It's rare to find an asset that simultaneously throws off a nice income stream and appreciates in value. Single-family rental properties (basically houses for rent) are one such asset, and one way to invest in them is to become a landlord.
For those who aren't ready to make such a large and time-intensive investment, the next best thing is to take a look at American Homes 4 Rent (NYSE:AMH), which is a real estate investment trust (REIT) that focuses on single-family rentals.
Consolidating a fragmented industry
American Homes 4 Rent owned 53,584 single-family properties as of Dec. 31, 2020. Demand has been strong for single-family homes in general, driven by an exodus from urban areas due to COVID-19, a change in preferences to the suburbs, and the increased adoption of working from home. At the end of this year's first quarter, American Homes 4 Rent had a 97% occupancy rate.
The single-family rental space has historically been extremely fragmented, dominated by mom-and-pop landlords who own a property or two and use that to fund retirement. Up until recently, the conventional wisdom was that single-family rentals were not a scalable endeavor, which means that operating costs would increase in lockstep with revenue.
In the aftermath of the residential real estate crash of 2006, many institutional investors swept in and bought distressed properties and got into the rental business. They are intent on disrupting and consolidating this market.
Last year, American Homes 4 Rent earned $154 million in net income on its portfolio of homes, which are capitalized on the balance sheet at $8.2 billion. Now, net income isn't really the best indicator of profitability for a REIT because depreciation and amortization are big non-cash charges. Most REITs use adjusted funds from operations (AFFO), and AFFO divided by the value of the portfolio gives an approximation of the yield on these assets. Last year, American Homes 4 Rent generated $368 million in AFFO on that $8.2 billion portfolio, which works out to be a yield of about 4.5%. Keep in mind that this is not a true cap rate (the way real estate investors measure profitability) because it uses book value rather than market value.
Real estate appreciation is helping increase the underlying value
Regardless of the cost basis used, that yield itself is pretty good. But here's the kicker: Home prices are appreciating at 11% per year, at least according to the latest data from the Federal Housing Finance Agency (FHFA). Atlanta, Dallas, and Charlotte, North Carolina, are American Homes' largest markets, and these have been some of the stronger metropolitan statistical areas. For example, Charlotte home prices are up 14% year over year, while Atlanta's prices are up 11%, based on the FHFA House Price sub-indexes. The FHFA index excludes the really high-end properties, so it is a good approximation of the type of house that American Homes would own. Given that for-sale inventory is bumping along at record lows, expect real estate price appreciation to continue.
If you add the 4.5% yield on top of the 11% real estate appreciation, you can see why American Homes 4 Rent is operating in a great space. Keep in mind that the book value of the portfolio is understated, because depreciation is deducted from the carrying value of the real estate, and increases in the market value are ignored. This means that American Homes' book value of $6.5 billion understates what the company would get if it liquidated its portfolio.
American Homes' stock price has been increasing as real estate prices have risen and is up about 27% this year at Monday's prices. The company also pays a dividend, although it's only $0.40 per share. This gives the stock a yield of 1.1%, which is pretty miserly for a REIT, but it reflects the fact that the company is investing in properties.
The company guided on its most recent earnings call for 2021 FFO per share to come in between $1.24 and $1.30, which gives the company a multiple of 30 times FFO at the midpoint of guidance. This premium multiple reflects the growth potential. The payout ratio (dividend divided by FFO per share) is only 32%, which is on the low side for a REIT.
Look for a dividend hike as REITs are required to distribute most of their earnings to shareholders. American Homes 4 Rent provides two ways to win: the cash flows from the underlying properties and the increases in valuation of the portfolio.