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The Rise of Build-to-Rent Homes: A Lucrative Investment and Housing Solution

Accruit
04/22/24
In this article, we'll discuss what build-to-rent homes are, why investors are increasingly drawn to this sector, and why more individuals are opting for rental living over traditional homeownership. Lastly, we will uncover if this sector is eligible for a 1031 tax deferred exchange. 
Build to rent homes 1031 exchange

In recent years, the real estate landscape has witnessed a notable shift in housing preferences and investment strategies. One trend that has gained significant traction is the concept of build-to-rent homes. This model involves the construction of residential properties specifically intended for rental purposes, rather than for sale to individual homeowners.  

What is a Build-to-Rent Home?  

Build-to-rent homes, often abbreviated as BTR, are purpose-built residential properties designed and constructed with the intention of being rented out to tenants rather than sold as individual units. Unlike traditional rental properties, which may consist of converted apartments or single-family homes once owned by a homeowner, build-to-rent developments are planned from the ground up to cater to the needs and preferences of today’s renters. 

These properties typically offer a range of amenities and communal facilities, such as fitness centers, swimming pools, coworking spaces, and communal gardens, aimed at enhancing the living experience for tenants. Additionally, build-to-rent communities often feature professional property management services to ensure tenants' needs are promptly addressed and the properties are well-maintained. 

Why Investors are Flocking to Build-to-Rent Homes 

For decades the approach for investors in the Single-Family Rental space was to purchase existing homes at a low price, make minimal improvements before renting the home out for a handful of years, after which time the home is ultimately sold. Today’s real estate market is proving that strategy to be very difficult, if not impossible. Due to a national housing shortage and high interest rates, the option for investors to buy existing single-family homes for a profitable investment are scarce. Therefore, many Single-Family Rental (SFR) investors are turning their sights and finite resources to Build-to-Rent homes.  

The growing popularity of build-to-rent homes among investors can be attributed to several key factors: 

Stability and Predictable Income Streams: Build-to-rent properties offer investors a reliable and steady stream of rental income, providing greater stability compared to other forms of real estate investment, such as flipping or speculative development. With long-term leases and a built-in demand for rental housing, investors can enjoy consistent cash flows and mitigate the risks associated with vacancy and market fluctuations. 

According to a report by Real Capital Analytics, investment in build-to-rent properties surged to a record high of $7.4 billion in the first half of 2023, representing a 43% increase compared to the same period the previous year. 

Favorable Market Dynamics: Changing demographics, evolving lifestyle preferences, and affordability constraints have fueled the demand for rental housing across various demographic segments, including millennials, young professionals, and empty nesters. Millennials are reaching a stage in life where they want a single-family home, but due to a lack of savings, high home prices and high interest rates, the desire for homeownership isn’t a reality – so they are turning to single-family rentals. As a result, build-to-rent developments are well-positioned to capitalize on this growing demand and achieve high occupancy rates. 

Data from the U.S. Census Bureau reveals that the homeownership rate in the United States declined to 64.5% in 2023, down from a peak of 69.2% in 2004, indicating a shift towards rental living. 

Scalability and Portfolio Diversification: Build-to-rent investments offer investors the opportunity to scale their portfolios efficiently by acquiring multiple properties within a single development or across different locations. The many aspects of property management are made easier if the properties are in proximity to others being rented out.  By diversifying their holdings across various markets, investors can spread risk and optimize their returns, particularly in markets with strong rental demand and favorable economic fundamentals. 

A study conducted by the Urban Land Institute (ULI) found that 72% of institutional investors surveyed viewed build-to-rent as a core or strategic part of their real estate portfolios, highlighting the sector's appeal for institutional capital deployment. 

Why Individuals are Embracing Build-to-Rent Living 

The appeal of build-to-rent homes extends beyond investors to tenants seeking flexible and hassle-free housing solutions. Several factors contribute to the growing interest in build-to-rent living among individuals: 

Flexibility and Lifestyle Benefits: Build-to-rent communities offer tenants greater flexibility and freedom compared to traditional homeownership. With shorter lease terms and the option to renew or relocate easily, renters can adapt to changing life circumstances without being tied down by mortgage obligations or property maintenance responsibilities. Tenants interested in getting a feel for a particular community before putting down roots through a purchase of a home can accomplish this without the significant commitment.  Others may not be able to afford a home in a certain area but feel the quality of the local school district is worth living in the particular BTR community. 

Research conducted by the National Multifamily Housing Council (NMHC) found that 79% of renters considered flexibility and the ability to relocate for job opportunities as important factors influencing their housing decisions. 

Access to High-Quality Amenities and Services: Build-to-rent developments prioritize the provision of premium amenities and services aimed at enhancing the quality of life for residents. From state-of-the-art fitness centers and resort-style pools to pet-friendly facilities and on-site concierge services, tenants can enjoy a resort-like living experience without the burden of homeownership. 

A survey conducted by Multifamily Executive magazine revealed that 67% of renters were willing to pay higher rents for access to desirable amenities and conveniences within build-to-rent communities. 

