Up&Up: A Negative Feedback Loop (Repost of Oct 2020 Analysis)
The market has seen a proliferation of sometimes innovative, sometimes value-creating venture-backed home ownership models. This series aims to explore which firms create value for users, investors, and society. Why society? Most of these firms claim to advance a social mission. Whether the co-founders believe in the mission or it is simply useful as a non-pecuniary form of compensation to underpaid employees and a dimension along which to attract capital, the social aspect of the mission warrants evaluation.
This time we explore Up&Up Homes, another variation on the rent-to-own (RTO) model (see Divvy). Up&Up derives its name from the phrase “on the up-and-up,” defined as “an honest or respectable course,” presumably to distinguish it from the myriad of disreputable RTO operators. Up&Up states that its “…mission is to provide a more accessible, flexible, and fair way to build towards homeownership."
While Up&Up presents modest improvements to typical RTO transparency and alignment of interest flaws, it also introduces a new set of flaws in each category. In analyzing Divvy, we touched on the traditional RTO model, wherein a consumer has a choice of homes owned by an entity that then enables the renter to amass equity toward an eventual purchase. Such RTO platforms are incentivized to maximize the spread between acquisition cost and sale price to consumer, the consumer's share of costs while the consumer remains a renter, and fees. Whereas an ignoble RTO operator might offer a selection of homes it purchased at auction with physical or title issues it wishes to offload onto an unsuspecting renter, Up&Up purchases the home of the user's choice and sells it to the renter at fair market value, not attempting to earn a spread on its cost (beyond market appreciation) and taking initial home condition risk itself. In terms of cost shifting, Up&Up does harness users with greater responsibility for repairs & maintenance. Regarding fees, and how typical deal fees are split amongst user & Up&Up, this information is not articulated on Up&Up’s website. With Up&Up appearing to seek current cash flow as opposed to predicating returns purely on short-term appreciation of a levered position in an asset with 15% historical per annum volatility, it limits acquisitions to homes in key geographies, perhaps based on whether market rent exceeds estimated OPEX & financing costs (with the latter being controllable). With Up&Up on the hook to sell the home if the user declines to buy, it is strongly incentivized to thoroughly inspect the home for physical defects and ensure the acquisitions price is at or below market.
How it Works
As with Divvy, Up&Up is inherently focused on savings-constrained prospective buyers. In its relative infancy, Up&Up is focused exclusively on homes St. Louis and Atlanta (although its weblink to St. Louis points to inventory in Atlanta so perhaps only the latter). It plans to soon enter Los Angeles, Dallas, Charlotte, Phoenix, Raleigh, and Tampa. Aside from Los Angeles, these are low barriers to entry markets wherein housing prices should escalate at an inflationary pace on average, and the relationship of rent to the cost of ownership should remain roughly in balance over time.
In terms of mechanics, after prequalification, a user (“User”) may then select from Up&Up's pool of 10k "pre-vetted" homes or suggest others. Up&Up attempts to purchase the home after User signs a four-year-lease (noted as standard in How it Works). The FAQ page describes a 2 year lease with 3x1 year extensions as standard; I assume the former in my calcs. Note that there are several model unknowns not covered on Up&Up’s website. User contributes the equivalent of two months of market rent (1-2% of home value ==> 5-10% of equity at 80% leverage) worth of equity into the acquisition. The user may then contribute additional cash into its equity account on a monthly basis. According to Up&Up’s website:
"As a part-owner, you earn a share of the profit from rent every month (based on how much of the home your own). This profit converts to more ownership in the home, compounding your investment. If the house appreciates in value, you earn more! For example: if your rent is $1,000 and $800 of it goes to paying the mortgage + taxes + insurance, there is $200 of profit. You earn $200 x (your ownership %)." — Up&Up
This is where deal economics begin to diverge from rationality. The above calc roughly describes levered net cash flow (NCF). It omits repairs and maintenance (R&M) and asset preservation capital (capex), with each party presumably funding its own administrative and management costs. In terms of R&M and capex, Up&Up encourages users to pay it themselves instead of paying their pro rata share by having Up&Up cover it and allowing it to flow through the monthly profit calculation (e.g. it encourages users to pay a $200 plumbing bill out-of-pocket when their pro rata share may be $10-20). Worse, the levered NCF saved by the user’s sacrificial R&M work is then freed up to pay Up&Up’s financing costs, benefitting Up&Up alone, since User’s appreciation is based on the percent increase in the home’s value, not the percent increase in the equity position.
