SeekingAlpha

The Case for Single Family Homes (Part 2)

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 30, 2011. To access his article on Seeking Alpha, please click here. In the first article in this series, we explored how "replacement cost" analysis suggests that single family homes in Phoenix are undervalued, and why they are much more likley to go up in value in coming years, rather than moving down.

In this article, we explore a second, independent, strong signal that single family housing in some areas is undervalued. For this article, we will switch to inland Southern California rather than Phoenix, since I know the rental economics better in this area.

Single Family Rental Economics Below is a home about an hour from Los Angeles that was purchased for a little over $100,000 in early 2010.

The buyers of this home are a father and son team who have purchased about 100 homes in the same area in the past two years. They have sold about sixty homes after rehabilitating them, and they have held onto the other 40 homes to create rental income.

They spent about $13,000 rehabilitating this property, so their total cost basis is about $115,000. Today, the house is rented for $1,450 per month. Assuming one month of vacancy each year, rental income is about $16,000 per year. Operating expenses are about $5,000 per year. Net income is about $11,000 per year. On their cost basis, the owners are getting about a 9.6% cash-on-cash return ($11,000/$115,000).

If they bought a similar home today, in need of repairs, direct from a bank, the market is more competitive and they would pay more--probably $130,000 instead of $100,000. Even so, they would still have well over a 7% cash on cash return. Once rehabbed, the property would be worth in the high $100s. This property is appraised at a retail value of $195,000 today.

A Quick Look At Multifamily Rental Economics Let's compare the single family home "fix-and-rent" strategy with buying apartments.

If one were to buy a 100 unit "Class B" apartment building in the same area as this home, it would trade at a capitalization rate of about 6.5%. That is, the income before debt service would represent a yield of about 6.5% as compared to the purchase price.

Given today's low interest rates on multifamily properties courtesy of Fannie Mae (currently under 5% for a 10-year maturity), the cash-on-cash return would be okay from the apartment property--probably about 5% after accounting for principal payments required by the mortgage, reserves and other factors.

However, if interest rates go up, or Fannie Mae stops subsidizing the apartment market by providing such low rates for apartment owners, the value of such assets could easily drop. Investors look at their cash-on-cash returns after debt service, and apartment values have been driven up by very low interest rates for apartment loans. If these rates were to go higher, apartment values would drop, just like bond values.

The Risk Of Buying Apartments Today The bottom line for apartment investors is, they can enjoy low single digit cash-on-cash returns. However, in my view, there is a substantial chance of capital loss, even if rents keep going up, because higher interest rates will lead to higher capitalization rates which means lower values.

For example, suppose we have a change in cap rates from 6.5% to 7.5% (which is historically a more typical cap rate for Class B apartments in secondary markets). A property with annual cash flow before debt service of $300,000 drops in value from $4.6 million to $4.0 million--a 13% drop in value. Now suppose that the property has a loan of $2.3 million. The $600,000 drop in value now equates to a reduction in equity from $2.3 million to $1.7 million, or a 26% drop in equity.

Apartments are currently a favorite asset class for real estate investors, but as the numbers show, there is real risk for apartment buyers when cap rates are at historic lows, as they are now.

Apartments vs. Single Family Home Rentals If, instead of buying a 100 unit apartment building, one were to purchase, say, 60 homes in the same area, there would be certain advantages and disadvantages.

The apartments would be much easier to manage, since they are all grouped together and there are economies of scale. Also, it is easy to get financing to buy apartments, while financing to buy single family homes as an investment is difficult to find and expensive.

The single family homes have the advantage that the current yield (cap rate) is a little higher than the current yield on apartments. Say, 8% vs. 6.5%. They also have one other important advantage. The homes can be sold individually, and if they are purchased from a bank by an experienced operator, they can be bought at "wholesale" prices.

As a result, a home bought for $130,000 and rehabbed for $15,000, for a total cost basis of $145,000, might be worth $185,000 once it is fixed up, because it can then be purchased by a family and once fixed up, the home will qualify for Fannie Mae or HUD financing (which increases the affordability for families substantially). After accounting for broker fees, there is still maybe $25,000 or $30,000 of equity created in the home, by virtue of a favorable purchase and an efficient rehabilitation, both of which create real value.

