The Expert Podcast

One of the future preparations or predictions for solutions to the housing market crisis is the building of new homes by contractors or builders. There's an expectation that millions of homes will be coming into the marketplace for home buyers as builders and construction companies accelerate the building of single-family homes. But one of the things that's happening behind the scenes that may be slowing that inventory down getting to the market is even within the new home construction there are investors and hedge funds buying these homes before they even get to the retail market.
One of the factors that's been talked about quite a bit in the used resale home market are hedge funds and investors coming in and buying up resale homes bidding all cash to offer them as rentals or to flip them. The new home market has not been threatened as much by that purchasing competition but according to the Wall Street Journal it appears that home builders are bypassing individual retail home buyers to sell directly to investors because mortgage rates are starting to get some price sensitivity by home buyers.
The price sensitivity doesn't exist with investors so if retail home buyers are not going to buy a home with a five or six percent mortgage because the payment's too high it doesn't necessarily mean that the builder has to lower the price. There are other buyers in the marketplace that are not interest rate sensitive and therefore not price sensitive. You can still come in and buy a house for cash use your institutional or commercial lending facility not as a individual mortgage on the property but as a commercial line of credit that you use as a company to buy hundreds of homes at a time at a lower rate and you can still make a cash flow by renting these homes out to retail individual residents.
Here's how that works: these investors who buy and sell houses are becoming popular customers the home builders they're looking to buy in bulk these new constructions. More than one in every four homes that were built by a new home builder was purchased by a professional rental investor. Notice the term rental and these investors have amassed 89 billion in capital to spend on building or buying new rental homes and that's going to be something which has an effect on new home availability.
So let's do the math on that. Let's suppose that an institutional investor is going to buy a house that's 400,000 and that's kind of in the sweet spot of median homes even new construction for a twelve to sixteen hundred square foot home might be four hundred thousand dollars directly from the builder and now that house might go for 450 or 460 if it was sold retail to a new home buyer but without a real estate commission a brokerage commission in bulk maybe 400 is more like what the institutional buyer might pay.
Well institutional buyer can still get cheap money inside their lending facility so if they have a line of credit from a large commercial lender maybe they have a four percent and that's even probably at the high end line of credit and it's interest only so they buy that four hundred thousand dollar house four percent interest only that's sixteen thousand dollars a year in interest boils down to about thirteen hundred dollars a month in interest payments. Now they'll have tax and insurance and some management fees on top of that but it's still gonna put them way less than two thousand dollars probably about seventeen eighteen hundred dollars in total monthly carrying cost.
That's a house a brand new three-two house sixteen hundred square feet can easily rent for twenty five twenty eight twenty nine hundred dollars so in reality they don't have any capital outlay because they're not putting any money cash out of pocket they're using their entire credit line for the purchase so their return on investment is very high. They have a some cost for fixed overhead of employees fixed overhead of maybe marketing advertising but having an outlay of sixteen seventeen hundred dollars a month in expense for a 27 or 2800 a month revenue stream that's a thousand dollars a month per house. You get a thousand homes that's a million dollars a month it's a 12 million dollar business without having any capital outlay.
So this is the reason why home builders are choosing to sell to bulk investors because they can turn a profit on the new homes quickly they don't have to let the home sit and they don't have to worry about appraisals financing delays closing costs punch lists it's a clean deal and the rising mortgage rates aren't affecting the values of these new homes. The builders are basically paying cash they have financing behind the scenes but it's a lower rate interest only and they still have a return on their investment. They don't have the price sensitivity that a retail buyer might have because a retail buyer has to look at their budget can i afford the mortgage at two thousand dollars a month 2200 a month for a 30-year mortgage they have to make that decision and the lender also has to make that decision for them.
Even if the buyer thinks i can afford 2,000 a month if their lender looks at their budget and their tax returns and their income statements and does not feel that they can afford that the deal's dead or if the appraisal comes in at 380 rather than 410 deals dead so the builder can look at these retail are these institutional investors and these commercial buyers as a clean deal no hassle no closing costs no delays cash deal and they can eliminate some of the retail costs such as a sales commission.
And it doesn't affect the demand for rentals in fact it helps a demand because those potential buyers that didn't buy the house as a purchase still need a place to live so the same number of residents are out there needing a place to live so if you're a potential buyer of that home and you didn't get it because you couldn't get your mortgage approved or there was too much of a bidding war or it was never available on the sales market because the builder sold it directly to a an investment company you might say well we have to find a place to live so let's just rent a house. You might end up renting the same house for 24 25 2700 so the rent might be more than what you would have paid on a purchase now you wouldn't have any money down on the rent so you wouldn't have to come out of pocket 70 or 80,000 but that's where the arbitrage for the home builders with the investors are making it a perfect storm to having fewer ownership homes on the market.
