Single-Family REIT IPOs Are Risky Bet

NEW YORK ( TheStreet) -- The big money on Wall Street has been busy snapping up foreclosed single-family homes at bargain prices for cash and converting them into rentals, in many cases crowding out mom and pop real estate investors and first-time home buyers.

Now they are finally offering you, the average Joe who just can't seem to get a mortgage in this market, a chance to participate in the nascent housing recovery.

A number of operators of so-called single-family rentals are seeking to raise money from the public as real estate investment trusts or REITs.

REITs are required to earn their income stream primarily from real estate and must distribute at least 90% of their taxable earnings as dividends. As REITs, they are permitted to deduct dividend from corporate taxable income and many REITs choose to distribute almost their entire taxable earnings so that they owe no corporate tax.

These investment vehicles have become increasingly popular with retail investors in recent years as they offer rich yields in a low interest rate environment.

Single-family rental operators who have mushroomed over the past year are increasingly adopting the REIT structure as it enables them to get access to a lower cost of capital compared to, say, private equity funding.

Silver Bay Realty Trust ( SBY) was the first single-family REIT to go public in December. American Residential Properties ( ARPI) raised $287 million in early May.

In the last few weeks, Waypoint Homes Realty Trust managed by Oakland, California-based Waypoint Realty Group registered an IPO filing for $100 million.

Colony Capital ( CLNY) is also listing its single-family REIT Colony American Homes, which plans to raise another $245 million.

These companies are being promoted as high-yielding REITs that could also provide an upside from rising home prices.

But with an unproven business model and a lack of comparative benchmarks in the market, they remain a risky bet.

A Unique Play on the Housing Recovery

Single- family rentals is not a new business. According to analysts at KBW, from 1973 to 2011, single-family rentals constituted 10-12% of occupied housing and 31-35% of occupied rentals.

But this is a unique period of opportunity for single-family rentals. A historic level of distressed homes for sale, price declines that have made housing remarkably cheap and high demand for rental units amid constrained credit conditions have combined to create an unprecedented opportunity for institutional investors to buy vacant, foreclosed homes in bulk and rent them out.

Moving beyond the current situation, the long-term argument for single-family rentals is that Americans will increasingly rent homes rather than buy them. For one, new regulations will make it much more difficult for homeowners without strong credit scores and a substantial downpayment to get a mortgage in the future.

Second, with millions of borrowers underwater and unable to sell, supply will remain constrained and force people to rent.

Third, the millennial generation, unlike the baby boomers, may just prefer to rent and have mobility rather than be tied down to a house and a mortgage.

And single-family homes will be an attractive option for the swelling ranks of renters with families. So this is an investment that could yield a steady income stream, much like multi-family dwellings.

KBW analysts also note an interesting advantage these REITs that own single-family homes have over other housing plays such as homebuilders and mortgage REITs. They offer a "hedge" against rising interest rates and tight mortgage credit. While such developments will likely hurt demand for housing, it will push buyers towards renting, benefiting single-family REIT operators.

According to the analysts, cash returns in the foreclosure-to-rental business could be in the 5-7% range, while total returns could reach 15-20%, with leverage. Some investors have already begun to attract funding, and if securitization of single-family rentals takes off, these returns could really be within reach.

A lot of 'Stupid Money' Out There

Still, while the opportunity might be compelling, it isn't clear if the market is big enough to support many players.

Frank Aronson, partner at Boston-based Posternak Blankstein & Lund, who specializes in real estate, is skeptical that the single-family rental market will be as big as some project. "It will shrink when housing gets better. The political ploy is always to raise the level of homeownership," he noted. "This is a sub-market with finite possibilities."

Several institutional investors have rushed into the business over the past year and it isn't clear who the winners and the losers will be. "I strongly suspect there will be a shakeout of these companies," said Aronson.

Already two big players have exited the market. Last year, hedge fund Och Ziff ( OZ), one of the early entrants into the business, called it quits. And now it appears Carrington Holding is also pulling out of the business, according to Bloomberg News.

