Institutional investors are reportedly “slowing down” on adding single-family rental investments to their portfolios.
Some people think the reason for this slowdown is that increasing home prices is hurting margins. I’d argue that this slowdown would not be as pronounced if more institutional investors adopted technology that helped them increase their rate of return.
Over the last fifteen years, I’ve seen countless examples of inefficiencies when it comes to building and managing SFR portfolios. Luckily, many of these can be solved with technology. Whether you’re an institutional investor that’s just starting to look into the space or one that wants to source and manage single-family homes more effectively, there are an increasing amount of technologies you can use to build a healthier portfolio:
Buying Low and Selling High
All institutional investors know the basics of how to identify whether a home would be a good fit for their portfolio. They look at the cap rate of a home (ratio of net operating income to capital invested) and see if the home is in line with the returns they look for in an investment. For instance, if a home generates $6,000 a year in net operating income, and required $60,000 of capital to purchase, the cap rate would be 10% ($6,000/$60,000). For most institutional investor a 10% rate of return is an attractive investment.
While cap rate calculations are straightforward, there are a couple of areas where technology can help institutional investors make these calculations more accurately and quickly.
Let’s talk about accuracy first. Rental potential is incredibly challenging to predict—it’s hard to come by accurate rental data, and the algorithms out there aren’t very good. Institutional investors that want to predict rental revenue more accurately have to build their own algorithms based on verified or primary data sources, like using Corelogic to see sales transaction prices, or partner with an organization that can demonstrate it has developed a more accurate algorithm than what sites like Zillow offer.
Institutional investors need to be able to deploy capital quickly so deal speed is one of the most important factors. They don’t have the luxury of looking up home values based on manual scans of MLS data, and calculating cap rates by hand or in Excel spreadsheet. Worse, I’ve seen investors who rely on public tools offered by Zillow or Redfin, which are not enterprise-grade. Instead, they can invest in building technology that pulls available data on homes that have sold in the specific state or region in which they are interested in investing, and compare the sale price of the homes against the projected average rent. Again, institutional investors will need a good rental data source to do this and finding such a source is the first hurdle.
For institutional investors who want to get even more advanced with their use of technology, they can develop tools that pull property tax data, along with expected insurance, maintenance, and capital costs, and show how these costs will affect their projected rate of return. Think of a version of Calculator.net’s rental property calculator that automatically populates all relevant caprate info for hundreds or thousands of homes at a time, and shows an institutional investor which homes are worth purchasing.
Also, most institutional investors calculate the value of their single-family homes based on the cap rate alone. This is a mistake. The value of a single-family home is not just the cash flow. It has inherent value as a place for a family to live their lives. Institutional investors should build models that account for dispossession of home prices based on expected future demand, rather than just current profitability.
Models should look at the equity across the entire portfolio of SFRs, and be able to project a return that includes cash flow during the hold period plus net equity growth after sales. The expected revenue from selling these properties needs be calculated into their projected returns.
As most real estate investors work with LPs, having a fund with a start date and an end date makes things predictable. So, the liquidation date should be factored into models as well so that towards the end of that period, the fund would ramp up dispossession functions and sell the homes in their portfolio.
Institutional investors generally outsource SFR management to a property management company. The problem with this is that many property management companies are paid to find new tenants, and take care of properties. This creates misaligned incentives. After all, if a property manager makes more money when they find a new renter, there’s little reason for them to worry about turnover. And if they’re paid to fix issues with apartments, there’s little incentive for them to work on long-term solutions to issues.
If institutional investors want to truly benefit from technology they need to consider the option of bringing their property management in-house. Technology companies are often stepping in and offering turnkey solutions that can act as a management layer. There are solutions that can automate communication with owners and tenants, digitize and fill out documents and identify the best potential renters.
If institutional investors don’t want to take property management in-house, they should at least make sure to evaluate how their property managers are using technology to improve operations and collect data.
There are no two ways about it. Managing a single family portfolio can be more hands-on than other investments. But the institutional investors that choose to leverage technology can reap the benefits of sourcing and managing SFRs more efficiently. When managed well, SFRs have the potential to offer returns that are hard to come buy with any other investment options.