The BTR Outlook For 2023 And Beyond: Resilient ... With A Twist

The everything, everywhere, all-at-once moment for residential real estate and construction's build-to-rent evolution from toddler stage to a coming of age is – to practically no one's surprise – over.

What 24 months ago looked like an obvious opportunity of sure bets, short-cuts, and plug-and-play deal models – every single one of which would be profitable – now looks like just about every other slice of the residential real estate development business: Hard.

That's not to say that -- as both a housing preference among consumer households and as a business investment, community development, and construction sector meeting a need – build-to-rent lacks validity, plenty of opportunity, and a rightfully lucrative place in the future of housing in the U.S.

What's become evident, however, is that BTR's "blue-sky" opportunity, like any other real estate venture, doesn't come without constraint. Rather than "everybody wins," the BTR blue sky may offer limitless growth and profit opportunity to a finite number of players.

Further, the reality check of the "end of the easy money era" has made a few things clear, and, at the same time, it has introduced a series of unknowns whose ultimate meaning and impact may only get recognized with the luxury of hindsight.

Two force-factors already materially impact BTR business pro formas: the cost of money and the plateauing and reversal of rent growth. Simply, rising interest rates' impact on borrowing costs are a direct conduit to higher construction build cycle expense. In turn, those front-loaded, higher construction finance costs funnel across to costs of capital once the project completes, leases up, and stabilizes, and need to be equalized with higher rents to produce an acceptable net operating income.

That's a big challenge now that rent growth has taken a pause, and may retrace a bit after a steady, heady past several years.

Real estate's version of natural selection will punish – and cull – players who either took the dirt-cheap-access-to-money or the non-stop-passthrough-of-higher-costs to renters for granted. Those players – in their rush – broke a cardinal rule of real estate, which is to never underestimate costs, and never overestimate revenue.

That will leave players who've practiced, failed, learned, and prospered in residential real estate cycles present and past as the ones who'll reap the blue sky opportunity rewards.

With eyes and ears on the ground in multiple regions of the United States, insight into the perspective of operators that run the spectrum from dabbling in BTR to approaching it with an institutional mindset, and having looked at over 75 projects last year alone, we believe there is reason for cautious optimism, writes Ron Gonski, senior VP for Growth at Mosaic, a TBD partner.

Gonski's 2023 Outlook: Build-to-rent remains resilient, offers eight invaluable insights into the moving-target challenges and opportunities for the build-to-rent segment of new-home development.

He notes:

BTR will continue to outperform traditional multifamily and generate “alpha”–a return that beats the market–this year. As it has over the past 12 months, BTR will carry a premium in key indicators such as per square foot rents, tenant quality, lease durations, and growth trends. Further, as experienced rental operators increasingly enter BTR and ramp up the overall sophistication of the asset class, more efficient community and architectural designs will lead to higher NOI for owners. And to the extent there is a drop in key project metrics, BTR will “bounce back” sooner and more quickly than traditional multifamily."

Nevermind that BTR may be the "youngest" of residential real estate and community development's classes. Its winners grasp the fact that they have to be smart and do the right thing across five essential raw material spheres to succeed sustainably: land, money, time, talent, and consumers.

It's a mistake to fall prey to the myth of a playing field tilted in your favor in when it comes to solving residential real estate and construction's hard problems. Widely discussed and long-known "opportunity areas" to bring improved processes and smarter decisions to play hold as true for the BTR space as they do in every other "space" in the ecosystem.

They include – but may also include others – the following opportunity areas.

• Vertical construction – where design-build productivity, process, data, automation and robotics technologies, and epic collaboration among build-cycle partners could capture, reinvest, and reallocate from 20% to 25% of direct input costs.
• Policy – a catch-all for land use, construction code compliance, regulatory burden, permitting and inspections by local/regional officials, tax, anti-trust, etc. that add a quarter to a third of asking prices or rents.
• Property investment/development – this opportunity area would require innovative models for equity in the residual land value, both to optimize resources and drive toward an expanded pool of potential renters and owners.

A post-easy-money new normal on the vertical construction front, for instance, has exposed that while single-family for-sale homebuilders and their pools of trade partners have the experience and processes best matched to typical product platforms, a big glaring obstacle tends to arise, which is that per square foot expenses for market rate single-family for sale typically run much higher than those for verticle for-rent communities.

Mosiac's Gonski writes:

Over the last two years, historic rent increases have been the primary savior of many a project’s economics. Over these next two years, construction costs will play a similar role. The math is simple: even as interest rates rise, construction costs in many markets are going down and may go down in even greater magnitude than the countervailing increases in debt service costs. Construction cost decreases also impact more broadly: a percentage increase in debt costs applies only to the portion of overall construction costs that is levered, whereas a percentage decrease in construction costs applies to the entirety."

Consumers – in a period of heightened uncertainty and volatility that could impact jobs, wages, and household formations patterns – remain a wildcard. Gonski and the Mosaic team express confidence in the fundamentals drivers of demand.

Notably, college grads did not flood the tenant market in mid-summer the way they typically have, instead reacting to high rents and uncertain economic conditions by living with friends and family. On the other side, however, lease renewal rates are at near all-time highs. All to say, the mix of factors will buoy rents. And overall, we continue to push out demand and constrain supply, which could lead to historic demand in the next 18-24 months similar to what we saw over the past 2 years."

"Historic demand" or not, one strategic approach to tempering an overly aggressive take on real demand might be to focus less on "rent by necessity" households, as their means and wherewithal are more sensitive to the kinds of economic turbulence that lies ahead.

Focus, instead, on the rent-by-choice segment, however, look at it through a lens of a discretionary renter for a shorter term, i.e. 24 to 36 months, and one who rents by choice for a longer haul stay. Those subsegments of total renter universes are the ones that will add resilience to pro formas that pencil as this fits and starts time period arrives at a next new normal.