5 is the new 6!

Traditionally speaking, Single Family Rentals (SFR) as an asset class has mostly been the domain of retail investors. That landscape has slowly started changing in the last decade. While still a tiny fraction, about 3% of SFR is owned by large institutions today, Invitation Homes being the largest landlord with about 80,000 homes.

Why is SFR always been a popular choice for Renters?

Although most Americans may associate apartments with rentals and single-family homes with home ownership, according to Freddie Mac, about half of non-rural renters and two-thirds of rural live in 1-4 unit SFRs, totaling 22.5 million SFR rental households or about 53% of of all rental households.

Out of these 22 million rental households, about to 88% of properties are owned by very small retail investors (1-10 properties), and another 7% by small retail investors (11-50 properties). All in all, the aggregate institutional ownership represents about 3% of the overall SFR rental market.

SFR has always been a popular choice among renters for a variety of reasons including privacy, additional space, availability of a yard, better space for kids & pets and so on. During the COVID-19 pandemic, for obvious reasons, the demand for SFR rentals far exceeded supply, thus creating a temporary disequilibrium in the market with both unprecedented increases in both rents and home value.

Home ownership has and always will be the American dream, although we may be seeing a slight shift in sentiment among millennials who might be more willing to embrace remote work or gig economy jobs, combined with the flexibility to move around without putting down roots (many people in my parents generation worked at one place their entire life and that is not true of my generation, and certainly less so with the next generation).While home ownership may not be for everyone, the preference for SFR rentals suggests that living in a single-family home may still be a possibility for many rental households - e.g., a $1,500 rental property may well be within reach of a family making combined income of $55,000 per year.

How has SFR investment sentiment changed in the last few years?

As an investment asset class, SFR has been popular because it provides non-correlated yields (rental income acting as an inflation-hedged fixed income product) with potential for appreciation (home price appreciation or HPA acting like a growth stock). Until a few years back, investors underwrote properties primarily based on the yield characteristics (capitalization rate or cap rate being the industry metric on which properties were analyzed). As this asset-class was primarily owned by retail investors, properties were mostly evaluated based on their potential for rental returns using capitalization rate (or cap rate) as a proxy for measuring potential yield. Prior to the pandemic, it was not uncommon to see properties in good secondary markets (Atlanta, Indianapolis and so on) bringing in cap rates in the high 6's. The demand-supply mismatch, in conjunction with historically low interest rate environment has sent property prices soaring in recent months. Typically when prices go up, you see a compression in cap rates. While the increase in HPA might offset the cap rate compression in a way that does not adversely impact total returns (I will write a more detailed article about this separately), many smaller buyers of investment properties do see the impact of the cap rate compression (offer prices of $20k or more above list prices). It is safe to say that a 5% cap rate is perhaps the new normal in most secondary markets today (there's also many assumptions that go into how initial rehab or property expenses are modeled and this directly impacts pro-forma cap rate. Suffice to say that if someone tells you they can find you 6% cap rate or 22% levered IRR properties in Atlanta at scale (while this is possible with certain value added higher risk strategies, the regular long-term rental properties come with lower risk and moderate return characteristics) talk to me first before you ink the deal.

Is it still possible to make good total returns on SFR rentals?

I believe that SFR as an asset class is just starting to get on the radar. It is estimated that today (Jul 2021), we may have a current shortfall or 4-5 million units (excess demand over supply). Yes, these properties are very pricey right now. Over time, with increase in supply or with interest rates going up, we will likely start seeing some mean reversion in terms of annual home price increases. Technology advances have made it possible to do desktop underwriting of remote properties (platforms like Roofstock.com allow remote investors to sit at their home in California and underwrite /make an offer on a property in Alabama with the push of a button). Portfolio diversification is a well-established investment strategy and many pundits will tell you that a well balanced portfolio should have some allocation to alternative assets. SFRs have always been popular alternative investments, but in recent years, they are certainly been having a moment. Overall, when purchased right and when managed by a qualified property manager, these assets can absolutely provide non-correlated yields and decent total returns (comparable with historical performance of equity markets).

How can I learn more about SFRs?

Like anything else, there is a lot to unpack when it comes to SFR investing. There are different strategies (fix and flip, long-term rental holds, various value-added strategies). There are also different investment goals (am I looking for capital preservation, supplemental income, growth, speculative investing etc). Then there's market selection - which growth or income markets should I be focusing on? After that, there's the buy box - what vintage, how many beds/baths, what square footage, should I be purchasing turnkey properties, properties with light rehab, heavy rehab etc). How should I be thinking about the underwriting? How does leverage impact my purchase decision?

These are complex topics. But it is no more complex than learning about the stock market or crypto currencies, private placements, oil & gas limited partnerships and a myriad of other investment opportunities. The good news is that there is a ton of information available and experts who can provide a decent summary of the factors that a potential investor should take into consideration when contemplating SFR investments.

Write a comment and share your thoughts. Also, let me know if you would like me to cover specific topics of interest pertaining to SFR investing in more detail. Until then, happy investing!

Author Bio

Sanjay Raghavan works at Roofstock where he leads the Roofstock One business unit. Roofstock is a market leader in the single family rental space, having facilitated over $3 billion in SFR transactions. Previously, Sanjay was a banker at a lower middle market boutique where he structured and sold income or income-oriented structured and corporate finance transactions. Sanjay has an MBA from the Wharton School, University of Pennsylvania.

Disclaimer: This article is for for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor does it constitute an offer to provide investment advisory or other services?by Roofstock Inc., or its affiliates.