 to 10,000 vacant homes. So a company comes along and buys 1,000 homes...make it 10,000 homes. Is there suddenly a demand for these homes? No. Out of the 150,000 homes there is a demand to occupy 110,000 homes. Can this company steal renters away from other rented homes? Possibly. But, if the other rented homes are at market and the new big company wants a market return, where is the incentive for a family to just switch homes? Especially considering many of the excess homes from the bubble era were built in marginal locations with possibly limited services (e.g. schools, churches, medical offices).
Chris Meyer, the author of Capital and Crisis, recently cited the comments of Camden Property Trust (CPT) CEO Keith Oden. Camden is a large apartment REIT, but Oden said on his company's earnings call that his company had tried to pencil out a single-family portfolio.
His team couldn't make sense of the numbers. For instance, he said developers are modeling $500 for capital expenditures. "That's just astonishing," he said. "The number could be five times that by the time you rip the carpet out and replace the sheetrock." He considers the capex numbers "silly."
Legendary property investor Sam Zell called managing a pool of houses "a hell of an operation to run," and made the point that no one has ever successfully made such an investment work.
Professor Christopher Leinberger echoes Zell's concerns. "You can cobble something together," but many units "are going to fall through the cracks as far as day-to-day management attention is concerned."
Unlike buying a completed and fully leased apartment project, these REITs are acquiring properties so fast their vacancy rates are around 50 percent. This has some investors asking hard questions. "You don't see REITs in any other sector coming public when they're not fully occupied," Jim Wilson, of JMP Securities, told the Wall Street Journal. "So the investors are saying, 'Are you actually getting these things leased?'"
The angle that purchasers are promoting is that if they don’t achieve the expected annual rate of return (which I have seen is around 6%), they will make it up on price appreciation. Some investors contend home prices are as much as 20% below where they should be.
As Case-Shiller and other indices show, home prices only came down to touch their long-term trend in this Depression. They are now back to being over-valued. I would contend the odds are much greater that real prices (adjusted for inflation) will decline by 20% before they increase by 20%. We can check back in 3 to 5 years and see how this played out.
George R. Mann, CRE, FRICS, MAI
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