New Single-Family REITs: Promising but Risky

by Ethan Roberts | January 15, 2013 11:51 am

Have you ever wished you could own investment real estate, but you simply can’t tell a hammer from a screwdriver, or the thought of dealing with tenants makes you break out in hives?

Issues like these prevent many investors from adding rental properties to their retirement portfolio, even though they’re seeking the potential for annual returns in the high single to low double digits these properties often generate.

But now there’s a possible solution that could provide the high income that many investors are seeking, without having to study up on basic plumbing. That’s because a slew of new real estate investment trusts (REITs) that invest in residential, single-family rental homes have burst on the scene.

Two such REITs that have just begun trading are Silver Bay Realty Trust (NYSE:SBY[1]), located in Minnetonka, Minn., and Altisource Residential (NASDAQ:RESI[2]) in Frederiksted, Virgin Islands.

Both stocks have shown strong performances thus far in their short careers. Silver Bay, which began trading as a $245 million IPO on Dec. 17 at $18.05, closed on Monday at $21.19. Altisource is a spin-off of Altisource Portfolio Solutions (NASDAQ:ASPS[3]). It opened for trading the day before Christmas at $15.05 and closed Monday at $18.38.

Despite lower home prices and anemic mortgage interest rates, the overall percentage of U.S. homeowners has dropped from a high of 69.1% in 2005, to just 65.4% in 2012 — the lowest since 1997.

By contrast, the demand for rentals has been very strong, and large hedge funds have been scooping up foreclosures in bulk from Fannie Mae and from lenders such as Bank of America (NYSE:BAC[4]) at 60 cents on the dollar vs. current market prices for new construction.

The chart below shows how monthly rents have climbed, while monthly mortgage payments, which peaked in 2007, have declined below rents in recent years.


Courtesy JP Morgan Funds

Despite the heavy demand for rentals, these two stocks aren’t risk-free. While a REIT is required by law to pay shareholders 90% of its profits in the form of a dividend, no such dividend has been announced yet by either company.

Eventually, given what other commercial REITs are paying, one would expect these start-ups’ yields to be somewhere in the neighborhood of 3% to 5%. In fact, the desirability of these new REITs would be reduced substantially if the initial dividend yields are less than that. However, at this point, the exact dividend is pure speculation.

Furthermore, there’s no option trading yet for either company, which means you can’t make additional monthly income by writing covered calls. But most important, neither company has reported earnings yet. Analysts’ estimate for SBY is for 42% growth over the next quarter and 18% for the year. RESI has no estimates yet. So, investors face risks for sure.

But the potential for growth is phenomenal when you consider how these companies have been able to acquire the undervalued assets that will make up the core of their business model. As a real estate investor for 17 years, I’m amazed by the potential cash flow that can be obtained when properties are purchased at 40% off fair-market value, particularly in distressed areas such as Florida, Arizona, Nevada and California that are still some 30% below the peak prices of 2006.

Looking at the numbers, SBY’s initial portfolio contains about 3,100 single-family homes, with an average monthly rent estimate of $1,170. This is close to the median rental for many of the middle-class areas in those states, and it will certainly appeal to the average renter. Furthermore, the lower prices paid for these properties should protect these companies if the rental market turns down in the years ahead. We saw this occur among apartments and lower-price single-family rental homes in the 2008-2010 period, when layoffs sent thousands of young renters home to live with relatives.

The typical expenses in owning a single-family rental home include homeowner taxes and dwelling insurance, which is cheaper than homeowner’s insurance because it doesn’t include contents. In states where homeowner taxes are computed by sales price, purchasing homes at a 40% reduction drastically lowers the taxes paid. The REITs also likely get bulk insurance discounts.

Investors should be asking three important questions about SBY and RESI:

Time will tell, and many bumps in the road are likely. But it’s for certain that the core business model is sound, and the cash flow should eventually be plentiful. Initial vacancy rates were a very high 63%, which will restrict cash flow until the bulk of the properties are rehabbed and rented.

I wouldn’t be a buyer of either stock unless they pull back decently from their currently extended pricing. Around $20 for SBY and $17 for RESI would represent 50% retracements since their IPOs, and would be a good starting point for dollar-cost averaging.

A more prudent approach is to wait for these companies to announce their dividends because that will be an integral reason for buying these stocks and will serve as protection from downside risk.

In short, these two start-ups have a world of potential, and as is usually the case, a healthy dose of risk as well.

As of this writing, Ethan Roberts didn’t own any securities mentioned here.

  1. SBY:
  2. RESI:
  3. ASPS:
  4. BAC:
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