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Our Rental Property Empire: Passive Income, Appreciation And Diversification
Investing in Property Property

Our Rental Property Empire: Passive Income, Appreciation And Diversification

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At High Yield Landlord, we invest heavily in rental properties that generate high cash flow, while we wait for long-term appreciation. Residential real estate represents 12% of our total assets:

Why Invest So Much In One Property Sector?

In a recent market update to members, we explain that:

“Given our cautious outlook (on the economy), we believe that the best real estate opportunities in the U.S. are found in non-traditional and more defensive traditional property sectors.

As a result, given that residential real estate tends to be more defensive, we have decided to overweight this sector within our portfolio.

Source

The Pros and Cons of Residential Real Estate Investing

Residential real estate investing is all about providing accommodation to tenants by owning and managing rental properties such as single family homes, condos, manufactured homes, apartments, etc. This sector has numerous qualities that make it quite attractive for investment right now:

(+) Simplicity: One of the most attractive aspects of investing in rental properties is that the business model is quite easy to understand. The beginner real estate investor does not need to have vast knowledge and experience in the field to be able to comprehend the fundamentals of the investment and even make reasoned investment decisions. Of course, there’s some baseline knowledge required – and the more you know, the better the results you are likely to achieve – but the knowledge required to participate (even successfully) is not prohibitive.

(+) Low Capital Requirement: Another pro is that the capital required for entry is relatively low. This is due to the fact that residential property prices tend to be much lower than other commercial property sectors and – due to the expected sustained demand for residential properties – obtaining generous financing terms is fairly easy to do. Which leads us to our third point …

(+) Consistent and Predictable: Residential real estate is quite defensive and also possesses a moat of sorts. This is because, regardless of the current state of the economy or technological innovation, the human body always will need physical protection from the elements, a comfortable and safe place to sleep, and a convenient and secure place to store frequently-used belongings.

That being said, as with any investment, there are cons to residential real estate investing. These include:

(-) Overbuilding risk: The potential for too much competing supply. Due to the lack of capital and informational barriers to entry as well as the popularity of the investment, there have been periods of time where certain locations, or even economies as a whole, have over-invested in the sector, resulting in too much supply relative to demand.

(-) The challenges and hassles of land-lording. Put simply: Owning rentals is a business, not a passive investment. Experienced landlords will attest that owning properties is a lot of work. The workload is generally more comparable to running a business rather than owning passive investments. It involves:

  • Advertising to find good-quality tenants, making showings, and interviewing tenants.
  • Doing legal work such as signing the lease, getting a deposit, and creating a limited liability company.
  • Monitoring tenants, otherwise rents will be unpaid or late, damage will be done, toilets will get clogged, etc.
  • Keeping up with repairs by identifying contractors, learning about building costs, analyzing different offers, monitoring projects, etc.
  • Obtaining financing, which, depending on the route you take and your credit score, is easier said than done. It often requires making a good case for your investment, obtaining offers from several banks, and giving up personal liability.
  • Taking care of customer service. Tenants will call you at all times of the day and night.

We call this “sweat equity” – because you will literally sweat to earn your return. Fortunately, for us, we have a better alternative:

Residential Land-lording Without the Hassles

As many of you may know, we believe very strongly that real estate investment trusts (REITs) (VNQ, IYR) offer numerous advantages to traditional rental property investing:

(+) High long-term risk-adjusted returns as evidenced by the fact that passive REIT indexes have outperformed different private real estate investment strategies by 4% to 6% per year in the long run. This outperformance has been fueled by the fact that REITs enjoy economies of scale (through owning billions of dollars’ worth of properties) in items such as financing interest expenses, property management and maintenance, and brokerage. It’s also fueled by stronger growth rates because REITs are able to boost growth beyond rent increases by issuing new shares and/or raising new debt to invest in accretive acquisition or even repurchasing shares if/when they trade at a discount to NAV.

(+) Truly passive income. Unlike rental properties, REITs are professionally managed, and you receive a consistent dividend check from your property investment every quarter. You do not need to put any “sweat equity.”

(+) Superior liquidity and transaction cost structure. REITs can be freely traded on liquid markets at a minimal transaction cost. In comparison, buying and selling rental properties is very costly and time consuming. It’s practically free to invest in REITs, but buying a rental may cost you 5%-10% in fees.

(+) Superior diversification. REITs offer the opportunity to invest in broad and widely diversified portfolios of properties in a liquid and cost-efficient manner. This results in significant risk mitigation as compared to private investments.

(+) Reduced personal liability. When you invest in REITs, you cannot lose more than your investment. You are not liable for the debt, and in case of legal troubles, you are protected. The opposite is often true with rental properties.

Two Top Picks for Rental REITs

In the remainder of this report, we will dive deeper into how our residential positions combine together to provide an attractive risk-to-reward with some exposure to different property types and quality segments.

In keeping with our conviction about REITs vs. rentals, our residential real estate investments currently consist of two REITs, though we are currently evaluating potential additions to this list.

