?Thinking of an investment in a hedge fund?

Question

Now that the hedge fund managers are ready to cash out on their SFR rampage, I wanted to take a look at some of their numbers. Is it a deal or no deal? Here is a quick, back of the envelope analysis, based on the amended SEC Form S-11 that AH4R filed on Friday.

So, are they even close to the 2% rule? To find out, look at their rent revenue per month to purchase price ratio. To keep the number as accurate as possible, I adjust some of the numbers to exclude property acquired but not yet in service. They have contributed $3.53B to property(note 1). Roughly 2/3 (68%) of their property is leased. In the last quarter, they recognized $48.7M in rent revenue.(note 2) Just using these numbers, I get an adjusted ratio of 0.68%.(note 3) Remeber, this is a quick, back of the envelope calculation. It is very possible their true rent revenues will be larger because of timing of lease signings, etc., in the quarter. But 0.68% is not impressive. Imagine buying a $100,000 property and getting $680 in rent. Not compelling. But wait, that isn't fair. Their average investment per property is $165,985, for a 1,969 sq.ft., 11 year old house.(note 4)

To be fair, this investment isn't meant to be just about rental income. They say "Our objective is to generate attractive, risk-adjusted returns for our shareholders through dividends and capital appreciation." The dividend rate is 5% for these higher priced ($25) preferred shares. So in my book, this is mostly about speculating on appreciation. A quick check of another REIT investment I know of (NYSE: HIW) shows a roughly 5% yield on common stock and shares at 2.2X book.

Bottom line: Their August IPO at $16/share and this offering at $25/share, along with their "fair value" approximation of Class A shares (note 5), make their market cap way too high for their current performance and asset value. For me, this is an opportunity not worth pursuing.

(1) Consolidated Balance Sheet Data, Pg. 76
(2) Property operations, Pg. 81
(3) ((48.7M *4)/12) / (3.53B * 0.68)
(4) Our properties table, Pg. 93
(5) Trustee Compensation, Pg. 114 (Class A: $15.76 to $17.23)

http://www.sec.gov/Archives/edgar/data/1562401/000119312513479861/d633362ds11a.htm

Giovanni Isaksen · Answer

Nice analysis @Chris Martin

Tom Barrack over at Colony Capital has a quick breakdown of the institutional opportunities and challenges (starting about 6:00) in this Bloomberg interview:

http://www.bloomberg.com/video/barrack-no-interest-in-weinstein-miramax-merger-oxQdjzvpQ9iobci~ByM9IA.html

Tom talking about Blackstone's resi lending platform: http://video.cnbc.com/gallery/?video=3000228443

and more from Tom: http://video.cnbc.com/gallery/?video=3000214952

Granted he's talking his own book (and he pulled their own REIT IPO during the taper tantrum) but his is the 30,000 ft. institutional view. Just like back in the late eighties and early nineties when apartment REITs first came and nobody really understood how they would completely change that market, the single family rental market will be changed: Small investors (The Mom & Pops in institutional lingo) will have to raise their game to compete, especially since as @Mike H. points out the institutions are working with equity capital instead of debt so their cost of funds is at least theoretically lower.

Mike H. · Answer

The 2% rules only applies to people like us who actually need to make a decent profit on these things. And, even then, the 2% rule actually only applies to the low end homes. When you start getting into the 90 to 120k price points and above, you are going to be incredibly hard pressed to even touch the 2% rule.

As for the funds. The one thing I think is missing is that their business model is completely different from ours. They don't use leverage even though they are technically using 100% of OPM.

But their model, it seems to me anyway, is to grow their portfolios large enough so they can issue securities against them and basically cash themselves out with a big pay day. And then the investors are the ones stuck with the returns on their rents and appreciation.

I think you're going to see some of these funds actually do quite well provided they've got good systems in place and are buying right. And I think you'll see some of the investors for these funds take an absolute bath on their investment.

The numbers, given their publicized occupancy rates just don't make sense to me at all. I don't see any way they can be making any decent profits with occupancy rates of 60 to 70%.

I've got 23 houses right now. At 65% occupancy, I'd be losing money and I self manage my stuff. These funds have a ton of built in overhead - from acquisition teams to property management.

I realize they may be getting some decent pricing on rehab and materials because of their scale. But sometimes I think these funds are paying more than retail on their contractors just because they need to use the big guys in order to handle the volume.