**Presumably the exclamation mark means the user should be excited about its equity appreciating at less than 1/5th the rate of Up&Up’s equity (assuming 80% leverage). More generally, Up&Up’s equity appreciates at more than ((Equity+Debt)/Equity) * User’s_Appreciation_Rate; greater than 5x the user’s stake in the case of 80% leverage, 4x in the case of 75% leverage, etc.
The top and bottom charts tell the story best: The gross appreciation Up&Up’s position enjoys is subsidized by the tepid appreciation of the user. Unless appreciation is very strong, Up&Up is unlikely to be a user’s best alternative for amassing a down payment.
Assumptions
(1) The user only contributes equity at time zero, with monthly profit also being on average zero (likely the case in LA even if Up&Up doesn’t take an amortizing loan to ensure it).
(2) We assume the mortgage is interest only. If it wasn’t, User's monthly payments would subsidize Up&Up's position to an even greater extent, in that User does not participate in gains from principal paydown. We also assume home appreciates at 3%/annum and that the mortgage funds 80% of the purchase, with User contributing 10% of the equity.
(3) User's returns are governed by asset-level appreciation, despite it paying its pro rata share of the cost of debt.
That’s right, the user’s equity stake subsidizes Up&Up’s stake (see charts). This is despite the user paying its pro rata share of the mortgage payment with its rent and receiving profit participation that is net of the mortgage payment. User's pro rata share of levered NCF depends on how much leverage Up&Up takes on and whether it obtains an amortizing loan, in which case User’s contribution toward principal payments would serve to pay down the mortgage balance, with the user not participating in equity created thereby a wealth transfer from User to Up&Up). For example, say the user and Up&Up buy a home for $100 with an $80 amortizing mortgage and Up&Up contributing $18 of the $20 of equity. If the home value increases to $105 while amortization reduces the loan balance to $75, the user’s $2 equity stake increases by 5% per home value appreciation, while Up&Up’s $18 equity stake expands by 55% to $105 - $75 - $2*1.05 = $27.9! Ten percent of the $5 in principal paydown was funded by the user; this $0.50 would have meant an incremental 25% appreciation on the user’s $2 equity stake. Up&Up is strongly incentivized to obtain a mortgage that, through amortization and loan size, minimizes levered NCF. In this way Up&Up could capture what would otherwise be user profit.
At any point the user can can convert its appreciated ownership stake into a down payment to buy the home it is renting or another Up&Up home at fair market value. After four years it could also redeem 90% of its appreciated ownership stake to invest elsewhere. It is unclear what other fees affect the user in the event it purchases an Up&Up home or redeems, but if the user has amassed a 10% equity stake in a home, then the 10% of this that the user would forfeit to redeem its equity (==> 1% of home value) is more than its pro rata share of the cost to sell the asset with a broker (±50bps), but not unreasonably so. The user has control over whether it declines to purchase, especially in the case wherein it selected a home outside Up&Up’s pre-vetted pool. Regardless, it seems fair that Up&Up should have the ability to defend the profitability it derives from home appreciation against User's whims, particularly if its pre-vetting process did not miss a material flaw. If User doesn't buy, it could cost Up&Up a 5-6% brokerage fee if it isn't able to move the inventory to another user or using Redfin.