Affordability and Cost-Efficiency: In many markets, renting a build-to-rent home can offer cost advantages compared to purchasing a comparable property. With rising home prices and tightening mortgage lending standards, many individuals, particularly younger generations, find homeownership financially out of reach. Renting allows them to enjoy the benefits of homeownership, such as modern amenities and community living, at a fraction of the cost. 

Data from the Joint Center for Housing Studies of Harvard University indicates that the median renter household spent 20.7% of their income on housing in 2023, compared to 33.1% for homeowner households, highlighting the affordability advantage of renting for many households. 

Can Investors utilize a 1031 Exchange on Build-to-Rent Properties? 

This large strategy shift in Single Family Rental sector, brings up an interesting question – Are BTR homes eligible for a 1031 Exchange ? The answer is dependent on the fact pattern of each specific situation, but there are some general considerations.   

BTR Property as Relinquished Property  

Under Section 1031, an Exchange r must have acquired the subject property with the intent to use as an investment or for use in a business or trade.  It seems clear that Build-to-Rent properties as Relinquished Property are assets used in connection with the BTR company’s primary business, so this important threshold is met.   

BTR Property as Replacement Property  

In general, an investor can utilize a Build-to-Suit (BTS) 1031 Exchange to dispose of existing real estate properties and acquire new land and construct their Replacement Property, in this case Build-to-Rent properties, upon the land with their Exchange Funds.  However, this cannot be done in a straightforward manner, rather the transaction must be facilitated using a third-party accommodator. 

The issue presented when an Exchange wants to use the value of improvements to property as part of the Replacement Property value, is that without anything more, using proceeds to pay for labor and material is not equivalent to using funds to acquire like-kind property.  Due to this distinction, in in the year 2000, the IRS came out with Rev. Proc. 2000-37 to provide a “safe harbor” structure to accomplish the end goal of allowing the improvement value to be counted as part of the overall 1031 Exchange . 

In a nutshell, the Exchanger retains the services of a an “Exchange Accommodation Titleholder” or (“EAT”), which is typically also a Qualified Intermediary, who takes title to the Replacement Property(ies), in a BTS exchange it is the raw land.  The EAT will acquire the property via a new LLC under which it is the single member.  While in title, the desired improvements are made as directed and supervised by the Exchanger.  Once the improvements are done, or earlier depending upon applicable exchange rule deadlines, ownership of the property is handed over to the Exchanger directly.  With this legal sleight of hand, the Exchanger is deemed to have acquired real estate as improved rather than simply real estate plus the value of labor and materials, the latter of which would not otherwise be eligible for a 1031 Exchange . 

BTR Property as Replacement Property with Land Owned by Related Entity 

In situations where the Exchange r is acquiring the new land from a third party, the transaction can take place as described above.  However, at times the target land is held by a party deemed “related” to the taxpayer entity, i.e. held by an affiliate.  In this case, it makes the structure of a BTS Exchange property somewhat more complicated. 

Under certain IRS Related Party rules, an Exchange r cannot acquire land that is owned by the Related Party.  So, without more, should the EAT in the process described above acquire the property from an Exchange r Related Party and then transfer it to the Exchange r, it would not pass muster.  However, there are a series of IRS Private Letter Rulings that provide a possible way around the Related Party impediment. 

This technique entails having the EAT lease the property from the Related Party under a long-term lease.  The EAT then makes the improvements, in this case builds the homes, and as a legal matter, the improvements are owned by the EAT as lessee and not part of the underlying (fee) land ownership.  The homes are ultimately transferred to the Exchange r as Replacement Property via an assignment of the membership interest in the lease.  The acquisition does not run afoul of the Related Party rules since the property improvements are received entirely from the EAT and in no respect from the Related Party. 

BTR Property as Replacement Property with Land Owned by the Taxpayer 

In the event the target land is owned directly by the Exchange r, the structuring is even made more difficult since a Related Party does not exist with which to enter into the lease arrangement to separate the parties.  In this instance, it might be possible to change the ownership of the Replacement Property from the Exchange r to a Related Party to the Exchange r.  Once that is done, then the Leasehold Improvement Exchange as described above can be structured.   

It is important to note that the IRS does not allow the Related Party issue to be skirted as easily as simply changing the ownership to that of an affiliate.  Pursuant to IRS Rev. Proc. 2004-51, in order to recognize such a change of ownership, a period of more than 180 days must elapse before the Exchange r is not deemed to own the Replacement Property.  Any such change to the ownership of the Replacement Property, at the minimum, would require a passage of 180 days before an improvement process could be put into place.  It would be helpful as well for there to be independent business reasons supporting the change in ownership.  

 

In conclusion, Build-to-rent homes represent a compelling investment opportunity for real estate investors seeking stable income streams, portfolio diversification, and exposure to the growing demand for rental housing. Similarly, individuals are increasingly turning to build-to-rent living as a flexible, convenient, and cost-effective housing solution that aligns with their lifestyle preferences and financial realities. 

For real estate investors looking to enter the BTR sector, 1031 Exchange s, specifically Build-to-Suit possibly utilizing leasehold improvement structures, can be utilized to defer capital gains, depreciation recapture, state, and net investment income tax. Depending on the owner of the land in which the properties will be constructed, additional planning and due diligence may be required in order to be in accordance with 1031 Exchange rules and regulations.  

 

 

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified  Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.