Our current two holdings – Front Yard Residential (RESI) and UMH Properties (UMH) – both emphasize affordable housing in their strategies as opposed to pursuing higher priced luxury housing.

We like this because affordable housing – while certainly not as glamorous – is a highly defensive sector since during a recession people without jobs will need to find ways to cut costs, including in their housing.

UMH Properties: Manufactured Housing

UMH owns a diversified portfolio of manufactured housing assets with enormous growth potential at many levels including rents, occupancies, and new lot developments. The valuation multiple of 16x FFO may appear high at first, but given that we expect the company to grow at ~10% for the next three years, the company is actually quite reasonably priced. While we wait, we earned a fully-covered 4.5% dividend yield.

Our buy thesis hinges on the following factors:

  • (1) Manufactured housing (MH) communities generate high cash flow, have only limited capex (investor owns only the land and associated infrastructure), they are very resilient to recessions (most affordable housing option), and finally, they are growing rents at a fast pace due to the lack of new supply.
  • (2) UMH is one of the largest owners of MH communities (giving it economies of scale and a networking advantage in the space), and it has significantly outperformed the broader REIT markets in the past five years. We believe that this outperformance is set to continue in light of strong fundamentals in a late cycle and a depressed valuation.
  • (3) Priced at $16.34 per share, UMH is valued at an estimated ~15% discount to NAV. The 4.5% yield also is very generous for a defensive “growth” stock. Finally, given that the management is one of the largest shareholders with ~$70 million of skin in the game, we are confident that they will act in shareholders’ best interests and work to close the gap to NAV.
  • (4) Recent quarterly results confirm our thesis as we are seeing an ever-increasing demand for affordable housing but very minimal new supply of manufactured home communities. Same property NOI grew by 6% which is faster than most other REITs. Yet, still to this day, the average rent remains very affordable at below $500 per month.

Manufactured home community owned by UMH:

source

Front Yard Residential: Single Family Rentals

RESI is our deep value pick among single family rental REITs that has already returned strong returns. The company owns a well-diversified portfolio of affordable rentals and trades at an estimated 35% discount to NAV. It pays an attractive 5.1% dividend yield, and we expect double-digit annual returns as the company closes down its excessive discount to NAV.

Our buy thesis hinges on the following factors:

  • (1) Broad diversification in strong markets. RESI owns more than 16,000 properties diversified across 20-plus markets. These markets (primarily pro-business locales such as Atlanta, Memphis, Dallas-Fort Worth, Indianapolis, Charlotte, etc.) are seeing strong job growth and migration trends, leading to strong portfolio occupancy, low turnover, and strong home price appreciation (~25% across RESI’s top 20 markets over the past three years).
  • (2) Their homes remain highly affordable (around the $150k price point), making them quite defensive against a potential recession.
  • (3) The deep discount to NAV. RESI’s shares trade at a deep discount to the underlying value of their properties. We believe that there are numerous catalysts for unlocking this gap. These include a partial or full sale of the portfolio to larger REITs and/or institutional investors, continued management execution at improving operational efficiencies which should be rewarded by the market eventually, and/or activist investors finally gaining a strong enough foothold on the company board to effect changes (i.e., share buybacks and more drastic cost-cutting measures) that will unlock value.
  • (4) Recent events imply that this thesis already is playing out well. The company continues to gain scale, improve its operating efficiencies by internalizing property management, and improving the occupancy rate. Management also is moving to mitigate risks by refinancing debt to elongate the debt maturity calendar and activist investors have been making some rumblings on the board. Activist hedge funds also have become increasingly frustrated and have been pushing for a sale of homes to fund buybacks or an outright sale of the company.

Single family home owned by RESI:

Bottom Line

We believe that a 12% allocation to deeply undervalued quality residential REITs is acceptable in a late cycle economy, but we would really like to own more of it. It serves as a hedge against some of our higher risk investments in less defensive sectors such as retail and hotels. Furthermore, we believe that both of these investments should rebound significantly from their current discounts to NAV once the market realizes that the high quality properties will continue to generate stable and growing cash flows and/or management forces the issue via property sales.

At the end of the day, regardless of what happens with the economy or these REITs in the short term, we remain confident that both will provide strong risk-adjusted returns over the long run as their improving business models, attractive property sectors, and deeply discounted pricing should combine to generate outperformance over time.

With Better Information, You Get Better Results…

At High Yield Landlord, We spend 1000s of hours and well over $50,000 per year researching the REIT, MLP and other real estate markets for the most profitable investment opportunities and share the results with you at a tiny fraction of the cost.

  • We are the #1 rated service on Seeking Alpha with a perfect 5/5 rating.
  • We are the #1 ranked service for Real Estate Investors with 1500 members.

Take advantage of the 2-week free trial and join our community of ~1500 “landlords” before we hike the price!

Disclosure: I am/we are long UMH; RESI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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