Monday, January 21, 2013

Silver Bay Realty Trust

The Great Recession created many interesting investment opportunities in the financial and real estate sectors.  One market that's been off limits to public REIT investors until recently has been the single family home rental sector.  Historically this market has been limited to local landlords as its questionable if economies of scale exist or are translatable to a national REIT.

Silver Bay Realty Trust is a REIT recently formed to acquire, renovate and lease out single family homes with an eye towards dividends first and capital appreciation second.  It was formed in December 2012 as a partial spin-off of single family homes from Two Harbors Investment Corp (TWO), a mortgage REIT managed by Pine River, and a portfolio of single family homes from Provident, a private equity real estate fund.  The new portfolio will be managed by PRCM Real Estate Advisors, a joint venture between the two management companies.  Below is the new corporate structure:

The company at the time of formation has 2,548 single family homes (1,660 contributed by Two Harbors and 880 by Provident) located in the target markets of Phoenix, Tampa, Atlanta, Las Vegas, Tucson, Orlando, Northern and Southern California, Charlotte, and Dallas.  Each of these markets has a positive long-term trend of being located in desirable and growing locations away from the midwest and rust belt.  The company's portfolio is pretty new, with only 881 (or 34.5%) of their homes being owned for over 6 months, their general timetable to renovate and stabilize a rental asset.  Of the homes that have been owned for more than 6 months, 91% of them are occupied for an average rent of $1,126.  Costs at this point are pretty difficult to forecast, but the company estimates all property related expenses (vacancy, bad debt, property taxes, insurance, HOA, repairs and maintenance, and capital expenditures) will average 40-50% of rental revenues.  Silver Bay also has plenty of liquidity as it has $229.1 million in cash and no debt (all the homes are owned free and clear).

Its clear based on the current cost structure and pro-forma income statement laid out in the prospectus that Silver Bay will need to ramp up pretty quickly due to overhead costs at the corporate level.  The company is doing just that by completing most of their asset purchases through bank foreclosure auctions, many of these properties are likely very distressed and require a lot of work before becoming a performing rental, the company is current pegging those renovation costs at 10-15% of the acquisition costs.

From SBY's S-11
But the opportunity to acquire foreclosures is probably worth the renovation costs as these are exactly the kind of distressed properties that have the chance to achieve capital appreciation as the housing market continues to recover, housing inventories normalize, and family formations return to normal.

As for the potential rental revenues and potential dividend estimates, here's my extremely rough back of the envelope calculation:
  • 2, 548 homes at $1,126 per month with 91% occupancy = $31.3 million
  • $231 million in excess cash could purchase an additional 1,900 homes (at the current average of $121k per home), assuming rents remain constant, rental income = $23.4 million, for a total of $54.7 million
  • Estimated property expenses are 40-50% of rents, so at 50%, rental income = $27.35 million, or $0.74 per share (37MM shares), that doesn't include the management fee or any first year extraordinary costs.
Assuming a normalized distribution of about $0.60 per share, and an 5% required yield, that would put the price at $12.00 per share, well below the current market price of $21.22.  This is a rough number and doesn't account for any added leverage Silver Bay might apply or any secondary offerings they might do to spread the costs over a larger asset base, but I think it's clear that shares aren't cheap at the current price.

I have a few other concerns besides the valuation, the one clear negative is the management cost structure, PRCM is due 1.5% annually of the total market capitalization.  Basing the fee off of market capitalization will encourage the firm to engage in secondary offerings, and as the stock price increases the profitability will decrease, an odd combination.  Also, if I were purchasing distressed properties for my own portfolio, part of my strategy would be to renovate and rent out the home until prices recovered, then harvest the gains and sell.  However, as part of the management and compensation structure, it appears Silver Bay would likely hold on to the rentals for the long term and realize those gains through rent increases.  I would prefer to see it structured more as a liquidating trust, over time working the portfolio down to zero, but that structure is more suited for a private fund.  I also have a bias against IPOs, the company is still too new and untested, the asset class seems like a difficult one to achieve national economies of scale, especially if operating the properties over the long-term.

While I don't think I'll get the opportunity to invest in Silver Bay at what I believe to be a reasonable price, its still an interesting company to monitor in case they have a temporary slip-up and the market overreacts.  I do believe there are substantial opportunities in single family homes, but its probably better suited to a different structure.

Disclosure:  No position

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