This article first appeared in the PB February 2015
issue of Pro Builder.
Before the Great Depression, the birth of Fannie Mae, or the debut of mortgage insurance for returning war veterans through the GI Bill, home builders regularly built for-sale and for-rent properties.
From the turn of the 20th century, the typical big-city builder bought blocks of land and constructed row houses on those tracts, or what today are referred to as townhomes. The builder would sell some units to whomever could come up with the hefty down payment—slightly less than 50 percent loan to value during the 1930s—and take on a mortgage with variable interest rates and a balloon payment due in as little as five years from origination. Obviously, the pool of consumers who could afford to purchase property then was much smaller than the population of renters. Those renters who could offer a partial down payment could arrange with the builder to rent with an option to buy. The builder monetized the rest of the project by selling to a property management company or an individual who would be the landlord.
“After World War II, big builders started to do only for-sale [homes] in the suburbs because now there were FHA and VA loans. Before the war, builders were shelter builders; you didn’t just get into single-family homes. You built for the user or, if you were a multifamily builder, you built for the portfolio,” says George Casey, president and chief executive officer of Stockbridge Associates, an industry consultancy based in Freeport, Maine, and a home building veteran with senior management stints at Toll Brothers and Orleans Homes, among others.
There are all sorts of influencers from the post WWII housing shortage, from the Levitt Brothers model for production home building to the 30-year fixed mortgage that industry watchers can point at to explain how home building evolved the way it did since the 1940s. The jury is still deliberating as to whether the Great Recession and recovery will produce a sea change in business models for builders. Yet some companies are dabbling with diversification by testing the rental property market.
Diversifying Against the Downturn
“I think the smart home builders are starting to ask: Am I really a home builder—which is code for ‘I build for-sale products’—or am I a shelter creator, which means my job is to put roofs over people’s heads, some [of which] are for sale, some for rent,” Casey says. Goodall Homes, in Gallatin, Tenn., closed 363 homes last year and started a master plan community in Henderson that is slated for more than 600 homes, most of them single-family detached, in addition to for-sale cottages, villas, and townhomes. However, Goodall also manages the rentals of five single-family houses and two multifamily buildings with three to six units each
and is considering buying about 10 more properties for Tennessee First Investments (TFI), the company’s fledgling rental division.
“Everything I read and see on the street says the rental market is going to be strong for years to come,” says Keith Porterfield, Goodall’s chief operating officer. “So it makes sense to us, where we can purchase some of these properties at our cost, to create some cash flow and get them into a good equity position over the next 10 to 15 years.”
Diversification is actually a distant goal for Goodall. The more pressing driver for entering the rental market was providing an ownership opportunity for the company’s key employees who manage that business and receive a cut of the profit. Launching TFI was more appealing and less complicated to president and founder Bob Goodall than creating an employee stock ownership plan or selling ownership stakes in the company. The rental properties so far are model homes built by Goodall and purchased at cost.
“It’s a long-term play for us,” Porterfield says. “We hope that in 10 to 15 years we have a really good equity position in these spin-off entities that perhaps can sustain us through a downturn in the economy.”
The Parc Riverside is a 287-unit luxury rental apartment building and is Toll Brothers' first project in Washington, D.C.
Lennar and Toll Brothers are among the big single-family players that are delving into the rental property business. Stock analysts have beaten up Lennar for moving resources that could be used to build more luxury homes and boost stock value into a market where growing rents are stabilizing and there are concerns about overbuilding. However, the Miami-based builder has stayed with plans announced in 2013 to construct $1 billion worth of apartments. Stuart Miller, chief executive officer, said during a second quarter conference call that Lennar is considering building single-family homes for rent if first-time buyers are largely unable to obtain mortgages. Toll Brothers, in Horsham, Pa., formed Toll Brothers Apartment Living and builds and leases luxury apartments in New Jersey, Pennsylvania, and the Washington, D.C. area, with plans to offer more in New York City and Massachusetts.
Beazer Homes formed a REIT in 2012 after acquiring 192 single-family homes for $18.9 million—10 percent of those properties were built by the Atlanta company and purchased back at a discount through auction, foreclosure, or short sale. A year later, the builder secured a $190 million credit line for buying and fixing up more houses to lease to renters. Beazer Pre-Owned Rental Homes amassed more than 1,300 homes, and managers said in 2012 that they planned an IPO when assets hit $150 million. Instead, the company last July exchanged its holdings for cash and a 15 percent stake, valued at $22 million, in American Homes 4 Rent, a major player in consolidating the buy-to-rent industry.
Fight the Cycle
The participation of these three players is not only a bid to take advantage of income opportunities in the fastest growing housing market but arguably is an effort to reduce some of the risk of being in a volatile and cyclical industry.
“The one thing that kills this business is the life-and-death cycle that you go through. It not only ruins capital, but a lot of private guys lost their businesses,” Casey says. “Rooms over people’s heads are a function of the number of households formed, and if the number of households is growing, there is a need for roofs over people’s heads. If you provide that by selling houses because mortgages are right, then great. If mortgage conditions are not right, then you’ve got the alternative of building for rent to go over people’s heads.”
