Wall Street Enters the Bidding . . . & Wins
One of the ways to make a lot of money is to have a great idea, commercialize it, and reap the rewards. Another is to win the lottery. Yet another is to inherit. But often, the pathway to prosperity comes from investing in someone else’s idea or business model and reaping the rewards. Such is the case with private equity, which often invests in businesses, positions them for sale, and then generates what hopefully turns out to be a handsome return on equity.
As any introductory course on corporate finance points out, one of the other keys to generating outsized returns on equity is to leverage the investment. Using someone else’s money (e.g., a bank’s), can allow equity investors to utilize their fixed level of investable funds across more investments, thereby generating higher total rates of return.
However, when it becomes more expensive to leverage investments as interest rates rise, the model breaks down just a bit. Suddenly, using someone else’s money becomes less profitable. What’s more, would-be purchasers of businesses cannot bid as loftily given that their costs of financing have also risen.
Under such a scenario, private equity would find itself with available capital to invest, but less opportunity for dealmaking. If only there was a way to utilize currently available capital to purchase assets at such times to generate income, and then wait for the right moment to sell those assets to plough into the next set of commercial ventures along with accumulated income.
Enter America’s housing stock. During and after the global financial crisis (GFC) of roughly 16 years ago, mortgage standards tightened aggressively after a period of frenetic homebuilding in America. Housing inventories soared along with foreclosures as home prices dipped across the nation. But eventually, the housing market recovered. Meanwhile, homebuilders built far fewer homes during the GFC’s aftermath even as the Millennial generation, America’s largest, came of age. With the pandemic shrinking mortgage rates and Americans scrambling to upscale their lives through homeownership, inventories collapsed. Prices surged. A surplus of housing turned into a deficit of units in the millions.
Private equity noticed. Here was an opportunity to purchase homes (with cash, thereby avoiding high interest rates), rent them out for income, and then position themselves for sale when interest rates fell, home sales surged, and opportunities to leverage equity became more plentiful
And private equity went big. Capital-rich firms like Blackstone and Invitation Homes, armed in part with stimulus funds, proceeded to buy up large shares of available homes for sale in rapidly expanding communities. In markets like Atlanta, GA and Phoenix, AZ, institutional investors made up 32.0 and 31.7%, respectively of all single-family home purchases in 2022. In Charlotte, NC, the percentage was 31%.
In many instances, American households could simply not compete with the all-cash, no contingency offers put forth by private equity. Meanwhile, home prices surged as inventories shrank. In private equity havens like Austin, TX and Las Vegas, NV, home sales prices increased by double-digits over very short periods.
Would-be Millennial buyers along with others turned into long-term renters. Rents surged as demand for rental units expanded, layering onto the sizeable returns being generated by private equity. The oldest of the Millennials turns 44 this year according to a traditional definition of the generation, which means that many now have children and aspire toward homeownership. But many have been frustrated by a lack of inventory, high and rising prices, and by what they view as extremely high borrowing costs that can largely be avoided by cash-rich private investors.
In many instances, private investors are not renting out homes as apartments. The “Airbnb effect” has been in full swing, with many investors seeking even higher returns by turning to short-term rentals. According to an Axios article from May 2024, there were roughly 50,000 active listings from Airbnb and Vrbo in Arizona. Such activity further limits housing availability, helping to explain why the shelter component of the Consumer Price Index has continued to generate substantial inflation even as price increases in many other categories have faded.
In some instances, private investors have become developers. Companies like American Homes 4 Rent have focused upon developing build-to-rent (BTR) communities. These developments are primarily single-family homes constructed specifically to be utilized as rental properties. In cities like Phoenix, AZ and Nashville, TN, the BTR sector has expanded massively.
There are many economic implications beyond homeownership rates among younger households and inflation. With many households paying more for rent, they are less able to save for homeownership or for retirement. Moreover, many prospective younger buyers have missed out on a period of rapid home price appreciation, thereby compromising their lifetime’s wealth accumulation. According to the U.S. Census Bureau, America’s homeownership dipped further, to 65.7%, during 2023’s final quarter. Two decades ago, that figure stood at 69%. Meanwhile, private equity concerns have more than proportionately benefited from a period of rapid home price appreciation in America.
There is at least one other economic consideration. The extent to which housing is undersupplied nationally is less apparent under such circumstances. At some point, private equity concerns are likely to sell their residential holdings in large quantities as interest rates fall and traditional dealmaking opportunities become more plentiful. Is it conceivable that a surge of homes placed on the market for sale in those areas disproportionately home to institutional investment will suddenly experience bloated inventories of available homes and falling prices? Perhaps.
There are social considerations beyond the economic ones. For instance, homeownership results in greater interest in community outcomes. Homeowners likely have a greater stake in community outcomes since the value of a principal investment is implicated. But with homeownership diminished, social cohesion and shared community interest is at least potentially compromised.
Looking Ahead
Many observers have wondered whether institutional purchases of single-family housing stock should be outlawed. While such views are understandable, it is unclear how such policymaking would be operationalized. After all, there is nothing inherently wrong or illegal about purchasing a home, even if it to maximize profits as opposed to securing a stable environment in which to raise a family.