And why did this crazy editor just tab in here and change my formatting? Sorry for the interjection there but I don't know why its indented now. Oh well.

Again, I just look at their occupancy numbers and their overhead and I don't believe they're really making much money at all in returns. Their whole model is to issue the securities to cash themselves out and then leave the investor holding the bag.

Theirs a sucker born every minute though and since these funds are so big with all the backing, they'll find a way to sell their debt instruments or whatever it is they're issuing. But any investors that buys their koolaid on this deal, deserves to lose their money..... Run the numbers. I don't believe they add up - at least not for all the funds anyway.....

Chris Martin · Answer

@Giovanni Isaksen I looked at those video clips. Thanks for posting the links. My overall comments are at the end.

Tom Barrack made the comment in the first link you provided (at 7:20 or so): "...the name of the game is we are going to turn this into an asset class just like Multi-Family (MF) ... (at ~7:40) "we will over the next 2 to 3 years prove up the fact that income off of these houses is exactly analogous to the muli-family business." At about 7:30 he makes the observation that SFR REITs are trading about book and apartment REITS about 2.5X book.

Regarding his comment about SFR REIT income analogous to MF? I don't see it. It is just not in the numbers. See numbers in my above posts. In addition to getting way better value in rent/invested capital, the MF REITs do a good job of expense control. It is a little early to tell how tenant turns impact expenses, but AH4R retention of 69% seems too low for the price points where they are playing. And I'm not convinced management of self storage units (that's the managmenet team's expertise) is comparable to managing SFR portfolios as large as AH4R. I'll give them the benefit of the doubt for the moment.

Until the SFR REIT can prove viability through operational performance or significant price appreciation, these stocks should trade at about book value. And in a REIT, I believe the asset value is based on basis, not theoretical appreciation numbers.

Overall: I think some Hedge Fund hanagers are trying to figure out how to make money at this game... how to make it work. The "plan A" IPO is a dud so far. (Yes, maybe it is too soon to call.) "Plan B" for some has changed to offering $500K+ financing (on 5+ properties) to "mom and pops"... the same type of players they were/are naively trying to bury a year ago. So these new lender/players are now going to compete with local commercial lenders? Sounds hokey. Are they clutching for straws? Looks like it.

IMO AH4R had the right idea with a SFR REIT. The probelm is it is a lot harder to achieve good profitability buying at $169K per door compared to MF REITs, so their premise of 2.5X book value is currently out of reach.

Their financing manuvers may save the day. Depreciation and amortization expense seems to be the elephant in the room today. That will impact REIT distributions. But I'm guessing they will 'pull a Fastow' (http://features.blogs.fortune.cnn.com/2013/07/01/the-confessions-of-andy-fastow/) and find some 'accounting' to meet the goal that SFR are exactly analogous to the MF business. Then all bets are off.

Chris Martin · Answer

@Mike H. Regarding "The numbers, given their publicized occupancy rates just don't make sense to me at all. I don't see any way they can be making any decent profits with occupancy rates of 60 to 70%." The occupancy numbers reflect their new acquisitions and "escrow" property that are under contract (or foreclosures not done with final accounting) but not owned, as well as not rent-ready property, rent-ready property not leased, or plain old 'between tenant' property. They still have a lot of properties in "escrow". This is why I only looked at "stabilized" and leased property.

I hear what you are saying regarding 2% rule applicability. But I look at it this way. Those apartment REITs out there, the "real REITs" in my mind, need to pay attention to profitability. They aren't saying 'we are buying cheap and we don't need to worry about making money because everything will go up.' I guess you can say the rules don't apply to AH4R, but do any rules apply to "real" REITs?

Apartment REITs need to be profitable. So what does a "real REIT" property look like? Lets take Avalon at Fairway Hills in Baltimore. How do I know the details of this place? Same as AH4R. I look up the "Profile of Current Communities" in the AvalonBay Communities, Inc. 10-K. On page 33, we see the 720 unit complex, with average rent of $1,487 per unit and "Financial reporting cost" of $53.528M. So, just for fun, let's look at their rent revenue per month to purchase price ratio. In their table, they have given us all the variables:

$1,487 / ($53.528M / 720) = 2.000%

I just couldn't help myself to use four significant digits. This was my first pick. Good first pick, eh?