Chief Executive Bruce Rose, who raised $450 million for the business from Oaktree Capital ( OAK) last year told Bloomberg that returns were not adequate to continue investing. "There's a lot of -- bluntly -- stupid money that jumped into the trade without any infrastructure, without any real capabilities and a kind of build-it-as-you-go mentality that we think is somewhat irresponsible," the report quoted him saying.

Indeed, the early entrants to this business face enormous challenges.

Good Yield Is So Hard To Find

Institutional investors are already finding it hard to acquire properties at good prices. Most players are chasing the same properties in the same cities, creating bidding wars that automatically lower potential yield.

Properties can be purchased in bulk only in places where there is abundant supply of foreclosed homes, so almost all players in the business are actively bidding in cities such as Phoenix, Las Vegas, Atlanta, Tampa and parts of California, which is why we are seeing a strong rebound in home prices in these markets.

Most players need to limit their buying to a few cities simply for operational reasons. Managing a widely-dispersed group of single-family homes is an operational nightmare.

In the case of multi-family homes, a number of units are clustered into a single building, lowering the cost of maintenance. But imagine having to handle, say, the plumbing issues of a thousand homes spread all across Atlanta.

"You need a management infrastructure that is much more diffused in the case of single-family homes," said Aronson. The attorney believes operational difficulties will ultimately trip up bulk investors who lack experience in property management. "People who rent don't take anywhere near the care of a house compared to those who own."

Many big investors are working with property management companies, but that means they are likely giving up some of the yield to management fees. Others are building their own management infrastructure, but that is going to take time to scale up.

Meanwhile, they are aggressively ramping up property purchases in an "arms race" fashion, hoping to build a large portfolio of homes before prices rise even higher.

But it takes time to refurbish homes and rent them out, which means occupancy levels in the initial years will be lower. That means lower cash flows and it means that investors buying these REITs will have to wait a couple of years before yields start firming up.

In some cities, the conversion of single-family homes into rentals has created more supply than there is demand for rental homes. KBW analysts factor in a 4% annual inflation in rent but it is not clear that all areas can pull off such significant rent increases.

A report from online company Trulia in April suggests single-family rents are already flattening in many markets. "Nearly 4 million more single-family homes have been added to the rental market since 2005. This new supply has fully caught up with the increased rental demand during the housing crisis - causing single-family home rents to flatten nationwide," the report noted.

Are REIT IPOs Worth The Risk?

Buying into a single-family REIT IPO is likely to be a high-risk bet at the moment, given that the business model is unproven and we don't have players with a well-established track record.

Investors who choose to buy into this need to be strong believers of the long-term story, says Scott Crowe, who heads a newly-formed real estate securities unit at Resource Real Estate. "Do you buy into the macro picture? -- Housing will recover, there will be a high propensity to rent and REITs will be able to penetrate this market."

Crowe believes REITs will be able to professionalize the single-family rental business -- historically the mainstay of mom-and-pop investors - in much the same way REITs have stormed the self-storage business that was once dominated by individual investors.

But even he is a little wary of the current crop of REITs hitting the IPO market.

For one, they are externally managed, which involves paying a fee to an outside company. Most externally managed REITs tend to trade at discounts because of concerns that manager and shareholder interests aren't aligned.

Secondly, while the REITs tout their experience in buying a portfolio of homes, none of them is contributing their legacy portfolio to the newly-formed REIT.

"They are keeping the juiciest opportunities for themselves," said Crowe of the companies tapping the market. "You are not buying a stable portfolio. You are buying an acquisition story."

Waypoint Homes Realty Trust for instance, will be externally managed by WREG, which has invested more than $500 million in 3,500 homes in the San Francisco Bay area, Los Angeles, Atlanta and Phoenix among other cities. But investors in the new REIT will not own this portfolio of homes.

The market is wary of single-family REIT IPOs as well. Both Silver Bay and American Residential are trading below their offer price.

Clearly, the market would rather see these REITs prove their business model. So it may be best to wait and watch.

-- Written by Shanthi Bharatwaj in New York.

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Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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