By the Numbers
Weighing corporate debt against securitization for financing
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The two largest, public single-family rental operators have both recently tapped the corporate debt market for financing. Despite the single-family rental sector tracking toward a record year of new securitizations, some observers have speculated that more operators could start turning towards senior unsecured debt. The added flexibility of issuing unsecured debt comes at a cost, however, and its use will probably remain restricted to companies with investment grade ratings.
The financing challenge for REITs
Most single-family rental operators are structured as private or public REITs, restricting their ability to growth through retained earnings. REITs are required to distribute a minimum of 90% of their taxable income to shareholders. Growing a REIT nearly always requires tapping sources of outside financing. REITs can raise equity capital by selling more shares, through joint ventures or otherwise attracting outside investors. That process can be slow, expensive, and it dilutes ownership, so debt financing is often preferred.
Secured debt is typically cheaper financing
The asset-backed securities market often provides highly efficient funding. Lenders like collateral and generally will loan money at lower rates when the loan is secured by tangible assets. The higher quality and more liquid the assets, the better. Analysis of recovery rates by S&P Global Ratings shows that senior secured bonds have average nominal recovery rates of 66.9% and discounted recovery rates of 55.9%. Senior unsecured bonds have average recovery rates of 52.3% and 44.9%, respectively. The higher recovery rates for secured debt translates into lower credit risk, all else equal, and a lower cost of funds compared to unsecured debt for the same counterparty. In the event of default, if the liquidation of the assets is not enough to cover the claims of the senior secured debt holders, the residual claims are pari passu with those of the senior unsecured debt holders.
When properly structured, asset-backed securities can have a higher rating than the unsecured debt of the sponsor. A low investment grade or non-investment grade company can often finance high quality assets through asset-backed securitization at a much lower cost of funds than the company could achieve on an unsecured basis. Unfortunately, trying to get a clean apples-to-apples comparison between secured and unsecured debt is tough. SFR securities typically have some combination of prepayment risk, amortization, risk that the coupon may decline over time, substitution risk in the collateral, and extension risk in the loans that can drive yields above that of a plain vanilla, fixed-rate corporate bond—at least for a highly rated issuer.
SFR securitizations vs senior unsecured
When single-family rental securitizations were still in their infancy, American Homes 4 Rent issued a 10-year, fixed-rate securitization in October 2014 with classes rated from AAA to A- (Exhibit 1). Approximate spreads to the 10-year Treasury, which was trading just above 2.50% at pricing, ranged from 129 bp for the ‘AAA’ front cash flow A class to 373 bp for the ‘A-‘ E class. The debt had a weighted average interest rate of 4.42%. From 2014 through 2015, AMH issued four SFR deals with weighted average interest rates ranging from 4.14% to 4.42%.
Exhibit 1: SFR securitization of American Homes 4 Rent
Note: The AH4R deal priced on 9/10/2014 and has a maturity date of 10/9/2024. The 10-year Treasury was 2.50% and spreads assume the securities were issued at par.
Source: Bloomberg, Amherst Pierpont Securities
Since 2014, SFR spreads have tightened as the market has become deeper and more liquid, the 10-year Treasury is 125 bp lower and credit spreads are hovering near post-2007 lows. Strong fundamentals and strong earnings for the second quarter of 2021 for SFR REITs contributed to an excellent opportunity for American Homes 4 Rent and Invitation Homes to tap the corporate debt market (Exhibit 2) for very competitive financing.
Exhibit 2: Senior unsecured debt of American Homes 4 Rent
Note: In its annual report, AMH notes that they effectively hedged their 2028 notes to yield an interest rate of 4.08% instead of the stated coupon rate of 4.25%.
Source: Bloomberg, AMH 2020 Annual Report, Amherst Pierpont Securities
AMH (Baa3/BBB-) had issued 10-year senior unsecured debt twice before, in 2018 and 2019, at interest rates of 4.25% and 4.90%, which was 158 bp and 225 bp over the 10-year Treasury, respectively. Their June 10-year issue came at 110 bp over Treasuries, while INVH managed to tap the market in August when 10-year Treasury rates were 30 bp lower and managed a spread 10 bp tighter.
It is difficult to compare the AMH securitizations to its corporate debt precisely. AMH has not financed homes through the SFR securitization channel since 2015, and INVH’s last SFR deal was in October of 2018. Until last year, the home portfolios of both companies were not growing appreciably so there was no strong need for new financing. It is possible to get a ballpark idea of where a new deal might come. Progress Residential priced an SFR deal on July 22 that has a 7-year weighted average life (Exhibit 3).
Exhibit 3: Progress Residential SFR securitization (priced 7/22/2021)
Note: the pricing benchmark for all classes is the 7-year swap rate. The bonds were issued at par.
Source: Bloomberg, Amherst Pierpont Securities
The weighted average coupon for the offered classes is 2.32%, or 128 bp over the 7-year swap rate, which is equivalent to the ‘Baa3/A-‘ D class of the securitization. That 2.32% cost of funds for secured debt can be thought of as roughly in-line with the AMH 2.375% 10-year senior unsecured debt, which has a lower BBB- rating but lacks all the prepayment and other risks embedded in the SFR debt.
Unsecured debt provides more flexibility
Investors can weigh the additional yield of the SFR securities against the added risks of corporate debt from the operator when and if its available. But there is little overlap between buyers of secured and unsecured debt from the same entity.
The upside for issuers is that unsecured debt provides a tremendous amount of additional flexibility, especially around realizing gains in properties. SFR operators who want to refinance, sell or tap equity in their properties are restricted from doing so while the properties are held in the trust backing a securitization. Rules vary across deals, and some do allow for collateral substitution or prepayments, but those allowances are typically on the margin. An operator experiencing rapid home price appreciation cannot easily sell properties to finance growth if they are trapped in a pool.
Other advantages may also draw SFR sponsors. Longer-term debt also reduces refinancing risk for the assets. Build-to-rent initiatives also likely require equity or unsecured financing. And SFR securitizations only finance finished, stabilized properties, not homes under construction. Equity or unsecured financing can allow for growth until construction is complete and an operator can replace it with cheaper, secured funding.
Unsecured debt certainly has a place in the capital structure of SFR operators, especially ones with investment grade ratings that may be able to get low rates. The additional source of financing is likely to drive more growth and eventually lead to a stronger securitized market as opposed to cannibalize SFR.
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