While the 2008 financial crisis prompted a cyclical shift in U.S. housing — impacting everything from home prices to who can qualify for a mortgage — an equally impactful demographic change was just taking shape. The unprecedented wave of Baby Boomers that began retiring would disrupt the balance of the housing market.
Valuations, Rents Rise as Urban Flight Combines With Tight Housing Supply
- Single-family rental (SFR) cap rates ticked down to 5.9%
- SFR return premiums narrowed to 5.0% above U.S. Treasurys, 0.9% above multifamily
- Purpose-built SFR units accounted for 4.5% of single-family construction starts
State of the Market
As measured by the U.S. Census Bureau, occupancy rates across all single-family rentals averaged 95.1% in the fourth quarter of 2020, ticking down by 20 basis points (bps) from the previous quarter (Chart 1). The latest estimate keeps occupancy levels near generational highs last seen in 1994. From 2007’s lows, occupancy rates for all SFR properties are up by 5.4%. The occupancy rate for single-family, owner-occupied units sat at 99.1% at the end of the fourth quarter, holding steady from the previous quarter. Together, these trends reflect a market where demand for single-family housing is outstripping supply.
According to DBRS Morningstar, annualized rent growth on vacant-to-occupied (V2O) properties rose by 50 bps to 7.5% in October 2020, the latest month of data availability (Chart 2). The October reading is the second highest for V2O properties since tracking began in 2015, and it comes just two months after reaching its all-time high of 7.8% in August.
Rent growth in vacant-to-occupied properties climbed steadily throughout 2020, despite pandemic-related headwinds during the initial shutdown. V2O rent tends to have a high degree of seasonality, reaching a bottom in the late fall and peaking in the spring. When pandemic-induced shutdowns began in the U.S. in March, the normal cycle of seasonal rent growth acceleration was interrupted. However, as time would prove, momentum was not thwarted but merely delayed. Since June, annualized rent growth has sat at 6% or higher, a level unseen since the spring of 2016. A tenant shift out of dense urban cities and a historically tight housing market are causing a bottleneck of demand for new SFR product, pushing rents higher.
Year-over-year rent growth in lease renewals rose 62 bps in October to an annualized 4.1%, on par with its pre-pandemic mark in March. Rent growth on lease renewals, which tends to see far less seasonal variability, fell dramatically between April and June, dropping as low as 1.4% — a symptom of landlords prioritizing renter retention during the worst days of the recession. Since then, rents have risen considerably but remain below the 4.5% average growth rate between the start of 2019 and when the recession took hold in March 2020.
Cap Rates & Prices
Property-level yields for SFR assets continue to fall. In fourth-quarter 2020, SFR cap rates ticked down to 5.9% — their lowest level on record. Measured quarter over quarter, cap rates fell by a remarkable 61 bps (Chart 3). Moreover, since second-quarter 2020, SFR cap rates are down 79 bps. Continued cap rate compression reflects asset price appreciation, low benchmark interest rates and growing operational efficiencies.
The yield spread between cap rates and the 10-year Treasury offers an estimate of the SFR risk premium (the amount of additional compensation needed to justify taking on the extra risk). In the fourth quarter, this spread fell by 82 bps to 5.0%, bringing it back near pre-pandemic levels (Chart 4).
Spreads between SFR and multifamily cap rates settled at 0.93% to end 2020, falling by 53 bps from the prior quarter and marking the most substantial single-period drop since late 2015. These data trends offer support to what most market watchers already know to be true: While there remains a yield premium for holding SFR assets as opposed to the same number of units in a multifamily property, the premium is falling fast.
The single-family rental sector’s institutionalization has meant that new purpose-built rentals are starting to contain differentiating characteristics from other single-family homes. However, the institutionally held slice of the SFR market is still dwarfed by individual investors, reflecting the sector’s infancy. As of the U.S. Census Bureau’s 2018 Rental Housing Finance Survey (released fall 2020), individual investors accounted for 72.5% of all SFR assets. The collection of LPs, LLCs and LLPs made up another 15.7%. Between real estate corporations and real estate investment trusts (REITs), the share of institutionally controlled SFR assets totaled just 2.3%. While the emerging trends may be for dedicated SFR communities and greater product heterogeneity, most SFR properties currently look just like any other single-family home.
Across the U.S. housing market generally, prices are accelerating. According to the S&P Case-Shiller National Home Price Index, valuations are up by 9.5% year over year through November 2020, more than doubling the growth rate of 3.7% reported one year ago (Chart 5). According to CoreLogic, housing prices are getting squeezed by extremely tight inventory levels. The share of housing units selling in less than 30 days on the market soared to 33.9% through October, toppling the previous peak of 21.4% reached in 2004.
