Back By: Steven Iannaccone and Erin Elferdink
Now that we have addressed what build-for-rent communities are and who these communities are expecting to have as residents in our BFR series, let us talk about who is developing this product type and why.
The early 2020s have been an evolutionary time for the housing industry. The COVID-19 pandemic prompted what some are terming “the Great American Move” in which households relocated away from large city centers, often prioritizing affordability, warmer climates, and more space both inside and out of the home. At first, elevated demand and a persistent shortage of housing created a supply-demand imbalance across both the rental and for-sale housing markets, coupled with record low mortgage rates, fueling steep rises in for-sale housing prices and rent growth across the country. The second half of 2022 introduced new challenges when the Federal Reserve began raising short-term interest rates, subsequently causing a spike in residential mortgage rates. The effects of rising rates almost immediately manifested as cooling for-sale housing prices and leveling rent growth, resulting in a higher cost of capital for consumers, investors, and businesses alike.
Despite the impact of rising interest rates and a volatile economy, the build-for-rent (“BFR”) sector continues to attract attention. A desire to gain exposure to one of the few new product types in the real estate industry, paired with the sector’s strong performance, elevated renter demand, and ability to adjust lease rates annually, has kept developers, operators, and lenders greatly interested in the build-for-rent space. While uncertainty in the market persists, the investment characteristics of build-for-rent housing are generally viewed as less risky, benefitting from downside protection and upside participation. This is due to the role that BFR communities play in providing attainable housing in the current market environment. As a result, these projects typically benefit from having high-wage renters, low turnover, and operational efficiencies that result in the asset class being more insulated than most other real estate subsectors.
Key Players in Build-For-Rent
Equity
As covered in our first BFR series, the build-for-rent space originated in the wake of the Global Financial Crisis when many private investors acquired existing single-family homes at a significant discount and operated them for rent, where homes were often scattered within established for-sale communities. It wasn’t until 2015 that early movers introduced today’s concept of BFR communities, building full communities of detached units with dedicated on-site management and typical multifamily amenities. Since then, the BFR asset class has grown in popularity across the country, with demand reaching new peaks in 2020 when the pandemic supercharged changes in people’s living preferences.
In response to the dramatic increase to demand, institutional players such as Blackstone, Lennar, J.P. Morgan, and many others publicly committed over $50 billion since March 2020 to develop and acquire SFR/BFR properties. While the headline-generating announcements have slowed since the Federal Reserve began their rate hikes, there remains significant equity available for the BFR sector. Private equity has been attracted to the relative safety and higher occupancies of larger-scale residential projects during a time of growing housing shortages, especially in light of lagging returns in other real estate sectors such as office or retail.
According to Northmarq’s 2022 Single-Family Build-to-Rent Special Report, build-for-rent construction starts and deliveries have continued to accelerate despite today’s economic volatility. Single-family build-for-rent starts averaged 10,000 units per quarter from 2017 through the first half of 2021, but beginning in the third quarter of 2021, starts rose to 15,000 units per quarter with levels reaching an all-time high of 20,000 starts by the second quarter of 2022. Deliveries of build-for-rent projects have followed a similar trend, with developers delivering 31,000 units during the first half of 2022, up from the 23,000 units completed during the same period in 2021. Construction starts and deliveries are forecasted to remain elevated, driven by ongoing renter demand and structural challenges within the for-sale housing sector. However, despite historically high development activity, experts say it could take nearly a decade to erase the nation’s housing shortage. A 2021 Freddie Mac report determined the US was short roughly 3.8 million housing units in 2020, up from 2.5 million in 2018, citing a dramatic slowdown in building after the housing bubble of the late 2000s. In the years to come, BFR developers will continue to address the housing shortage by adding differentiated multifamily products that can support a single-family lifestyle. This new development has the potential to help correct the undersupply of housing units across the country. As the sector performs as an effective solution to housing attainability, investors will be further drawn to the asset class.