Casey adds that building for rent is a different business model than what the industry is used to. But since builders didn’t figure out how to do it, companies outside the housing industry—Blackstone Capital, Waypoint, American Homes 4 Rent, and others—did. “In the end, the home builders who logically should have figured out how to do it, basically got trapped in their own negative logic,” he says.
Mark Kroll co-founded Sares Regis Group of Northern California in 1992 and has diversified the multifamily developer and property management company with a portfolio of 16,000 for-sale and for-rent units. The San Mateo, Calif., company also includes home builder Regis Homes Bay Area as an affiliate.
Kroll cautions that moving into the for-rent arena for multifamily demands more project management skills and less of the production/manufacturing acumen such as managing schedules and cycle time that home builders are used to. Sares Regis’ core market is the Bay Area, which is primarily urban and infill, so each development has to be unique and different. “You’re not reusing your successful plan,” he says, adding that holding onto and managing rental property is a professional discipline and shouldn’t be treated as a hobby.
“Property management is an essential part of delivering the right rental experience,” Kroll says. “It’s a sophisticated business that requires significant training and infrastructure to do correctly. You can do both—for sale and for rent—but you’ve got to have the expertise. You’ve got to have the capital structure and the long-term commitment to be the best in your market place.”
The Palisades at Sierra del Oro in Corona, Calif., includes resort-style amenities and is another project from MBK Rental LIving.
Tim Kane, president of MBK Homes, once perceived his company’s role primarily as being a builder of for-sale single-family detached homes and condominiums. But in 2009, while the industry was mired in the recession, MBK managers reexamined its strategy. This year the Irvine, Calif., builder has 250 apartment units in multifamily complexes under construction and probably will close the same number of single-family detached houses. Today, Kane sees MBK as being a shelter supplier.
“I’m hoping that the real advantage of being diversified comes in the next downturn where it provides some insulation,” Kane says. “The benefits of being diversified are not as great now as being prepared for the downturn. Hopefully in the next downturn both the rental and the home building markets are not affected in the same way, so you have some way of mitigating the slump.”
Unlike the wild gyrations in home prices during the recession and recovery, the rental picture didn’t change as dramatically. Rental unit occupancy in Southern California historically has stayed above 92 percent, fluctuating by no more than 6 percent. So even during bad times, odds are that a building will be mostly leased and generating income. Another attraction for MBK is that builders are only able to monetize the capital tied up in projects by selling, which could be at a loss if they get caught in a downturn. But apartments are assets that generate income, and owners can hold out for a better market rather than being forced to sell into a slump. MBK has the staying power to wait out bad markets since its parent company and financial backer is Mitsui, a multinational real estate company. Also, MBK has a track record with building condos, so transferring that construction experience into apartment building was easy, Kane says.
“When you look at building a house for rent, your margin isn’t a whole lot less than if you build for sale,” Casey says. “It is less, but your velocity is five to six times the velocity you get when you’re doing for sale. So when you look at it from an ROI standpoint, it’s not bad.”
Should I Stay or Should I Go
Any builder involved in rental, whether it’s a multifamily building or a single-family house, will have to decide whether to recover its return on investment by either selling the asset—as Beazer did—or figuring out how to manage property if it’s going to hold on to it for a while. Goodall Homes is in the early stages of its rental business and doesn’t have enough apartments just yet to press managers into bringing in someone internally to take care of the apartments or hiring a property management company. Porterfield adds that they’re leaning on fellow builders who have been in the rental business for several years already to learn how they figure out the optimum time to rotate out of an asset by selling and when to bring in more apartments.
When MBK first considered entering the rental business, managers took a cursory look at building single-family houses to lease. The builder opted to focus on multifamily because many units under one roof or in one complex presents an easier property management challenge than taking care of rental houses that are dispersed. Also, there was no commercial market in 2009 for selling single-family rentals. Institutional investors have since bought houses to rent, but most of those assets were distressed properties acquired on the cheap through foreclosures, auctions, and short sales. Since there has long been a commercial market for selling multifamily properties, getting involved with those kinds of assets presented MBK with an easier exit strategy than did building houses to rent, which might have to be sold one at a time if the owner has a large portfolio.
Some property management skills for renting are transferable from home building. For example, the resources and process for servicing a new home for warranty work is similar to maintaining and fixing apartment buildings. Opening and staffing an office to market and lease apartments is compatible with selling a new home. But there are rental property management nuances that new entrants will have to learn. MBK eventually intends to have its revenue mix split between building and renting shelter. It also plans on managing its rental properties someday, but in the meantime, the builder has hired a property management company to handle those duties and is learning along the way.
“Property management is a whole skill set we are looking at,” Kane says. “One example is when you lease a unit. One big question you have to consider is when does this unit come up for leasing again. For instance, if you have a three-bedroom unit, September is the worst time to lease because school has already started and people are not looking to move. You want that thing available in spring or early summer.”
There are rent revenue tactics such as motivating potential tenants to sign a nine-month lease by charging less rent per month than on a 12-month lease, so that when the tenant moves out the unit will be available during a month when more renters are apartment-searching. There is also leasing software with algorithms available that can show the optimum time to rent units based on unit size, the mix of apartments in a portfolio, and market conditions.
“We thought it wasn’t going to be that big of a jump because servicing a home for warranty work for a year is not unlike a tenant in an apartment,” Kane says. “But there are a lot of nuances to the leasing business that we are learning.”
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