The Economy Has Changed; Has The Built-For-Rent Business Changed With It?
The hottest trend in real estate is the built-for-rent single-family home business (”BFR”), but now that mortgage rates have doubled, the stock market has gone bearish, home sales are crashing, and the talk of possible recession is on the wind, investors in this segment are asking more questions about potential risks. There are some legitimately worrisome new trends, so some of the issues and concerns that are being raised are quite appropriate, while others are based upon some misconceptions. This article is meant to address both.
The Most Frequent Question: Rent Growth
One question that investors are asking now is “will rents drop as home prices slide backwards?” One thing is for sure: the recent (15%-20%) rates of single-family rent escalation cannot be sustained, even though the incomes of new-lease-signers have risen rapidly over the past two years. We expect rent gains for the next few years to be a fraction of the rates of increase of this year and last, but, supported by strong income growth among renters, we still contend that 5%-6% rent growth is still likely in most parts of the country. Any underwriting that includes continued double-digit increases in 2022 or 2023 would be decidedly unrealistic and risky, but low-single-digit increases are still in the cards.
One bullish indicator that substantiates the prediction of further rent growth is renters’ incomes. Their incomes have been rising more rapidly than the incomes of the overall population. This partly reflects the fact that people in the typical renter age groups (Millennials and Gen Z) have been advancing in their careers, as people often do when they leave their 20s and age into their 30s. Renters’ incomes have risen by 7.1% so far in 2022, and we’re only halfway through the year, according to a new report from RealPage.
Based upon this, my expectation is that renters’ incomes will probably be up 10%-12% for the entire calendar year of 2022. There is room then for further rent increases — RealPage data furthermore shows that market-rate renters are currently spending 23% of their income on rent, which is well below the 30-33% affordability ceiling.
Part of the rate of increase in incomes may be attributed to former home shoppers who recently decided not to purchase, and who decided to rent, but most of the increase is attributed to career growth. The RealPage study found that the age of renters has not increased, showing that the bulk of the increase in incomes is not due to former home-shoppers deciding to rent; they would typically be older than the average renter.
Some analysts have raised the alarm that rents have risen in some Sunbelt markets to above what local incomes can sustain. Those data exercises do not take into account the fact that much of the surge in demand in those markets (most notably in Florida, Texas, and the Carolinas), is coming from non-local incomes, typically from states with much higher levels of income and higher income taxes. That said, there are some single-family rentals now listed on Zillow in Phoenix that are showing rent reductions, and some national single-family rental companies are cancelling pending acquisitions and a few are selling some of their holdings. This all bears some close monitoring.
It is also worth noting that there are two parts to the question of rent growth. There is the likely movement of rents in the overall market, and then there is the potential for rent escalations for an individual BFR development. Rent escalations for most BFR projects will likely exceed the average rate of increase in the market they’re in. This reflects the “filling in” of the development with people, making it feel more like a living neighborhood to prospective renters who are touring it. Also, if there is an amenity such as a clubhouse and pool, rents in a given development typically get an extra boost once the recreation center is open.
Impact of Lower Home Prices on BFR
Some are concerned that as home prices go lower, that will drag rents lower, just as rising prices over the past few years dragged rents upward. This is a possible threat, as the homebuilders are now offering concessions and discounts. Mitigating this threat is the way that would-be homebuyers respond to such discounts. When a builder is lowering prices each month, the buyers tend to put off the purchase, possibly staying in the rental market for another year or two, so that they can re-enter the purchase market after home prices have stabilized. The householder figures, “why buy now, when I can wait a year and get the same house for $50,000 less?” Newly-built homes in rental single-family communities allow them to do that without giving up the single-family lifestyle. In that sense, builder price cuts will likely feed demand for BFR developments.
This will be an increasingly prominent story in the coming weeks. When builders start cutting prices, not only do would-be buyers stop in their tracks, but buyers who are already under contract to purchase a home often cancel the contract. They see the price being lowered on the same exact model in the same subdivision, and they feel they are about to overpay. When a buyer falls out of contract, the builder has another inventory unit they need to sell, and that unit will be much harder to sell in this environment. Expect to see increased cancellation activity in the months ahead as a result.
While home price declines are a possibility, particularly in the exurban areas that boomed during the worst days of the pandemic, this will not have a chilling effect on built-for-rent housing demand. It might be tempting to say that when home prices go lower in an area, people will revert from being renters to owners again, but the reality is that the monthly payment will still be higher than the cost to rent in many locations. That’s a direct result of the new mortgage rate environment, which is expected to persist. After all, the primary driver of declining home prices has been the effect of higher mortgage rates on the monthly payment.