Let me try another, more expensive ($201K!) place. Avalon Towers in Metro NY/NJ (page 32), with it's $3,255 monthly average rent for an (average) 1,143 sq.ft. place. I'm sure it is very nice, but come on! Can't be profitable, right?

$3,255 / ($21.953M / 109) = 1.616%

These are $201K per unit properties!! Well above 90 to 120k price points and while 1.6% falls short or 2.0%, it's a far cry from 0.68%!

Summary: Anyone doing even 30-45 minutes of analysis can see that at least one new residential REIT player is short of other traditional players in the multi-family space. And what are investors going to compare to? The "real" REITs.

Chris Martin · Answer

Thanks for the reply. Maybe hedge fund initiated, but this company is organized as a REIT and I'm guessing it will be around for a long time. If it is financially attractve, that's a different story.

It's always interesting reading a company's business plan, prospectus, or SEC filings. "Through September 30, 2013, we have acquired approximately 46% of our properties through foreclosure auctions and 54% through broker sales and other acquisition channels." That's a lot more courthouse activity than I would have thought. Per the trustee sale filings at my local courthouse, I do know that AH4R was buying a lot a few months ago. (I'm checking every few months to see when I can think about resuming.) In the interim, I just shake my head and walk away.

From the chart at the top of page 101, I'd say they are on the tail end of their capital deployment phase. Locally, I confirmed this from public records. Only 74 acquired properties in 2013Q4, down from 96 in 2013Q3, 302 in 2013Q2 and 160 in 2013Q1.

Operationally, they have $30M in Accrued property taxes that will most likely hit their expense column hard in this quarter, 2013Q4. It will be interesting to see how that expense is allocated. With about $18M in expenses for "Leased single-family properties" last quarter, that $30M looms large. And the non-cash expense for depreciation and amortization is HUGE. It is literally half of their revenue. Makes me wonder if they are going to struggle to get taxable income for any shareholder distributions (for a REIT, distribution of taxable income is a requirement.) And 30% annual turnover will add to property turn expense and incremental vacancy factor in the near future.

Valuation wise, it looks like REITs are often compared to book or asset value. My (literally) back of the envelope share calculation was off in my first post since I calculated allocated Class-B shares, not outstanding shares. AH4R has 162.7M class-A shares outstanding per their 10-Q, but 189.9M in their S-11. And all those other classes (Class B, Series C, Series D, Series E) add up to an additional 54.3M outstanding shares. I see about 244.2M Class-A equivalent shares outstanding and at $16.20, that's $3.96B in market cap (yes, Yahoo is off by $1B). That is only about 10% above their capital investment amount.

Given the numbers, I don't see this REIT commanding a huge market premium. And the stock market is telling them exactly that.

Giovanni Isaksen · Answer

@Chris Martin Thanks for your detailed reply. Whether they can ever prove the model is the issue. Like @Mike Peter, a client of mine who works at a large hedge fund did a detailed analysis and they passed on it as well. He said that fully reserved they just won't cash flow enough consistently to drive the returns above hurdle. Which is why the REIT exit is the best way out for them as you stated Chris.

I also agree that SFR REITs are worth 1x book and if they could prove their model they might get to 2.5x but in the public markets all bets are off. With some good CNBC facetime and the momentum guys get a hold of them the sky's the limit. I can see Jim Cramer pimping them with bells and whistles and throwing things.

Mike Peter · Answer

Chris Martin

...sorry

Mike Peter · Answer

@Chris Miller

Chris, I really like the depth of your analysis. I work for REIT and private real estate fund. During the crash we had several Hedge Fund type groups approach us with large single family portfolio bids. My conclusion; these funds will only be successful by rebounds in owner housing and quick (within 5 year) sales of entire portfolios.

Essentially, we did not do the deals because they did not fit the metrics of a reasonable dividend model based upon rental rates (which I believe is the conclusion you are coming to).

Steven Stokes · Answer

@Chris Martin

Haha thanks. Great post, good information and I'm enjoying the back and forth of this thread here.

Chris Martin · Answer

Investors aren't jumping onto this investment. That was the main point of my post. Actually the main point was why they aren't (or shouldn't be) jumping onto this investment. If this investment was interesting (as far as valuation), it would pull a bitcoin;)

?Thinking of an investment in a hedge fund?

?Thinking of an investment in a hedge fund?

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