Description

Front Yard Residential (RESI)

PT: $12.50ps (+50%)

Front Yard Residential is a sub-scale SFR REIT (single family rental real estate investment trust), owning 15,000 houses, largely across the Southeast.  Less than two months ago, it was under contract to be taken private for $12.50 per share; in the wake of COVID, that deal blew up, and the stock fell by half.  However, the company received a material breakup fee, its assets are performing better than ever, and the would-be buyer now has a 6% toehold equity stake.  We expect RESI to be sold soon after financing conditions stabilize, for a price at or above where it was recently under contract.

The thesis has four key points: (1) RESI is an attractive business facing multiple tailwinds; (2) several parties have tried buying RESI over the past few years at prices much higher than the current; (3) RESI is worth MORE today than it was then; and (4) all stakeholders’ interests are aligned for RESI to be sold in the next 18 months.  Consider the following:

• SFR has institutionalized as an asset class – in the wake of the GFC/housing crash, many institutions rushed out to buy single family homes, with the idea that renting them would be a new institutional asset class. It’s been a bumpy road, but the vision has ultimately proven itself, with two major REITs (Blackstone-backed INVH & Wayne Hughes-backed AMH) and a number of large private portfolios.
• SFR requires local density/scale – to generate adequate returns, one needs local density (hundreds of homes in each sub-market) and a scaled platform (~25,000+ homes).  Otherwise, it’s much harder to keep occupancy consistently high, and repairs/maintenance become much more costly as one is forced to use outside contractors for even routine repairs.  RESI has good density in certain markets, but it has work to do in deciding which of its smaller markets to exit or densify in. More importantly, the 15,000-home platform is too small – overhead consumes nearly 1/3rd of the NOI for RESI, compared to ~10% for AMH/INVH.
• SFR benefits from demographic tailwinds – as millennials form families and have children, they have begun moving out of the cities in search of more space and better schools. Millennials are more comfortable renting than prior generations, and they are in a worse financial position to buy, often due to high student debt burdens. Simultaneously, limited supply and growing demand for the best school districts in attractive sunbelt cities have led to rental growth that exceeds most other types of real estate
• SFR is a COVID beneficiary – across the world, people are reconsidering the cost/benefits of urban living, with many deciding they would prefer a bit more space; this is providing an additional tailwind to an asset class that was already well-positioned.  In addition, performance so far has been strong: RESI recently reported 3.9% rental growth, an uplift in occupancy, and no deterioration in collections for April & May.  Trends have been strong across the space, which has led to AMH & INVH trading above NAV currently.
• Institutional Asset quality – there has been some criticism that RESI’s asset quality is too low; indeed, its average age and rent are below that of INVH/AMH (RESI @ $1300/mo, compared to $1650/mo @ AMH and $1850/mo @ INVH). However, there are other, privately held institutional portfolios with metrics more similar to RESI’s. Tricon (listed in Canada but their portfolio is in the US) has average rents of $1400/mo, though the difference between Tricon & RESI becomes even smaller when you go market-by-market. Our understanding is that privately held FirstKey Homes (Cerberus) is at an even lower price point. The lower quality should manifest in lower growth rates and higher CapEx burden (as a % of NOI), which is what we see. In our view, the important aspect is that they are not out-of-line with the broader institutional peer set, and the lower quality is priced in: at NAV, gross rental yields for INVH homes are sub-8%; they are below 8.5% for AMH and TCN CN; for RESI they are just under 10% (the stock is implying north of 11%)
• Private market value is 50% higher than the stock – earlier in 2020, RESI was under contract to be purchased by Amherst for $12.50 per share in cash. According to the merger proxy, there was another offer that wasn’t far behind (we have heard $12ps cash); there were seven first-round bids; and there have been multiple offers north of $12ps over the preceding couple of years.
