Single-Family Real Estate FHFA US
December 11, 2021 - 10:18pm EST by
woop
2021 2022
Price: 600,000.00 EPS 0 0
Shares Out. (in M): 1 P/E 0 0
Market Cap (in $M): 120,000 P/FCF 0 0
Net Debt (in $M): 480,000 EBIT 0 0
TEV ($): 600,000 TEV/EBIT 0 0

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Description

SUMMARY

Dixon Mills.  Two months ago I visited a $3,500/month Jersey City rental in Dixon Mill (link), a converted factory.  The broker mentioned the owner was also willing to sell for $575,000.  When the broker left the room, I told my wife (and you’ll get a sense of what she has to deal with): “No way it rents for that.  Why sell for $575,000 if it can be rented for $3,500/month?  That’s a good return even without appreciation.  Assume 2% appreciation and you’re looking at a safe, mid-teens post-tax return.”  (Note that the 2% gets goosed by the low-cost, tax-deductible, LBO-style leverage in real estate.)

Not as Competitive as One Might Assume.  Two weeks later we met the same broker at another property, and I asked what happened with the Dixon Mills spot.  He said it rented for $3,500 a week later.  Apparently the owner was retiring to South Carolina and wanted to sell but ended up renting to a British guy who would have bought a place except for his ongoing divorce, which led him to not want to own anything.  In this instance, the retiree would have potentially sold for non-economic reasons (ended up renting though), and the renter would have otherwise bought if not for extenuating circumstances.  I said that if he encountered any others with similar economics to call me, and his partner chimed in that I was standing in one (#12, in my spreadsheet below).

Talking around, this seems more common than one might think.  Sellers are often motivated by non-financial forces.  Then especially on the demand side, down payments can be difficult, renting is easier than buying time-wise and brain-damage-wise, and people value the flexibility of renting (especially in cities).  On the flipside, it’s of course important to avoid markets where the competition consists of “investors” who use US real estate as a safe deposit box (e.g., those trying to get their money out of Russia).

Outline.  In this writeup, I will address why I think the opportunity exists to earn good rates of return in single-family real estate exists in the first place (already touched on).  Then I examine 15 Jersey City properties for which I’ve run the numbers—some financial winners (such as Dixon Mills, #6 in the spreadsheet), some stinkers (in particular, the fancy high-rise condos with high HOAs), and some in between.  I analyze these using (1) a shorthand that’s common in real estate—looking at the Year 1 cash flows, (2) a detailed rental property model, and (3) a buy-then-rent-out model that compares the 10-year NPVs of (a) renting a property to (b) buying it, living in it a few years, and then renting it out.  I assume 2% inflation and appreciation as a base modeling case and 10% for an extreme case.

Spreadsheet.  https://docs.google.com/spreadsheets/d/1-qKMR-6jXw5nksm_oSlQxkoKheD-kErs/edit?usp=sharing&ouid=100785826776745715867&rtpof=true&sd=true.  Input cells are shaded gray.

Side Note.  In the process of writing up a low-liquidity, ~$10M microcap that had dribbled along for 20 years but now seemed like it might turn the corner (eye roll), it occurred to me that this is, in fact, a better risk-reward and worth more meaningful discussion.

TOPICS

  • Why Does the Opportunity Exist?
  • Pure Rental Investment Property
  • Rent vs Buy-Then-Rent
  • Why Single-Family?  And what About the “Brain Damage”?
  • Do Rental Properties Keep Up with Inflation?
  • Risks
  • Conclusions
  • Catalysts

WHY DOES THE OPPORTUNITY EXIST?

Inflation.  I’ll try to avoid getting too philosophical about the macro environment.  But it makes intuitive sense that we didn’t see serious inflation until now and that it’s likely to continue—though the economics of this idea doesn’t depend on its continuation.  Quantitative easing—printing money and buying financial assets—is best for those who own financial assets.  However, little of that translates to actual spending on goods and services.  Make a rich person richer by pumping up the value of financial assets, and he/she is unlikely to spend much of that on stuff that affects everday inflation.  Bridgewater estimated that quantitative easing was ~8% effective at stimulating on-the-ground spending (couldn’t find the source, but this discussion of the “inefficiency of Monetary Policy 2” conversation hits the point: link).  But send checks to people who will actually spend the money on everyday goods and services, and inflation kicks in.  And to really get inflation, just send $10,000 checks instead of $1,400 checks.  Sending checks pulls two inflationary levers: (1) spending increases and (2) supply decreases (since the checks compete with people’s need to work).  It’s hard to see why this would stop given that voters receive the largesse.  (Note that I don’t mean to imply a political view on this.)

Sub-3% 30Y Fixed Mortgage.  Despite inflation reportedly running 6.8% (fastest rate since 1982), the 30-year fixed rate is below 3% in a lot of cases and tax-deductible (up to $750,000 for a personal home, but there are ways around the cap).  It pays to safely borrow as much as you can in such an environment, and a 30-year fixed mortgage provides the natural instrument for an individual.  

Valuation.  A natural reaction is a concern regarding valuation.  Sure, you can borrow at low, long-term, tax-deductible rates, but you’re paying sky-high prices—so good luck.  If, however, one knows an area reasonably well, anchors the valuation in rental prices, and avoids common pitfalls (e.g., deferred maintenance, dodgy HOAs, etc.), that can serve as a margin of safety against overpaying.

DO HOME PRICES KEEP UP WITH INFLATION?

Yes.  The chart below relies on Robert Shiller’s data (link).

Figure 1: Inflation and Home Prices

From what I’ve read, whether rent prices keep up with inflation can depend on the area and the landlord.

PURE RENTAL INVESTMENT PROPERTY

Shorthand and Detailed Models.  I compiled two models: (1) Sheet “Shorthand Yield” offers shorthand yield that’s a bit generous—but that I’ve often seen—that essentially looks at the Year 1 cash flow profile (but assumes maintenance of the debt ratio, ignores taxes, and ignores eventual seller transaction costs); and (2) Sheet “Detailed 10Y IRR” offers a detailed model that aims to get the mechanics right.  Since the devil is in the details, (2) is a financial model that orients the investment much as one would with a stock (EV, income statement, free cash flow, balance sheet, return metrics, and IRR).

Dixon Mills, the $575,000 2-bedroom that rented for $3,500 would have shaped up to an 11.9% post-tax 10-year IRR based on my assumptions that include 2% price appreciation (and 1031 exchange).  

Figure 2: Detailed #6 Dixon Mills (2% Inflation)

Results Depend on the Property.  That’s not to say all of the 15 examples post healthy prospective returns.  Example #1 of the 15 in the spreadsheet, a fancy waterfront condo, produces a 2.5% post-tax 10-year IRR if there is no home-price appreciation—not a crazy assumption given the weak rental cash flow profile (why assume someone else would be willing to accept an even lousier rental yield).

Supercharged Performance During Inflation.  The scenario in Figure 2 envisions low inflation.  What happens if inflation skyrockets?  If, say, inflation rises to 10% and we assume home prices keep up (see Figure 1) and, for the sake of argument, rents rise at a slower 6%, it results in a 26.0% post-tax IRR according to the modeling.

Figure 3: Detailed #6 Dixon Mills (10% Inflation)