Build-to-Rent: Fastest Growing Dynamic in Real Estate
There is a rapidly growing segment in the homebuilding industry known as Build-to-Rent (BTR), which is quietly adding billions to homebuilders’ bottom lines and over time will likely boost the earnings potential for those companies which choose to partake in the practice.
And while many of Wall Street’s big firms are landlords, they’re mostly keeping it to themselves. Indeed, from a contrarian standpoint their silence suggests that there is still plenty of money to be made from the practice since once the hype starts, you’re usually close to the top (remember AI).
All of which indicates that average investors still have ample opportunity to participate in this emerging trend.
The Big and Complex Picture
There are two components to housing supply; existing homes and newly built homes. Under normal circumstances there is adequate supply of both; not in the present.
Normally, there is some sort of balance between buyers and sellers based largely on housing supply and interest rates. The pandemic pushed the complexity of the system into overdrive, as large numbers of people moved away from cities increasing the demand for homes in areas where there was a shortage; suburbs, rural areas, and less densely populated states. This migration spawned a building boom in those areas which was boosted by record low interest rates and the Federal Reserve’s record QE liquidity injection into the economy.
The record low mortgage rates which accompanied the Fed’s QE during the pandemic and the early post pandemic period allowed those who could find and afford a home to buy during a period of record low mortgage rates. These homeowners are now locked into their circumstances by those low rates. They’re finding it difficult to justify moving due to the presently higher mortgage rates. This has worsened the supply of existing homes for sale – in effect removing a substantial source of the supply of homes from the market.
Moreover, there is little evidence that the movement out of cities into suburbs and specific regions of the U.S. has changed, even as the Federal Reserve has raised interest rates aggressively over the last year.
Build-to-Rent: The Next Step for Homebuilders.
The housing sector accounts for 16% of U.S. GDP, yet homebuilder stocks rarely get the same press as high tech, energy, banking, and other marquee’ sectors on Wall Street; unless something goes wrong. Yet, over the last several years, homebuilder stocks have quietly delivered well above average returns.
For example, Apple (NSDQ: AAPL) has gained more than 45% for the year, while homebuilder D.R. Horton (NYSE: DHI) has gained nearly 39% since January 1. That’s not an accident, especially in recent times. That’s because homebuilders are presently in the driver’s seat when it comes to supply and demand. Here’s why.
After the pandemic the burden of providing new housing supply has fallen on the homebuilders, who have yet to catch up to demand because higher interest rates have reduced the number of credit worthy buyers while home prices have been rising.
Yet, despite the ongoing and steady building activity, there still aren’t enough homes available for purchase. The net effect has been steady and even record earnings for homebuilders despite the presence of higher rates. The price chart for the U.S. Ten Year Note (TNX) above shows the long term trend of the benchmark rate for mortgages, has been rising for years but may be turning lower as the economy shows signs of slowing.
The price chart for the S&P 500 Homebuilder Subindustry Index (SPHB) over the last ten years shows the dramatic long term bull market in the homebuilder sector. Moreover, it displays the group’s resiliency as every major drawdown has turned into a buying opportunity. In fact, even during a period of higher interest rates the presence of low housing supply has kept homebuilders in a good position. More recently, as rates have turned down SPHB is again moving higher.
Now the system is adjusting as many buyers have been priced out of the market by higher rates and the demand for rental homes is rising. This is where it all comes together as I discuss below.
I have been a long term bull on the housing sector and have several homebuilder stocks as part of the PCA portfolio. Happily, they have delivered excellent returns over time.
I own shares in homebuilder D.R. Horton in my private investment account. And over the last two quarters, while digging deep into the earnings press releases and through the follow up earnings calls transcripts, I’ve noticed that the fastest growing sector of the builder’s earnings is what the company calls its rental operations.
Most recently, DHI delivered another excellent quarter, especially given the challenging climate hatched by higher mortgage rates. But aside from the usual revenues and earnings numbers, here’s what caught my eye.
The numbers for the rental division were extraordinary and illustrate an underappreciated portion of potential growth in future earnings for homebuilders who enter this new and rapidly expanding segment of the industry. Here are DHI’s 2023 Q4 results for the rental segment with year over year (YOY) comparisons:
- $1.4 billion in revenues comparted to a loss of $21 million;
- $217 million in pre-tax earnings compared to a loss of $13.1 million;
- 3006 single family rental homes sold vs. 96; and
- 1582 multifamily rental units sold vs. none in the prior year.
I was so surprised by the magnitude of the growth that I contacted the company for clarification. And here’s what I received as a response. According to Jessica Hansen, Senior VP for Communications at DHI: “we are building out entire build for rent communities with no known buyer upfront, leasing them up and then marketing them for sale to investors generally after they are at or approaching lease-up stabilization.”
In other words, homebuilders are responding to the changing times by diversifying their traditional business model of building homes to order, by also building homes specifically for rental purposes, filling them with tenants, and then selling them to investors once the communities reach critical mass.
In addition, as Horton’s earnings release shows, there are two regions of the U.S. which have the largest demand: the Southeast and South Central. According to Ms. Hansen, these two regions, especially “Texas and Florida have been two of the strongest states in the U.S. for housing and are the largest component of our South Central and Southeast regions, respectively.”
These regions show no sign of slowing.
Where to Put Your Money
You can certainly consider investing directly in shares of homebuilder stocks or by owning the entire sector via the SPDR S&P 500 ETF (XHB), which I frequently mention here.
As the price chart clearly shows, this ETF captures the general price trend of the housing sector. Before investing, however, you should be aware that this ETF also invests in companies which provide building materials and ancillary services to the homebuilders. Sometimes the shares of these ancillary companies will trend differently than those of the homebuilders due to earnings or other external factors.
For a more direct investment in BTR consider companies such as American Homes 4 Rent (NYSE: AMH), which specialize in buying, refurbishing, maintaining, and renting single family homes. The stock’s price pattern has an uncanny resemblance to that of XHB, which suggests investors are flocking to companies which specialize in single family homes, both as rentals as well as in the more traditional homebuilding sector.
AMH is currently under modest accumulation as the Accumulation/Distribution (ADI) line has turned up while the On Balance Volume (OBV) indicator has confirmed. This means that short sellers (ADI) are covering their positions while buyers (OBV) are overtaking the sellers. A move above $36.50 would likely signal that prices are moving higher.
Much of what happens next with AMH will have to do with what the Fed does with interest rates, how the bond market trades in the next few weeks, and how mortgage rates respond.
The supply and demand balance for housing remains in favor of homebuilders who are diversifying their business model to accommodate the rising demand for single family home rentals.
The new dynamic of Build-to-Rent is growing rapidly and offers homebuilders a new way to grow earnings and revenues.
Given the ongoing population dynamics, the long term trend for homebuilders and for select companies in the single family rental business isn’t likely to change anytime soon.
Wall Street’s relative silence on the subject of BTR is quite bullish as it signals that the big guys are still making money and don’t see the need to take profits by selling to the public.
Editor’s Note: For market-thumping gains with mitigated risk, I suggest you consider the advice of our colleague Jim Pearce, chief investment strategist of Personal Finance.
Personal Finance, founded in 1974, is our flagship publication and it has helped investors build wealth for nearly 50 years.
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