And just like we said the investors are a reliable customer because interest rates don't affect them they already have the cash on hand they have a line of credit they don't have to get an individual mortgage for each property and here's an example of a builder this particular builder in Arizona decided to focus entirely on rental houses so his building pipeline is building houses for rental buyers not for individual retail buyers and it also helps streamline the building process.
You can build all the houses the same as a commercial builder or general contractor you don't have to sit with the buyers for each house and go over paint swatches and granite selections and flooring everyone's different which slows down the building process you can build them all the same or maybe have two or three options and just crank out the houses and not worry about the fact that one particular buyer might want a very unusual combination of interior finishes and it makes the building process cheaper.
A builder might save five or ten thousand dollars on labor costs on efficiency of not having to customize each house with interior finishes selected by the buyer and sometimes at the last minute they'll change and want a different finish and even though they may pay more for it it's not a big profit margin for the builder because the price of the house can't change too much because the lender is not going to add on another thirty thousand dollars in appraisal value just because you spent thirty thousand dollars more on interior finishing the appraisal value is not going to change that much.
And here's an example that builder built a community of homes that are renting for 2,500 a month and these houses are only 1100 square feet so the construction cost at maybe 200 a foot that's going to put you at 220,000 building cost plus a lot that might cost you 30 or 40. You have some site work some permits you know your cost basis may be 300 or 310 or so as a builder and you can sell it for a clean deal for 400.
The buyer now has like we talked about 400 grand they have a payment of 1300 plus tax and insurance maybe 1600 they rent it for 2500 they make 900 a month cash flow. The builder is probably better off selling their house directly to the the investor at 400 rather than selling it for 459 to a retail buyer because 459 you have a six percent sales commission so now that's 25,000. That brings your net down to you know 430. By the time you do extra labor the delays in construction missed opportunity moving on to the next house and additional costs for customizing the house that might eat up that entire 25 or 30,000 extra net profit so these deals even though they might be transacting for less money are much more appealing for the builder or general contractor.
So how does this affect you? If you are a new home buyer you may not see this invisible market competition building houses or taking up the resources of home builders to build rentals dedicated single-family house. If you are a general contractor and you are considering building for a retail buyer or a rental investor consider the math on both of those if you're selling to a retail buyer maybe you mark up the margin more because the cost basis will be higher and maybe you want to sell to some of the rental investors because it'll be a more streamlined process.
It kind of boils down to what kind of general contractor you are if you're more of a custom low volume builder now you can focus on the retail buyer for single family homes if you are a higher volume construction company then maybe some of these commercial investors might be more appealing if that's the case you may want to adjust your floor plans and your finish packages accordingly if they're going to be rentals because you know a rental with a builder grade cabinet countertop paint floor is going to rent for about the same as one with higher grade finishes and if it costs you twenty or thirty thousand dollars more for higher grade finishes you're not going to get that much more from the investor.
From a retail buyer you may get more because they may put more emphasis on those um specific design type features but if retail buyers are going to be less present in the market it may be a speculative risk for you as a general contractor to build homes with those upgraded interior finishes also floor plan sizes. A retail buyer is going to want a bigger home you know in the 2,000 square foot range 1800 1900 at least where rental home consumers yeah they may want the bigger space but as a rental they're going to be more comfortable with 11 12 1400 square feet maybe 1500 square feet because it's going to be bigger than an apartment anyways even if it was the same size as an apartment the fact that it's a detached single family home is the advantage that's the advantage they're looking at the size is equal to an apartment paying a little bit more to have a detached home and a single family form factor will be the thing that gets that rental demand up.
And you can back into the math to know what your investor buyer's looking at for math you know most of them have lines of credit in the three to four percent range right now and that may go up later this year so you can back into the math you know what the taxes are going to be you can get an estimate on insurance if there's hoa fees back into that math they probably have about a 10 percent management expense for the maintenance upgrade or maintenance repairs uh management fees some vacancy factor if you factor in 10 that's their cost basis and you can do the math accordingly and know what they're going to rent it for that's how you can back into your numbers of what the transaction price might be from a rental investor standpoint.
If you are an investor and you're looking to purchase homes to rent out as new homes you may find builders that are already building that way but you may want to contract with a particular builder to build two or three homes for you as rentals either in a an existing retail neighborhood or in infill lots or maybe one single parcel that's a small parcel that can be subdivided to fit three or four homes into it separate detached homes and if you work with the right kind of builder and tell them what you're looking to do there can be an economy of scale with septic or utilities with zero lot lines possibly if it's a rental property you can do zero lot lines a lot easier because the the end user demand isn't going to discount that type of plot of the floor plan on the lot as much as a retail buyer would so there's a lot of opportunities for everybody.
If you are a retail buyer and you're looking to buy a house to live in consider this hidden secret invisible market that's taking up resources as another competitor and it might accelerate or make it more urgent to get into a home as soon as you can.