By contrast, there is almost no way to purchase apartments at "wholesale cost", at least not within an hour's drive of Los Angeles. Anything worth owning will become a competitive auction led by the large number of opportunistic investors who have been trying to buy apartments since the downturn began. The most common complaint from these savvy investors is that there is too much competition, and not enough product available to buy.

Conclusion Most members of the Seeking Alpha community have no interest in being landlords, let alone being landlords for a portfolio of single family homes. The point of this article is two-fold:

The attractive economics of the "fix-and-rent" market today, as compared with the apartment investment market, suggests that home values are near a floor in the most beaten down areas of the Southwestern U.S. It is hard to see values falling much further when already the numbers are compelling for investors to purchase these properties at current prices, given current rents; and The "fix-and-rent" strategy outlined in this article can be accessed by passive investors as well, but only if they know the right people. The key is to find trustworthy operators with a demonstrated track record, and to be able to structure a mutually favorable program to deliver cash flow and a portion of any equity created to the investors. And to insist that the operators have real "skin in the game" in the form of capital alongside the non-operator investors. The Best Of Times For Single Family Home Investors Who Can Execute

For those seeking to gain exposure to real estate intelligently, "small is beatiful." In other words, unglamorous investments like a portfolio of single family homes in a blue collar neighborhood trumps "trophy properties" like pricy Manhattan office buildings--if one is looking for current cash flow and solid risk-adjusted returns.

Several years from now, many investors will look back at the investments that are being made today by obscure but hard-working teams like the father and son team that bought the property pictured above, and they might ask themselves, "why didn't I put some money into that?"

The answer is, this is a truly contrarian strategy and it is non-scalable, so you won't hear about it from any mainstream firms who need to invest on a large scale.

The Case For Single Family Homes

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 22, 2011. To access his article on Seeking Alpha, please click here.

I recently spoke to another Seeking Alpha contributor who expressed concern that home prices could drop significantly from their current levels. This article explains why that is very unlikely to happen.

Case Study: Phoenix I am a real estate receiver for a shopping center in northwest Phoenix. When visiting the property recently, I drove around the neighborhood surrounding shopping center, which featured 1970s-built ranch houses that would be familiar to many people who grew up in the western U.S. I was struck by two things: (1) many of the recent sales in the neighborhood were well under $100,000. Some were as low as $50,000; and (2) the other shopping centers nearby were not filled only with 99 Cent Only stores and check cashing shops. In fact, the closest grocery stores were upscale, with hardwood floors and expensive lighting in the produce area, as well as other upgrades.

Replacement Cost and Why It Matters The cost to build a new home similar to the ones I saw in Phoenix is at least $130,000. This includes land development costs such as streets, curbs, gutters and utilities, as well as city and county impact fees, plus hard constructions costs. I am assuming that the land is free -- with land costs of just $20,000 per lot the total cost is likely in excess of $150,000.

Now let's look at the historical population growth rate of Phoenix. Below is a chart, courtesy of Arizona State University's Water Simulation project.

If Phoenix is going to continue grow, even at half the projected growth rate, then home builders will eventually need to start building homes there again. However, the only place with vacant land to build homes is on the outskirts of the city, far from jobs, which tend to be closer to the core.

Granted, some people may prefer to live in a new home for $160,000 in the distant suburbs (this is about the lowest price at which homes can be built and sold profitably). However, others will prefer a 1970s house for $125,000 -- in a neighborhood with upscale grocery stores and a much shorter commute to work.

The bottom line is, home values in places like Phoenix are much more likely to go up in the coming years than to go down. In all likelihood, we are looking at a bottom right now. Values reflect the supply-demand imbalance brought about by the foreclosure crisis. But replacement value is a more fundamental driver of stabilized value. And replacement value dictates homes such as these are undervalued currently.

