Wall Street Thinks U.S. Homes Are Overpriced

House hunters don’t need to be told that property is too expensive right now. But Wall Street has an idea by just how much.

The stock market is pricing portfolios of American homes at a hefty discount to what houses are changing hands for in the open market. Shares of single-family landlords Invitation Homes and American Homes 4 Rent are trading at 35% and 20% discounts to their net asset values, respectively, according to real-estate analytics firm Green Street. Invitation Homes’ stock has traded at a particularly large discount to NAV since interest rates began to rise in early 2022, but the gap has widened by 10 percentage points in the past year.

Put another way, while the average house in the metro areas where Invitation Homes owns its properties sells for $415,000 based on Green Street’s analysis of prevailing market values, the company’s share price implies that investors think $310,000 is more appropriate.

If a large and persistent gap opens up between the property values implied by publicly traded stocks and private markets, it can mean that a correction is on the way. In 2020, shareholders in listed office stocks priced in upheaval caused by the pandemic shift to remote working months before values started to tick down in private sales.

“Share prices are signaling that single-family-home prices are too high and are not sustainable,” says John Pawlowski, a managing director at Green Street. However, he points out that home values can remain disconnected in public and private markets for longer than for commercial real estate because prices are set by owner-occupiers rather than investors.

Wall Street landlords are notably quiet at the moment. In the third quarter of 2024, large institutional investors that already own more than 1,000 properties were behind just 0.3% of all U.S. home purchases, based on data from John Burns Research & Consulting. Strip out the second and third quarter of 2020, when Covid-19 lockdowns effectively froze housing transactions, and big investors’ home-purchasing activity has dropped to its lowest share in seven years.

Buying from the existing housing stock doesn’t make much financial sense to Wall Street right now. The average American home is valued at a roughly 4% cap rate, a measure of the annual net operating income a property could generate as a percentage of its market value. This is too expensive for big investors who need to buy at a 5%-to-6% cap rate to make an acceptable return, given how costly it has become to borrow.

Notably, landlords can’t make the math work, even though their cost of debt is slightly lower than a regular buyer. The rate on a 30-year mortgage for a consumer is 6.93% based on data from Freddie Mac, while a large housing investor can borrow at roughly 6.25%, according to industry professionals.

Ordinary buyers and investors have different priorities when sizing up a house purchase. An owner-occupier will focus on whether they can afford the monthly mortgage payment, rather than obsessing over cap rates. They might be willing to overpay if the house is in a good location and is the right long-term fit for them or their family.

It can be frustrating for institutional investors when house hunters bid prices up to irrational levels in tight markets, as is happening today. But sky-high valuations have a silver lining for landlords. Oddly, family homes have turned out to be a great hedge against higher interest rates, as the lock-in effect of ultralow in-place mortgages has protected valuations. And now is a great time for landlords to prune their portfolios and sell properties at near-record prices.

As the existing housing stock is so unaffordable, investors need to find other ways to grow their portfolios. Large players such as American Homes 4 Rent are building houses themselves, or buying newly constructed units directly from builders. This should be helpful for the undersupplied U.S. housing market.

There is also a small pool of properties that can be picked up at prices that make sense to investors. According to real-estate investor Amherst, around $12 billion of two-to-four-bedroom homes are currently listed for sale at a 5.75% cap rate. These properties are cheaper because they need work. But it might be more lucrative to patch them up than to build new ones, given it currently costs $200 a square foot on average to build a house compared to $20 to $30 a square foot to renovate.

Competition from deep-pocketed Wall Street buyers is the last thing pinched house hunters need at the moment. But it is worth asking what it would take to tempt the “smart money” back. Without further reductions to borrowing costs, or a big uptick in rents, a 10%-to-15% decline in U.S. home prices would be needed to turn big investors’ heads. That might be a good indicator of how much home buyers are overpaying in today’s market.