Silver Bay Realty Growing NAV Despite High Expense Levels

Investors still aren't convinced that the single-family rental house market provides an investable opportunity, and for good reason. The cost for a corporation to build up a portfolio of rental houses, renovate them, and lease the properties continues to be expensive. Missed by the focus on cash flows, Silver Bay Realty Trust continues to grow its net asset value (NAV) by seeing the valuation of its houses rebound. Fellow rental property owner American Homes 4 Rent has seen similar stock weakness.

The primary focus of Silver Bay Realty and American Homes 4 Rent has been whether these collectors of rental properties will be able to generate strong rental yields. For now, the question might be whether these stocks can even generate positive cash flow, much less a high yield.

In the end, investors might not need to be overly concerned about a strong rental yield if Silver Bay can continue growing its NAV. The NAV sits at $19.50, while the company's stock is stuck near lows below $16. Investors need to remember that housing price appreciation can be as important as cash flow, especially if one believes in a housing recovery and the rental houses were purchased at depressed prices.

Unbelievable purchase prices
In the latest conference presentation for Silver Bay, the CEO provided some incredible valuation details. The company claims that a rental property with an average cost basis of $129,000 has a replacement cost of $200,000. Note that the cost basis is after the company has spent roughly $20,000 renovating the house. Using an estimate of 2.5% inflation over the next five years, the forecast would be for replacement costs to jump to $225,000.

Silver Bay would generate annual returns on investment of 12% for the period based on price appreciation alone. In general, any cash flow from renting houses would all be gravy for investors.

The incredible part of the equation is that the current NAV of $19.50 is based on comparable housing sales and not those replacement costs listed above. Looking at it another way, the listed $17.16 book value is equal to the $129,000 cost basis. By only paying $16 per share, investors are obtaining these rental houses at even greater discounts to their replacement costs.

It's equivalent to obtaining 10% off of an item at the store after using a 40% coupon. Interestingly, American Homes 4 Rent makes no mention of NAV in its earnings release. The company doesn't address valuation changes in rental properties, either.

Uncontainable expenses
The biggest issue in the rental market continues to be whether the formative stage will actually give way to lower expenses once stability takes place. For its part, Silver Bay has decided to prove out this concept by eliminating housing purchases during the third quarter. The company spent the quarter renovating and leasing properties at a record pace, however, expenses continued to add up. Occupancy numbers jumped up to 89% for properties held over six months, and an even higher 95% for stabilized properties.

While the leased properties dramatically increased, costs soared in tandem. With revenue of only $14.5 million, total expenses soared to nearly $21 million. The most concerning part for investors were expenses such as $3.6 million for property management fees, $2.2 million on advisory management fees, and another $1.9 million on administrative expenses. In total, $7.7 million, or over 50% of revenue, was spent on managing the properties.

Another very concerning fact is that if the 5,575 properties were fully leased at the average rent of $1,161, this would only equal $19.4 million in rental income. Considering that 100% rented properties isn't possible, the company has to reduce its expenses by at least $1.4 million while leasing the remaining 1,000 units in order to break even.

American Homes 4 Rent once again offers a completely different view. The REIT had 21,267 properties at the end of the quarter, yet it spent 35% of the $49.4 million of revenue on operating expenses for leased properties. The company also clearly broke out the expenses for vacant properties and had roughly 5% spent on administrative costs.

Bottom line
The picture is still positive for the single-family rental companies. The companies purchased houses in prime markets at what appears to have been near the lows. However, investors focus on the concept being unproven and the lack of short-term cash flows. Silver Bay suggests that operating cash flows and dividend hikes will start in 2014, as the company moves away from the formative stage.

Investors who believe in the concept have the opportunity to purchase the company's stock at a substantial discount to the costs to replace rental homes. The reality of operating cash flows next year would be a huge bonus for Silver Bay's stock, which should see solid gains from growing NAV.

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