Debt
Construction financing for build-for-rent properties is expected to remain in demand over the next few years as more BFR projects enter the development pipeline. However, the current interest rate environment has had a negative impact on a developer’s ability to maximize non-recourse construction loan proceeds. Rate increases have prompted banks to underwrite higher debt service coverage ratios and wider credit spreads on top of elevated current benchmark rates, which have resulted in lower total loan proceeds available for a project. Although construction loan terms are less favorable than they were in the first half of 2022, there remains sufficient appetite in the market to proceed with new projects despite higher costs of capital. Large operators view build-for-rent projects as a way to diversify their portfolios and meet the demands of a desirable pool of renters, while lenders view the proven rapid rates of lease-up and premium rents as a way to de-risk exposure to new development deals.
Banks are currently the largest source of construction financing, albeit at lower loan-to-cost ratios than they were a year ago. Well capitalized developers willing to provide credit enhancement are achieving the best terms, especially from existing lending relationships. Where credit enhancement is not possible, many projects today are being structured with a mezzanine loan or preferred equity tranche to create a more highly levered capital stack. Additionally, Fannie Mae and Freddie Mac have remained active in issuing take-out financing upon project stabilization.
Operational and Strategic Efficiencies of Build-For-Rent
Investors and lenders alike are attracted to the operational efficiencies that can be achieved through the construction and leasing phases of build-for-rent communities. Because single-family homebuilding is the most common construction type, BFR developments can utilize readily available supplies of labor and materials. Certain construction elements, such as foundations, are much simpler to construct for single-story BFR units compared to traditional multifamily developments. In addition, detached units allow construction and final inspections to be completed in phases, optimizing overall efficiency and reducing unmarketable downtime of finished units. Once construction is complete, BFR projects typically command a 10-15% rental rate premium over comparable traditional multifamily units, according to John Burns Real Estate Consulting.
Many investors have turned to the BFR space as a strategic inflationary hedge for their portfolios. Commercial real estate assets hold intrinsic value, are available in limited supply, and offer owners the ability to increase rents in response to rising inflation. This is especially true within the build-for-rent sector, where shorter, one-year leases allow owners to adjust rent prices to keep pace with inflation and rising costs. Rental real estate has historically experienced stable and non-cyclical demand driven by needs-based housing. In particular, the demand for rental housing is reinforced during economic downturns where home ownership can become more constrained. This can lead to households staying longer than intended in rental housing as they wait for more certainty in the economy. The ability to recast rent prices and the relative operational outperformance of the asset class are both highly appealing to investors in the face of rising interest rates and general market uncertainty.
These construction and operational efficiencies, coupled with unprecedented market demand and unknown inflation risk, are the main reasons why Halstatt, large institutional players, and lenders are eager to participate in the build-for-rent space.
Halstatt’s Involvement
Heightened investor attention and proven strategic and operational efficiencies in the BFR space have only served to solidify Halstatt’s conviction in the asset class. To date HREP has committed to six build-for-rent development projects, equating to over 1,150 units. Each project will be built within an established master-planned community and/or benefit from existing infrastructure and lifestyle amenities in growth markets across the Southeast and Texas. They will also be supported by a wide variety of amenities, such as onsite leasing centers, clubhouses, pools and fitness centers, parks, and more.
We believe that existing BFR and SFR product lacks the features desired by today’s market and is not available in significant quantities in strong locations in the Southeast U.S., representing an opportunity for us to fulfill an unmet need in the market. Halstatt has historically participated in demographic-driven apartment investing with a focus on affordability, meeting the needs of the middle-market, and the ability to drive value through strategic, value-added business plans. Similarly, Halstatt has enjoyed decades of success by leading the development of master-planned communities and formulating product and price segmentation within single-family for-sale developments. We believe this track record of success will be instrumental in refining and perfecting our value creation approach to build-for-rent development and operations.
Halstatt’s first and second pieces in the thought leadership series defined build-for-rent communities and discussed who these communities are expecting to have as residents. Our first piece in the series, titled “Evolution of Rental Housing – The Rise of Build-for-Rent,” details the asset class while the second piece, “Demographic Shift & Lifestyle Preferences Drive Build-for-Rent Demand,” outlines the target end user for build-for-rent.
