Why I'm Still Excited About This Unique Corner Of The Real Estate Market

Nathan Slaughter's picture

Monday, August 29, 2016 - 12:00am

by Nathan Slaughter

Barry Sternlicht knows a thing or two about real estate. The Harvard Business School grad got started early, buying up more than 7,000 residential apartment units in the early 1990s at fire-sale prices following the savings and loan crisis. 

Soon after, he signed a mega-deal with real estate tycoon Sam Zell, exchanging many of these apartments for an ownership stake in Zell's Equity Residential (NYSE: EQR). This transaction ultimately netted Sternlicht (and his investors) handsome triple-digit returns. But that was just the beginning for this savvy investor and the company he founded, Starwood Capital. 

Starwood later built an empire of luxury hotels, amassing a global portfolio of more than 1,200 resorts under upscale brands such as Westin, Sheraton, St. Regis, and Le Meridien. Incidentally, it sold this collection to Marriott last year for $13.6 billion. 

Elsewhere, Starwood has made big investments in retail shopping malls in Sweden, suburban office parks in South Florida, and undeveloped land parcels in California.

As I discussed last month with my High-Yield Investing premium subscribers, Starwood has also teamed up with Colony Capital to create Colony Starwood Homes (NYSE: SFR), which owns 35,000 rental homes. Sternlicht helped orchestrate this venture, which has already generated gains of nearly 50% this year. 

To say this guy is an astute real estate investor is like saying gold medalist Usain Bolt is kinda fast. 

That's why pensions, endowments and rich investors around the world have pumped tens of billions of dollars into Starwood's various private equity funds and real estate investment platforms. So when Sternlicht speaks, it pays to listen. 

As it happens, the veteran investor just gave a ringing endorsement to one particular real estate subsector -- and he's backing it up with more than $5 billion in cash. 

Sternlicht is investing aggressively in the same asset class that made his first fortune 25 years ago: apartments. When asked why, he explained that the multi-family residential market is the "healthiest in my lifetime," adding that "we don't see that trend reversing."

For a guy who has seen just about everything, this enthusiastic assessment was eye-opening. And it wasn't just idle talk. Those comments came October 26, the same day that Starwood purchased 23,000 apartment units from Sternlicht's old buddy Sam Zell. Even by Starwood's standards, this is a big deal -- the largest apartment acquisition in company history.

He has since plowed several billion more into this shopping spree, essentially doubling down on a confident hand. Sternlicht sees considerable upside in rental markets such as Seattle and Nashville, Tenn. He really likes Austin, Texas, noting that 250 people are moving into the area daily, or about 1,750 per week.

In many of these cities, the influx of new residents is outpacing the construction of new apartments. There just isn't any space to build in downtown Chicago or Boston, yet rental demand is climbing 6% to 7% annually. That leads to a shortage of available units, which inevitably exerts upward pressure on prices. 

A decent unit runs about $1,500 per month in Denver and $2,200 in Washington. 

Some sharp entrepreneurs are making big bets in apartment ownership. One laid out the math succinctly, pointing to an online listing for a building with 49 units priced to sell at $1,750,000 (around $35,000 per unit). Assuming a 25% down-payment, you could finance the remainder with a 6% bank loan that would cost about $78,000 in annual interest. 

He goes on to say that this type of apartment would generate an average cap rate (operating income divided by property cost) of 8%. That means a yearly revenue stream of $140,000 provided by rental income after expenses. Subtract the $78,000 owed to the bank, and the property would throw off about $62,000 per year in free cash flow. 


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Sounds great, but most of us aren't in a position to take out a 7-figure loan, nor do we know much about how to run an apartment building. But you can own hundreds of these buildings through companies like Starwood Capital. 

The market sure recognizes the potential. Just check out the performance of the iShares Residential ETF (NYSE: REZ) over the past two years against the S&P 500. 

REZ Has Outperformed The Market 2-to-1 Over The Past 2 Years

 

But I still believe the best days lie ahead. 

As I explained in the April 2016 issue of High-Yield Investing, multi-family housing is one of the best ways to capitalize on the spending patterns of the 4 million Millennials that are reaching the age of adulthood each year. Surveys show that this generation eschews the burden of ownership, as two-thirds prefer to rent versus buy.

That's particularly true in urban markets where home prices are astronomical. An average house costs $917,000 in San Francisco (more than 10 times the median annual income). No wonder so many incoming younger workers are moving into apartments. 

As you can see from the chart below, the percentage of Americans that own their own homes has fallen to 62.9% -- the lowest level in 50 years. 

 

 

The lack of affordable homes isn't the only reason people are opting to rent instead of buy -- rising mortgage rates will soon present another obstacle. As it stands, apartment occupancy rates are close to 95% nationwide.

The first time I dove into this sector, I recommended Equity Residential (NYSE: EQR), an industry giant with 85,000 units and a special dividend on the way. I still stand behind the company. But I recently recommended a much smaller player within the pages of High-Yield Investing. At a dividend yield approaching 8%, this well-run outfit offers twice the dividend yield of its larger competitors. If you're interested in getting the name and ticker symbol of the stock, along with the rest of my top income picks, simply go here

Nathan Slaughter 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.