One More Data Point: Price History Past value is certainly no indication of future value in real estate. Still the table below showing the history of sales of a home in northwest Phoenix, which I chose more or less at random from website trulia.com, is remarkable. This home fell by 77% in six years. It recently sold for half of what it was worth 17 years ago, in 1994.

Note: this article does not purport to say anything about the near-term direction of the stock prices of home builders such as KBR or Beazer Homes. It only argues that at some point, their services will be needed once again and before that can happen, values of existing homes need to move up significantly.

Equity Residential's Implied Cap Rate, And Why It Matters

Jan Brzeski is a contributor to Seeking Alpha. The article below is a copy of what he posted on August 22, 2011. To access his article on Seeking Alpha, please click here.

I am a full-time investor and fund manager focused on non-traded real estate investments. Right now I am focused on investing in real estate loans with a nice margin of safety, but that fall outside of bank lending criteria and therefore offer much higher yield than one would expect.

Every now and then, I take a look at traded real estate assets, and frequently the results amaze me. Today, we'll look at Equity Residential (EQR). All analysis in this article is based on the latest quarterly report on the company's website. To see the source document, click here.

Before we go into the details, I'll tell you the bottom line: public market investors pay a huge premium for the liquidity that they enjoy. To my mind, they are paying far too much, especially if the goal is to have steady income and there is no compelling reason for the investor to be able to liquidate an investment from one week or month to the next.

How Much Cash Flow Do EQR's Apartments Produce? In this article, we are not going to analyze EQR the way Wall Street analysts do. Instead, we are going to analyze it the way experienced real estate investors do. And we are not going to be extremely precise about the numbers. A rough estimate will give us a good view of what is happening.

In the latest quarter, operating income was about $146 million. But that is after deducting $159 million of depreciation, which is not a cash expense. If we add back the depreciation, we see the approximate cash produced by the portfolio of apartments owned by EQR, before debt service, is $305 million. Annualizing that number, we have about $1.2 billion of cash flow from operations (roughly the equivalent of "net operating income" to put it in real estate terms).

What Does it Cost to Buy EQR? EQR's balance sheet shows about $10 billion of debt. According to Yahoo Finance, the market capitalization is another $17 billion (rounding). There is a bit of preferred equity, but it seems to be small enough to ignore for our big picture analysis. So the approximate enterprise value of EQR is $27 billion.

The Implied Capitalization Rate Now let's look at the implied capitalization rate of EQR. That is the net operating income of its portfolio of apartments, divided by the price we need to pay to own that portfolio. The answer is, $1.2 billion/$27 billion, or about 4.4%.

Does that represent a good cap rate or a bad cap rate? It depends on one's perspective, but a seasoned real estate investor would tell you that, given EQR's portfolio, which includes plenty of units outside of the coastal land-constrained markets, a 4.4% cap rate is mighty low.

In other words, those who limit themselves to investing in real estate via today's public markets may be overpaying by a wide margin, relative to what's available to those who are willing to cut out the middlemen on Wall Street and in REIT corporate offices.

I am not advocating buying any old apartment building... only pointing out that yield hungry investors in the public markets should take a look at the underlying numbers once in a while and compare what they can get on Wall Street with what is available on Main Street.

As I will outline in future articles, the best risk-adjusted returns for investors seeking yield from real estate today are not in the REIT universe, and they are not even in the universe of acquiring individual real estate assets (except for a small number of very special situations). Instead, the best risk-adjusted returns can be had from making short-term real estate loans. Currently, banks refuse to make loans on certain types of real estate transactions, allowing private lenders to earn higher returns than would normally be possible.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Jan Brzeski's Article Appears on Seeking Alpha

Jan Brzeski's first contribution to the Seeking Alpha investment research community has been published. In the article, Jan argues that public REIT shares such as those of Equity Residential are trading at a premium to the value of their underlying real estate. He explains that investors seeking yield from real estate and related assets can find better risk-adjusted returns outside of the public markets. To access the article, click here: http://seekingalpha.com/article/289077-equity-residential-s-implied-cap-rate-and-why-it-matters