• Private market bid is rational – we estimate NAV in the $12-15ps range, which is consistent with an undepreciated TBV of $10ps (plus a bit of market home price appreciation), as well as with an average home price of $160,000. More importantly, we think a strategic acquirer would be able to cut overhead by more than half, boost NOI margins a few points, and refinance the debt, leading to acquirer’s FCF of $1.00 per share. It’s worth also noting that a portfolio of this size – with a stable operating platform & on the cusp of reaching scale – is not easy to put together, and there is some additional value here for any financial buyer looking to enter the business & with the capital to scale it up.
• Self-help initiatives bearing fruit – RESI internalized its property management functions last year, which caused collections disruptions and led to weak operating results; results posted this year indicate that disruption is over, and operations are on a strong trend.
• RESI is worth more now than six months ago – when RESI was in its sales process last year, the disruptions caused by internalizing its property management functions were depressing results and likely lowered buyer interest (and bids). Additionally, RESI’s assets (and SFR in general) had not been tested in a recession yet; the last few months have proven the assets’ defensiveness and this evidence should increase buyer appetite. Finally, the Amherst termination fee brought in additional value (it was $1.00ps accretive to TBV) and took down leverage.
• Forced selling – there were a lot of arbs in the stock, and they have been a source of forced selling (at the same time, we have seen some insider buying in the wake of the deal break).
• Leverage is very high – RESI is ~70% levered, which is north of 15x EV/EBITDA, given the lack of scale. In our view, this is the largest risk in this investment, though it is mitigated by: (a) the big liquidity injection they just got from Amherst; (b) single family homes are one of the most easily financeable assets; (c) they have turned off the dividend, allowing them to build a bit more equity; and (d) the strong growth they have been reporting should also help bring this down.  FWIW, falling interest costs are a tailwind for levered FCF.
• Backstory & Governance are a mess (and that’s a good thing) – RESI has a pretty ugly backstory: it was formed by Bill Erbey (of Ocwen/Altisource infamy) to be a dividend-paying capital vehicle for buying nonperforming loans in the wake of the housing crash. There is plenty of useful backstory on the Erbey companies on VIC: OCN, ASPS, AAMC, RESI, and HLSS. When that model blew up, the plan shifted to convert these NPLs into SFR; this model also failed because the NPLs were generally attached to low-quality homes, and they had no local density (at least not in attractive places to live). Erbey then brought in the current team (led by George Ellison) to convert to a more traditional SFR model, which he has done: liquidating the NPLs and REOs and deploying the proceeds into portfolios of institutional quality SFRs with local density from Amherst, PIMCO, INVH, and others. There have also been a few costly activist defenses. A lot of value has been destroyed along the way, but that hit has been absorbed. Most of the historical entanglements have been resolved (there is still a $50mn termination fee due to Erbey-controlled AAMC), but it is clear that Erbey is now eager to move on. Many analysts that have covered the stock a long time are (justifiably) fatigued/jaded, which we believe to be a reason why the opportunity exists.
• Economic logic strongly supports a sale – RESI is a good business, and it would be attractive/accretive to many buyers looking to build scale in SFR. At the same time, with a sub-$500mn market cap and a sub-scale portfolio (plus a messy backstory and many burned investors/analysts), RESI makes no sense as a public REIT.  It’s worth much more to a buyer than it is to the public market.
• All stakeholders are ready to sell – There is some concern in the market that management (and general governance issues) is a barrier to a sale, but we think this is a false narrative. Management has generally taken the right steps towards cleaning up the business for sale over the past few years, including unwinding the toxic Altisource entanglements: (a) internalizing property management & terminating ASPS; (b) renegotiating the fee structure with AAMC; and (c) negotiating the ability to terminate AAMC at-will. Additionally, you have: (a) activist-appointed directors in place; (b) concentrated & engaged ownership (Erbey + Deer Park + Amherst now control ~30%) that are ready to move on; and (c) they already did sell the company!
  

Catalyst

• more good operating results
• resolution/break with AAMC
• sale