Tuesday, April 02, 2013

The Crowded Trade: Buy-to-Rent Housing

Demographically, it appears there is a generational glut of single-family suburban homes on the horizon.

A trade is officially deemed "crowded" when everyone is rushing into the market with eyes only on the upside and little concern for the downside--for example, buying homes as rentals. Here's a typical headline:

Any market that gets crowded quickly experiences a corresponding rise in price and risk. Rational minds then start looking at the potential downside--for example:

Why could the buy-to-rent housing party be running out of air? The basic reason is the difference between buying real estate as rental housing, which is a speculative market, and the rental property market itself, which is grounded in real-world supply and demand.

Simply put, if the supply of rental housing exceeds demand, rents (the cost of renting shelter) decline. That jeopardizes the fat returns the speculative buyer was counting on: Is There a Rental Supply Glut? (The Big Picture)
A key piece of the story is being left out of all the sell side research and financial press “housing recovery” stories. In the case of Phoenix — and most likely most other heavily distressed regions turned ‘investor havens’ throughout the nation — it looks like the missing piece of the story is the lackluster demand for the mega-supply and nowhere remotely close to the rental returns investors had hoped for unless you bought the right property in a relatively small window that slammed shut in early 2012.I have also believed for a long time that the lack of foreclosures — and the mortgage modification/workout bubble — would ultimately be a killer for those hoping to rent houses to distressed borrowers. Of course, that’s because the banks and gov’t let all these potential borrowers rent their own houses from them at 2% interest only for 5 years. And this is exactly how it’s playing out.
This is only one dynamic of many in the buy-to-rent stampede. Let's quickly review the other main dynamics.

1. Housing is clearly experiencing an echo bubble. No wonder, given the Federal agency and Federal Reserve subsidies: 3% down payments, super-low interest rates and a dearth of other investment opportunities:

2. The Federal Housing agencies are openly transferring ownership of what are quasi-public assets (defaulted private homes owned by Fannie Mae) to the usual financier predators and parasites: private equity funds, hedge funds, investment funds organized by investment banks, etc.

Structured Sales Transactions (i.e. the bundling and transfer of Fannie Mae owned properties to private capital)

In their desperate search for higher yields, these concentrations of private capital are buying thousands of houses and placing them in sprawling portfolios of rentals:

3. The demand for rentals ultimately depends on jobs, income and demographics.Demand for rental housing depends on household formation rates: people moving out of their parents' homes or the dorms creates demand for rentals. But they need jobs that pay enough to support the often-hefty rent for an apartment or house.

I have reprinted this chart from Doug Short many times because the foundation of the real-world economy is real wages, and an 8% decline in real wages does not reflect an economy with strong household formation:

As a percentage of the workforce, the number of fulltime employees is at multi-decade lows. Yes, it's possible for three or four part-time workers to rent a house together, but how much demand does this doubling-up create?

4. The basic premise of buy-to-rent--that people who lost their homes in foreclosure will need to rent a house--may be overstated. The number of homes in foreclosure--currently 1.5 million, according to RealtyTrac--may sound big, but compared to the entire U.S. housing market, it is marginal.

There are about 75 million owner-occupied homes, roughly 25 million owned free-and-clear (no mortgage); 130 million dwellings, of which around 111 million are occupied and 19 million are vacant. Of these, perhaps 4.5 million are second homes or vacation rentals. What We Know (and Don't Want to Know) About Housing (June 16, 2010)

How many households leave their foreclosed home and move into a converted garage, the family home, or an apartment? There are no reliable statistics (that I can locate), but if the Phoenix market described above is typical, the demand for rental homes may be more a figment of echo-bubble imagination than reality, at least in typical markets. (New York City and San Francisco are not typical.)

5. Demographics do not support robust household formation. Older folks are jettisoning the family home and moving into retirement communities, often in cities that offer amenities and nearby healthcare. If anything, it appears there is a generational glut of single-family suburban homes on the horizon: Housing and demographics (Acting Man blog).

6. A house is not a financial instrument: it is a real object in the real world, and it falls apart without constant maintenance and attention. The tenants are real, too, and they don't just spin off a 6% yield like a machine. They make demands for repairs, they get behind in the rent, they move out and create a vacancy, and so on. Real life has a very strong tendency to erode profit margins and net income in unexpected ways.

Crowded trades are often described as boats with everyone on one side. Boats loaded in this fashion tend to capsize once exposed to the slightest volatility (wave action). A crowded room is also a common analogy for a crowded trade: once the herd realizes the trade is no longer a guaranteed winner, the herd rushes for the exits, dumping their assets onto the market. This sudden rise in supply (inventory) causes prices to plummet.

The buy-to-rent boat is looking rather overloaded, and the bullish side's gunwales are only a few inches above the water.

A MARKET CLEARING EVENT: The Global End Game - Part II: CHS and Gordon T. Long discuss the cycle of deflation and the endgame of leverage, credit and phantom collateral:

Things are falling apart--that is obvious. But why are they falling apart? The reasons are complex and global. Our economy and society have structural problems that cannot be solved by adding debt to debt. We are becoming poorer, not just from financial over-reach, but from fundamental forces that are not easy to identify or understand. We will cover the five core reasons why things are falling apart:

go to print edition1. Debt and financialization
2. Crony capitalism and the elimination of accountability
3. Diminishing returns
4. Centralization
5. Technological, financial and demographic changes in our economy

Complex systems weakened by diminishing returns collapse under their own weight and are replaced by systems that are simpler, faster and affordable. If we cling to the old ways, our system will disintegrate. If we want sustainable prosperity rather than collapse, we must embrace a new model that is Decentralized, Adaptive, Transparent and Accountable (DATA).

We are not powerless. Not accepting responsibility and being powerless are two sides of the same coin: once we accept responsibility, we become powerful.

Kindle edition: $9.95       print edition: $24 on Amazon.com
To receive a 20% discount on the print edition: $19.20 (retail $24), follow the link, open a Createspace account and enter discount code SJRGPLAB. (This is the only way I can offer a discount.)

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