Some people will never learn. All of us should remember the crash in the mortgage-backed securities markets, when real estate prices plummeted just a few years ago. Investors discovered that falling home values combined with homeowners who couldn’t afford to purchase a house made them poor investments. Wall Street executives reap the rewards of questionable transactions and acting in ways most people would not consider ethical, leaving the investors holding the bag. Rating agencies also made money when they rated terrible deals as grade A.
This is part 2 of bad real-estate investments, this time with a particular type of REIT. Although the players and circumstances are slightly different, the implications for investors are almost identical.
REITs that manage single-family rentals are companies that own and maintain real estate. A REIT is an real-estate investment trust. It is legally required that it earn the majority of its money through real estate, and must distribute 90% as dividends. These REITs were not even in existence a year ago. During the downturn, a number of large corporations, many with no real estate experience, began buying foreclosures at low prices. They now have to decide what to do with the thousands of homes they bought.
They cannot sell large numbers of properties without decreasing overall value and thus affecting their bottom line. They don’t want the houses to be rented out for extended periods of time due to their lack of experience and the possibility of capital losses in the future. They choose to follow the path of financial kingpins at big banks, dumping large risks on investors and keeping the benefits for themselves. Mom-and-pop investors are likely to buy in due to the high yields and assumption that collateral is prime real property.
Silver Bay Realty was the first single family rental REIT to go public. It was followed by American Homes 4 Rent (note: not all REITs are good investments). There are two reasons why investors might want to invest in Silver Bay Realty. They want to join the ever-increasing real estate market and take advantage of rising home prices. They believe there will be more renters than owners, due to the difficult economic environment, tight lending and the expectation that younger people will want to remain mobile. The first assumption is unlikely to hold true as real estate prices are at an all-time high and are artificially supported by Fed actions. Although the second assumption is probable true, it is outweighed by the reasons below. These are some of the reasons to not invest in this area:
1. The logistical nightmare of managing thousands of homes in different states and cities is first and foremost. It is necessary to have a structure in place to ensure quality tenants are leased, as well as general maintenance and cleaning. It is difficult and expensive to manage multiple geographies. This isn’t like managing large apartment buildings. Using local property managers could severely reduce any profits. The Wall Street Journal reported that American Homes 4 Rent had a 42% rate of vacancy earlier in the year. Each house must be kept clean and have functioning plumbing, electrical, and appliances.
2. Any residual profit will likely be very small due to the overheads of the above items and the high salaries paid by owners and staffing legal teams.
3. The longer-term model for this type REIT is no longer sustainable due to rising real estate prices and hard-to-find bargain houses.
4. This type of REIT allows investors to own small parts of many properties, rather than being able point to one property as collateral. My industry, mortgage note buying, knows the equity and credit information of the payer before we buy a real estate note. An REIT investor doesn’t know any of this information, and must trust others to have done their due diligence.
Single-family rental REITs may be a good option if you are looking for high yields on a potentially losing investment. Keep your cash on hand for investments that offer a decent rate of return.