Loan-to-value ratios (LTVs) on SFR mortgages fell by a weighty 5.4% in the fourth quarter of 2020, settling at 60.4% (Chart 6). LTVs tend to fall during a recession, reflecting more conservative underwriting. Here, the pandemic appears to be a double-edged sword. Not only is there evidence of fewer ultra-high LTV loans, but underlying asset values have accelerated during the pandemic — a unique feature of this particular downturn.
Debt yields ticked down by 26 bps between the third and fourth quarters, averaging 10.2% (Chart 7). Debt yields have consistently sat between 9.8% and 10.8% since the middle of 2015. The inverse of debt yields, debt encumbrance per dollar of NOI, rose by 25 cents in the fourth quarter to $9.81 (Chart 8). These trends suggest that appetites for credit risk remain healthy despite the pandemic.
Supply & Demand Conditions
Residential Default Rates
During the housing crisis, investors with available financing took advantage of the market dislocation, acquiring large portfolios of single-family assets at steep discounts. Mortgage default rates soared over 8%, and an abundance of buyers began seeding the SFR sector as we know it today (Chart 9).
Default rates rose by 39 bps in the third quarter of 2020, landing at 2.5% — the largest quarter-over-quarter jump since first-quarter 2010. Moreover, default rates are up 67 bps year over year. While the trajectory is concerning, current default rates do not constitute distress in absolute terms. The inflection brings default rates just below levels last seen in early 2018. A categorical difference between this crisis and the Great Recession is today’s housing market has an oversupply of potential buyers, and prices continue to rise. At-risk homeowners have better options this time around, namely the ability to sell into a seller’s market and greater access to refinance capital. While an increase in housing market defaults remains possible, if not likely, the current market’s economics should limit the frequency and severity of distress.
Build-to-rent continues to become a significant feature of the SFR sector. A lack of tailored supply has led to unique and diverse strategies to add inventory. Some operators add new units piecemeal, constructing a singular unit on each parcel of land, while others opt for large-scale community developments. The nonuniformity is leading to product differences along the lines of price, size and amenitization. As a result, renters drawn to the asset class have a more robust set of options to optimize their housing decision.
Based on an analysis of U.S. Census Bureau data, between 1975 and the start of the prior recession in 2007, SFRs accounted for less than 2% of all single-family construction (Chart 10). The SFR share of single-family starts has since climbed. In 2013, the SFR construction share approached 6%, and today it remains elevated at 4.5%. SFR construction starts totaled 42,000 units through the 12 months ending in third-quarter 2020, up by 3,000 units from the previous quarter and only down 3,000 units from its all-time high (Chart 11).
Tracking Future Demand
Utilizing Google Trends, the popularity of the search term “homes for rent” is leveraged as a proxy for existing and future hotspots of SFR demand. Metropolitan areas in the Southeast dominated the list throughout much of 2020, including in the fourth quarter. For the second consecutive quarter, Memphis, Tennessee charted the highest frequency of the search term (Table 1). The metro consistently ranked near the top of the list in 2020, never falling below seventh.
A ranking produced by Mynd Management, an Oakland, California-based SFR property manager, ranked Memphis as the second best market for sellers in 2021 based on appreciation trends from the past two years. Like several other smaller, less-dense cities, Memphis has benefited from growing demand for properties outside of the nation’s more expensive metros — a pre-existing trend that has accelerated during the pandemic. Moving past Memphis, metro areas in Georgia continue to dominate the top 10. Macon and Savannah come in at second and fourth, respectively, in the rankings. Thomasville and Atlanta also arrive in the top 10, as they did in the third quarter.
To track which parts of the country might expect to see new demand in the coming months, we measure the popularity of the search term between the third and fourth quarters of 2020, noting where the biggest jumps occur. Leading the way is Meridian, Mississippi, which jumped 192 spots to land at number 13 on the list — the largest quarter-over-quarter jump of any metro in 2020 (Table 2).
Over the near term, the single-family rental sector remains well positioned to grow from secular and pandemic-created trends. While working from an office may become more common in the years ahead than it was in 2020, there is a growing sense that we are unlikely to go back to a pre-pandemic model. According to a PwC survey, only one in five executives believes having their entire team in an office five days a week is optimal. If greater workplace flexibility becomes a lasting trend post-pandemic, it will also translate into greater housing choice flexibility, likely boosting demand for exurban options.
Moreover, the ‘mom and pop’ dominance of the SFR sector leaves significant room for product improvement and managerial efficiencies. For 2021, the pandemic’s continued strain on household finances combined with rising lumber prices, a critical construction input for single-family homes, are moderating factors to keep an eye on. The balance of risks, however, are heavily outweighed by supporting fundamentals and demographic tailwinds. All else equal, SFR is in a good position to continue its bull run through the year ahead.