A Lousy Real Estate Investment

Will some people never learn?  Everyone should recall the collapse of the mortgage-backed securities market, as real estate prices plunged just a few short years ago.  Belatedly, investors found out that declining home values mixed with homeowners who could never truly afford to buy a house made for lousy investments.  The investors were left holding the bag while Wall Street executives reaped the rewards from making questionable transactions and acting in ways that most of us would consider unethical.  Even the rating agencies made money as they labeled horrible deals as grade A.

Now comes part two of bad real estate investments — this time with a certain type of REIT.  The players are different and the situation twisted slightly, but the ramifications for investors are nearly identical.falling homes in a row

Single-family rental REIT’s are companies that own and manage real estate.  A REIT is a real estate investment trust that is legally required to earn most of its money from real estate and must distribute 90% of the taxable earnings as dividends.  These particular REIT’s did not even exist a year ago.  A number of large companies, some with little real estate experience, started buying foreclosed houses at bargain prices during the downturn.  Many of them bought thousands of these homes, and now they have to figure what to do with them.

On the one hand, they cannot sell large volumes of properties without lowering overall values and thus hurting their own bottom lines. On the other hand, they don’t want to rent out the houses for long periods of time because of their limited experience in this area and the potential for capital losses at some point in the future.  So, they choose the road of other financial kingpins at the big banks — keeping the rewards for themselves and dumping huge risks on unsuspecting investors.  The mom-and-pop investors presumably buy in because of the high yields and the assumption that the collateral is prime real estate.

Silver Bay Realty was the first single-family rental REIT to go public in December 2012, followed a few months later by American Homes 4 Rent and American Residential Properties (note: some REIT’s are actually good investments — just not this particular type).  Investors might jump in for a couple of reasons.  First, because they want to get on the real estate bandwagon of ever-increasing home prices.  Second, they believe that there will be more renters and less owner-occupied houses due to difficult economic conditions, tight lending, and the expectation that younger adults will want to stay mobile.  That first assumption is almost certainly not valid, as real estate prices seem to be peaking and are being artificially sustained by Fed actions.  The second assumption is likely true, but is overruled by the reasons below.  Some of the reasons not to invest here are:

1. First and foremost is the logistical nightmare involved with managing thousands of unique homes in different cities and states.  The structure to manage leasing to quality tenants, general upkeep and maintenance, cleaning, etc. across various geographies is expensive and complex.  This is not like managing large apartment complexes, and using local property managers would severely dent any profits.  The Wall Street Journal reported earlier this year that American Homes 4 Rent had a 42% vacancy rate.  Each house needs to be clean, with well-functioning plumbing, electrical, appliances, etc.

2. Given the overhead of the items mentioned above plus high salaries for owners and for staffing legal teams, any leftover profit is likely to be quite small.

3. With real estate prices peaking and bargain houses hard to find, the longer term model for this type of REIT is not sustainable.

4. An investor in this type of REIT owns small pieces of lots of properties rather than being able to point to a specific property as collateral.  In my own industry of mortgage note buying, we know the amount of equity, credit information on the payer, and loads of other data before we commit to buying a real estate note.  A REIT investor knows none of that information and must trust that others have done proper due diligence.
So, if you want to chase high yields on what is probably a losing proposition, then single-family rental REIT’s might be for you.  If not, keep your cash handy for investments that have a decent chance of providing a good rate of return on your money.


Written by Alan Noblitt

Alan Noblitt is the President of Seascape Capital, LLC, and works as both a real estate note buyer and a business note broker. Alan has an MBA from Arizona State University, a B.S. from the University of Wyoming, and is licensed as a California Real Estate Note Buyer.

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