The Tortoise Is Still Winning

While I’m sure you have at one point or another become familiar with the fable distinguishing the relative virtues of reptiles and leporidae, it is all too frequently used as an excuse for a lack of progress as opposed to how the meaning of the fable was intended for interpretation. Striving to “be the tortoise” means applying tactics that will lead towards steady, sustainable growth/progress, not “doing nothing at all”, which is an important distinction for the types of people that seem to mix metaphors in conversation. I wanted to go over in detail how our entities (including our current fund) have gone about our particular brand of reptilian imitation, but first, I have to throw in a bit of an addendum to the Silver Bay update that I gave last week.

I mistakenly indicated that SBY was the only one of the three publicly traded SFR REITs to have significant holdings in Columbus, OH. It turns out that not only was I wrong, but I was wrong by a lot. Within a day of my post, the 8-K for American Homes 4 Rent (AMH) was filed, and included detailed breakdowns on MSAs that were unavailable in the previous quarter, as they had been lumped into a single category of “all other”. As it happens, AMH has actually acquired 640 homes in Columbus, which is more than double the holdings of SBY (and more than 6 times as many as us!), and is leasing them out at a better (albeit still atrocious) rate, with 322 leased homes, which is good for 50.3% occupancy (as compared to 35% for SBY). They have also focused on a higher price point (which may or may not indicate better quality inventory, but probably does), as they have a book value of $140K per property, which would put their capital deployment at $89 MM in Columbus if they are defining book value the same way that SBY defines aggregated cost. Of course, they didn’t publish any data on their average lease amounts, which means I can’t reverse engineer their NOI, but if we use the average of the GSI in their 32 markets that comprise the “all other” category, we are talking about the average property renting for $1384/month. Assuming all of the other things that we assume for our own underwriting (and for my theoretical SBY comparisons), that would put them at a 6.13% cap rate if all properties were leased, or a 3.08% cap rate in their current state. They would also be generating roughly $5.35MM in GSI, which would be good for a 16.63 GRM. Which would make them slightly better than SBY in the Columbus market, and only slightly, and perhaps only because they didn’t publish their actual rent numbers for Columbus.

So what the hell? Why are we doing so much better than these publicly traded companies?

I think it has to do a lot with our reptilian approach.

From the very beginning, the mantra (if investment theories s have mantras) of our model has been that yield is priority number one, and home price appreciation is a distant second. That requires us to underwrite properties that will allow us to hit the desired metrics in a vacuum, regardless of whether home price appreciation actually occurs. Conversely, and because we aren’t currently leveraged, if home values move in the opposite direction (and because we aren’t buying near either coast or flood zones), we aren’t stuck with a bunch of houses that are underwater if Murphy’s Law decides to apply itself to the housing market (or to complete the joke… nature). My point in all of this is that we are doing some really, really not at all sexy, boring, but at the same time sound, real estate investing.

Enough with the general terms and stretched metaphors though… how about some real data?

The first deal we did in Columbus was for 41 houses. We probably overpaid (by our standards, but certainly not by market standards), but I guess that’s a function of being new to a market and having an excessive amount of capital to deploy in a short period of time. I bring up those two points because they are precisely the two problems that face SBY, AMH and ARPI, yet it took all of those companies several years of operations and post IPO accountability to start making any changes. By comparison, we took a look at just this very first deal at its completion, and while we still view it as a landmark, successful deal, there were a lot of ways that we could improve.

First, there were a number of properties in a geographic area that we have since begun to target that we are willing to pay a premium for. When I say premium though, I don’t mean that we are willing to pay the sort of premiums that the REITs will pay, but a premium for us. Meaning, the aggregated cost at which we are willing to purchase a property will approach a minimum 12-cap in these areas, which is the lowest acceptable minimum cap of any geographical areas in the MSA. That allows us to ramp up acquisitions in this area and acquire inventory more rapidly, because we can still meet our yield goals while being able to ride the wave of public/private partnership that is almost certainly going to result in an improvement in this area, which may in turn result in our goal of home price appreciation.

A side effect of determining the acceptable minimum cap rate for a specific geographic area is that it forces you to think about what your acceptable minimum cap rates would be in all geographic areas. And think we did. Some areas have a min-15%, some are 18%, some are 20% and some don’t have an acceptable minimum cap rate because they are so likely to sustain higher than acceptable levels of vacancy and turnover that they would be materially unreliable for the purposes of projecting a cap rate, and thus affect the salability of the portfolio down the road. Just the process of figuring out what areas are “worth” is in and of itself a good process, and has been instrumental in our success thus far.

Another component of maintaining low vacancy numbers, an incredibly important part of being successful from a yield perspective, is not starting out with vacancy. I know that seems like an incredibly simple concept, but for some reason, it isn’t part of the model for any of the REITs. They continue to purchase vacant homes, rehab them, and lease them over a period that is built into their underwriting for six months, and often takes longer. That simply doesn’t make any sense. Our approach differs significantly. An incredibly large percentage of our inventory (I didn’t calculate it since the real numbers are insignificantly small, but its upward of 90%) has been purchased with existing leases, and rental pro-rations and security deposits are paid through escrow. This allows us to be yielding our expected rate of return on day one of the investment, as opposed to some TBD future date. It also allows for more yield certainty, since the rental numbers are by definition accurate, not an estimate based on a property manager attempting to earn new business.

As of right now, this has resulted in 83 of 87 properties leased across all entities, which is good for 95.4% occupancy. Additionally, the newly created Patriarch Real Estate Fund has 8 out of 8 properties leased, so while that is admittedly an incredibly small sample size, it is also as perfect as we could possibly be. This kind of reptilian derived efficiency allows us to provide strong results, such as a GSI of $666,120 across all entities over an aggregated cost of $2.7MM, good for a GRM of 4.06. The fund is even better, with a GSI of $65,796 over an aggregated cost of $241,583, good for a GRM of 3.67. Our internal metrics are very conservative with regard to expenses (especially vacancy, considering our low actual vacancy numbers), but even with our overly conservative projections we are still hitting a 12.31% cap rate across all entities, and a 13.62% cap in the fund.

I’m very pleased to be able to report this successful of performance, and will take great pride in maintaining the process that has allowed us to achieve the results.