Merging landlords see growing profit on rentals

House For Rent
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It was supposed to be a short-term play. Investors would buy thousands of bargain-basement single-family homes during the foreclosure crisis, rent them for a few years and then sell them off and be done.

That's what the critics thought anyway, but that is not how this still-nascent class of real estate is playing out. Instead, the big players are consolidating, which could make the stocks of those left standing potentially more attractive.

The announcement last week of a merger between Arizona-based American Residential Properties, which owns 8,938 rental homes, and California-based American Homes 4 Rent, which owns 38,377, was the third such deal in the asset class this year. The combined company will own and manage homes in 22 states and is projected to have an equity market capitalization of $5.5 billion based on closing prices as of Dec. 2.

"In our view, this is a very positive outcome for both AMH and ARPI shareholders, with substantial upside opportunities for earnings accretion over time," said analysts at Raymond James, which is acting as financial adviser to American Homes 4 Rent. "The sector's recent consolidation should only improve visibility, liquidity, and valuations among the remaining large players."

The reaction on Wall Street to the merger, however, was not so positive. AMH shares were down nearly 5 percent at the close last Thursday, the day of the announcement. Analysts called that curious. (Shares are off 5.9 percent year to date.)

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The decision to merge was not an easy one for Laurie Hawkes, who co-founded American Residential Properties just three years ago with CEO Stephen Schmitz. The two will remain with the company until the closing of the merger.

Hawkes blames rough third-quarter earnings on transition pains, as the company became less of a buyer and more of a manager of the rental homes. She still believes firmly in a vast growth potential for this sector, despite the recovering housing market. The roadblock, however, has always been capital.

"The stock market expects us to accomplish in three years what it took the multifamily sector 25 years to do. The ability to raise capital to grow is the critical element for the single-family rental sector, but issuing dilutive equity or increasing leverage were not attractive options for ARPI," Hawkes said. "Absent access to growth capital, we concluded consolidation made sense in order to enhance scale, increase operating efficiencies, share best practices and create additional value for our investors. We are rearranging the chairs in the room to optimize performance."

Two other major players in the sector, Starwood Waypoint Residential Trust and Colony American Homes, announced a merger in September that could create a company with just shy of $8 billion in assets. Together they own about 30,000 homes.

Earlier this year, Silver Bay Realty Trust agreed to buy the entire portfolio of Atlanta-based The American home. That consisted of 2,460 rental properties in three states.

"This is the natural evolution of how the industry is growing up," Aaron Edelheit, former CEO of The American Home, said just before the sale to Silver Bay closed.

Scale has always been the buzzword in the brave new world of large scale investors in single-family rental homes. Managing thousands of individual homes is a far greater challenge than managing units in a single apartment building. Some have outsourced the management, while others built an infrastructure from scratch.

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Large-scale investors have bought close to 200,000 mostly distressed properties to rehabilitate and turn as rentals since the height of the housing crash, according to several reports. That is still a small share of the roughly 15 million single-family rental properties nationwide.

The total number of single-family rental homes increased 35 percent since 2006, with smaller investors also taking on millions of distressed properties to rent. This happened as the nation's home ownership rate fell to the lowest level in 50 years.

Blackstone's Invitation Homes is the behemoth in the sector, having purchased more than 50,000 properties. The expectation is that it will take IH public at some point soon.

"Our focus is let's perfect the model. Let's get a world-class management team. Let's have really clean simple metrics that the market can understand," Jonathan Gray, Blackstone's global head of real estate, said in an interview with CNBC last July. "And when we show up, we want a business model fully leased. It will look more like a traditional multifamily read as opposed to some acquisition vehicle that's hard to follow. So we think if we can execute on the business, we'll find a way to communicate that to the public market investors."

Investors in rentals continue to bet that home ownership will remain low or even go lower. Tight lending, rising home prices and a generational shift in attitudes favoring renting are all on their side. Convincing Wall Street, however, has been tougher.

"The opportunity to buy additional homes at attractive prices is strong, the market demand for rentals is robust and the value of the homes is appreciating, but the stock market has not given credence to the underlying value of the real estate or the sustainability of the cash flows — hence the discount in the trading levels of all of the publicly traded SFR stocks," Hawkes said, referring to single-family rentals.

Hawkes pointed to the affordability and ease of the new class of rentals and, with the caveat that professional management still needs to improve, said that the quality of rental choices will boost demand in the long term and push home ownership well below where it is now.

Unlike multifamily, whose management structure and costs are now firmly in place, there are still opportunities, she said, to realize savings and improve margins.