The Pace of BFR Construction Will Continue to Chase Demand
Hunter Housing Economics’ national forecast is for an increase in BFR production from an anticipated 100,000 to 110,000 units in the year 2022 (even with an economic slowdown) to 150,000 new housing units a year over the next four or five years. That said, starts of homes in general are headed lower for the rest of this year and probably into next year, with the expected plunge being greater for f0r-sale housing, and much less severe for BFR home starts. After the economy recovers from its current cyclical weakness, assuming a mild recession starting sometime this year, the demographic drivers will again reassert themselves, driving demand toward 150,000 homes per year or higher.
Impact of Higher Cost of Capital
Another effect of higher mortgage rates is a higher cost of capital for developers and investors in the built-f0r-rent space. This applies not only to smaller investors who use debt but also to the large companies that use mortgage-backed securities. For example, Progress Residential has seen the interest rate it pays on its MBS issuances go from 2.2% in the summer/fall of 2021 to 5.3% in June of 2022. The higher cost of capital is already causing some BFR projects that “penciled out” to an acceptable rate of return at early-2022 interest rates to no longer be feasible today. Or at least the risk is viewed as too high. The takeaway is: choose locations carefully and do serious due-diligence. The investors in these communities will demand it.
As a result of this, there will be some BFR land deals that will get repriced at a lower land basis. This will be necessary to allow the yield on the investment to be high enough to make sense in a part of the cycle when money is no longer cheap.
Effect of Higher Mortgage Rates
While the cost of capital is the dark side of higher interest rates, higher mortgage rates could actually be a positive for rental demand. As mortgage rates edge higher, more buyers will find the monthly payment out of their reach, and more demand is expected to shift from ownership to rental demand. On top of this “renter-by-need” demand, there will be continued growth in “renters by choice.” It should be kept in mind that this “by-choice” group is much smaller than the “need” group. In many cases, they can be householders who are planning to buy a home and are only renting for a relatively short interim period. The “by-choice” group however is also a reflection of the fact that millennials are starting families now, and have much less of a bias toward ownership than prior generations (and they have now been in the workforce for more than a decade and can afford to spend more on their housing).
There has also been some discussion in the media recently about the possibility of overbuilding in the built-for-rent niche. Some analysts point to the $30 billion (at the low end) or $65 billion (some estimate $75 billion at the high end) worth of capital that is looking for land and development capacity all around the country for BFR. The reality is that not all of the capital that has actually been announced is likely to find an investment that is suitable, due to the scarcity and price of well-located land. Capital is going to be much more selective in 2022 and 2023 than it was last year when the land rush was in full swing, and that will keep the currently undersupplied BFR sector from getting oversupplied anytime soon. Even if $75 billion is the eventual number, by 2024 or 2025, when BFR absorption is expected to be up to 150,000 units a year, that will equate to about a two-year supply, which is not problematic at an aggregate level.
Rising Interest Rates and Recession Risk
There is increasing concern of a potential recession in 2023, resulting from recent and expected future increases in interest rates. We expect built-for-rent projects to be much more resilient in the face of a possible slowdown than for-sale housing developments.
In general, weaker economic conditions force many people toward renting instead of buying. This tends to keep the rental sector relatively stable during downturns. There are some people who have to simply move in with relatives, but a much larger share of the market will rent. Also, there will be a rise in foreclosures, and that may add to demand for single-family rentals, as people who lose their homes typically look for a single-family home to rent.
Household formation rates are now back up to 1.5 million annually, which is above the pace of new home construction, likely to ease to 1.1 to 1.2 million going forward as the contracting economy causes more people to take a roommate or move in with relatives. Even at that lower level of household formations, demand for housing is expected to be sustained higher than production.
There has been concern expressed lately about the fact that growth in the adult population in the U.S. is slowing, and although that is true, that is not the most relevant metric. The largest subgroup in the population is turning age 27-31, and the 30-39 age group is the relevant one for built-for-rent. This segment of the population is starting to form families, and those young families are a prime audience for BFR. It should also be noted, with regard to the overall slowdown in population growth, that the limitations on international travel and migration during COVID played a causal role, and that effect will be temporary.
The composition of these new households is also turning out to be highly supportive of housing demand. Based upon Fed analysis of Census data (graph above), there has been a recent structural decline in the share of people “living with roommates/others” and a rise in other living arrangements, including “living alone.” This trend has generated increased headship rates (especially people in their 30s), and therefore increased demand for new residential units.
Headwinds and Hopes
There are new headwinds, and there are new concerns. That said, the BFR sector has a long runway ahead of it. Millennials will be forming more families in the years to come, and built-for-rent will be the best pathway to single-family living for many of them. Market due-diligence firms like ours are still getting a flood of interest in built-for-rent market studies, indicating that many firms are still seeing the potential outweighing the risks, or at least considering it worth giving it a careful look. That’s why I see continued growth in the built-for-rent sector for the foreseeable future.