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Wednesday, March 12, 2014 - 14:30
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Wednesday, March 12, 2014 - 14:30

84 Million Reasons To Buy This REIT

Wednesday, March 12, 2014 2:30 PM

Rising rates have investors spooked from buying real estate investment trusts (REITS), with $384 million of outflows in U.S. REIT funds in January alone. The fear is that higher rates will raise financing costs for highly leveraged real estate holdings, which will in turn limit distributions.

This may be true in theory, but investors are overlooking extremely strong catalysts for growth and historical returns that are hard to beat.

The National Association of Real Estate Investment Trusts (NAREIT) monitors sector returns. Its index of equity REITs has outperformed the S&P 500, the Russell 2000 and the Barclays Aggregate Bond indices over the 10-, 20- and 30-year periods. Over the 40 years to 2010, the NAREIT index has provided annualized income returns of 8.3% and an annualized price return of 5.5%.

On that backdrop of strong historical returns, there is one segment of the real estate market that has never really been accessible to retail investors like you and me. Unless you are an accredited investor (or your last name is Trump), you most likely haven't been able to build a portfolio of single-family rental houses.

Private equity and other institutional investors have been pouring money into single-family for the past couple of years on expectations for strong price appreciation and rents that cover expenses and then some.

These big-money players not only see the rebound in housing as a long-term secular story -- they also have another reason to be bullish on this investment opportunity.

Actually, they have 84 million reasons.

Years Of Rebound Ahead
Millenials have also been called the "boomerang generation" because of the group's tendency to move back in with their parents. Unemployment rates have been higher for this younger group of workers, and it has shown through in statistics on homeownership.

Data from the Federal Reserve show that household formation plummeted by 800,000 households a year over the five years during and after the 2007 recession. About half a million new households were formed each year over the period, the lowest rate since World War II.

As the economy rebounds and these 84 million people transition into prime earning years, they will be looking to move out on their own, first into rentals and then buying their own homes. Aggregate net worth has already made new highs on a strong stock market, and it is only a matter of time before the younger generation starts thinking about that white picket fence. This could put a big tailwind behind the market for single-family rentals and property.

Millenials, those born between 1980 and 2000, make up the largest generational group, and the oldest millenials are getting too old to live with Mom and Dad. These new renters and homebuyers should help support other strong real estate fundamentals for at least the next decade.

Strong Markets, Discounted Properties
Starwood Waypoint Residential Trust (NYSE: SWAY)
is a single-family rental REIT that was spun off from Starwood Property Trust (NYSE: STWD) last month. It is one of the first rental companies to list shares and offers retail investors the opportunity to benefit from institutional management in the single-family environment. Starwood Waypoint has been building its portfolio since the IPO in February with the recent purchase of 707 single-family homes in Atlanta, Chicago, Phoenix, Dallas and Houston, as well as in California and Florida.

The company is also investing aggressively in non-performing loans as a cheaper acquisition tool. Starwood paid $219.7 million for 1,736 NPL loans versus a cost of $707.5 million for its 5,049 rental homes. This means the company is able to acquire distressed properties for an average of $127,000 apiece, compared with $140,000 for conventional purchases.

The company has its core portfolio in 12 cities across the United States. Many of these cities were among the hardest hit by the housing bust and consequently are seeing the greatest price appreciation in the rebound. The graphic below shows management's expectations for price appreciation in each city.

Markets within dashed boxes represent core areas making up more than 5% of the initial portfolio. Combining forecasts for appreciation with the company's portfolio distribution of homes yields an expected price appreciation of 46% over the four years to 2017. Almost half of this is driven by assets in Miami (23% of the portfolio and 54% expected appreciation) and Atlanta (16% of the portfolio and 57% appreciation).

Higher housing prices also mean higher rents and more cash returned to shareholders. The company is expected to be granted REIT status this year and will payout a minimum of 90% earnings before taxes. Starwood Property Trust pays a yield of 6.4%, relatively high among REITs, and I expect that Starwood Waypoint will also aim for a high yield. Management projections call for a 6% to 6.5% unlevered net yield on the property portfolio.

For investors worried about occupancy rates and costs of managing single-family housing, management reports the occupancy rate across the company's properties is 95% with a net operating margin of 64%, above the 62% average for multi-family REITs.

Value Opportunity Around Uncertainty
Book value was estimated at $26.47 per share on the spin-off distribution date, ahead of several key acquisitions. Other publicly listed companies, Altisource Residential (NYSE: RESI) and American Homes 4 Rent (NYSE: AMH), trade for 1.6 times and 1.1 times book value, respectively. This implies a price range for Starwood Waypoint of $29.38 and $41.29 a share.

Shares are trading just over the previously estimated book value, probably on the uncertainty of newly issued shares and an untested company. I would be a buyer below $29 per share and set a target price of $34.40 per share on a multiple of 1.3 times book value, amounting to better than 20% upside.

Beyond the long-term outlook, there is the potential for a pop in the stock when the company issues its first quarterly earnings report. The update to book value and confirmation of the company's operations could help improve sentiment and reduce uncertainty.

Risks to Consider: Starwood Waypoint is still a relatively new company within a relatively new industry of large-scale single-family rental management. There are bound to be unforeseen hurdles along the way. Some of this uncertainty may already be priced in, but investors should be ready for higher volatility than in other REIT shares.

Action to Take --> Take advantage of the market uncertainty in shares of Starwood Waypoint Residential Trust. The shares are trading at book value with the market pricing peers well above book. Strong tailwinds are on the horizon as millenials start moving out on their own over the next few years, and this should help boost home prices and rentals.

P.S. My colleague Nathan Slaughter has been pounding the table for months now, telling readers of his High-Yield Investing advisory about the enormous opportunity in real estate right now. And thanks to stocks like the ones mentioned above, regular investors have a chance to get in on the action. To learn more about Nathan's absolute favorite picks in real estate, which help regular investors unlock an income stream previously reserved only for America's privileged elite, follow this link.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.