Value for Users
I’m not inherently opposed to RTO. The “friends-helping-friends” deal that CEO Michael Wong cites sounds fair to me. The renter is paying market rent, and is sharing landlord responsibilities pro rata with its capital partner. The renter is incentivized to maintain the home well, which is good for everyone, and costs and returns are split according to capital contributions. In Michael’s words:
“Because our splits were based on our down payments and rents were defined by the market, we both knew this was a fair deal among friends.” — Michael Wong, CEO
Its possible that I’m being too hard on Up&Up, but the above is distinctly not what it offers. Its true that there are unknowns regarding Up&Up’s model; if they are uniformly structured in favor of the user, its possible that the model could on balance present a fair (yet unnecessarily complex) deal. E.g., I’ve been assuming transaction costs are shared pro rata amongst the participants, but its possible that Up&Up pays them all, offsetting the prohibitive economics mentioned above. Its possible that by offering the user unlevered returns on its equity, it is really just trying to minimize the user’s volatility exposure and didn’t recognize the incongruence of harnessing the user with debt service only for it to earn unlevered returns on equity. Further, just because Up&Up could increase amortization and leverage to appropriate User’s pro rata monthly profit to pay its debt service doesn’t mean that it will. Its possible that Up&Up’s analytics team was unable to translate the “friends-helping-friends” archetype into a template without introducing distortions that happen to disadvantage the user.
The point of RTO is to accrue savings / equity towards ownership. Its somewhat predicated on the (flawed) idea that home ownership presents the best investment vehicle for building wealth. If homeownership as an investment does make sense, it is less likely to in this form. Per the charts above, earning +/-3% appreciation per annum on SFR equity plus a pro rata share of whatever monthly levered NCF remains will not decisively impact user wealth. If a user signs up with 10% of the down payment to invest in a home (presuming this equates to 2 months rent), it would have to invest the equivalent of an additional 4 months of rent at the end of every year of its 4 year lease to save up enough to put 20% down. What percentage of prospective users have sufficient income do so? For those that do, how are they better off investing at such a low rate of return instead of in a 60/40 portfolio or in INVH, wherein they can at least receive their rightful levered returns?
There are positive aspects to the Up&Up model. Users can test drive before they buy, derisking the purchase (User learns the home’s subjective shortcomings and capital needs). While User has to lease for 4 years and forfeit 10% of its equity in the event it doesn’t find a more satisfying alternative on Up&Up, that is still better than paying 7-8% of the home’s value to sell it after learning the hard way. That said, User could achieve much of this conventionally at lower cost. Secondly, users can earn a return on their security deposit. If the user received its pro rata return on equity instead of being forced to subsidize Up&Up’s position, or the user’s only alternative was to lock up 2 months rent elsewhere (most institutional landlords require ≤ 1 month), then this dimension would be more meaningful.
Whether Up&Up can build volume with strong marketing and a veneer of “friends-helping-friends”, without above-trend SFR appreciation over the next four years, its initial cohorts will likely disproportionately fail to be able to afford to purchase, which will constrain its growth. It puzzles me that Up&Up forces users to subsidize its returns when with users only providing 5-10% of the equity, this subsidy 1), can’t move the needle for Up&Up’s much larger stake and 2) ensures users will fail to amass wealth thus killing the product’s long term viability. Why build in model incongruity of this sort that contravenes one’s mission for so little short-term gain?
Value for Investors
The above are expected unlevered returns for a condo located at 12773 Caswell Ave in LA, as if owned by INVH (black) or Up&Up (blue). Increasing returns over first few years of hold period are attributable to the amortization of transaction costs over more years. I’ve highlighted the higher probability outcomes in each table, with INVH holding longer term, Up&Up holding the length of its lease, and appreciation between 3-4%. While comparing unlevered returns allows us to focus on the fundamentals, I grant that it overlooks Up&Up’s asymmetric structuring with the user (see text for why I’m okay with this).
Rents: Based on new apartment product of equivalent size on neighboring block.
OPEX: Based on INVH's 2Q'20 costs as a % of revenue. R&M also reflects interior hallways using input from high density apartment OPEX (from Rampart Ridge). With Up&Up we assume a generous $2,500 reduction in OPEX and replacement reserves (user care & DIY, however irrational).
Transaction Costs: We assume 6% brokerage fees for INVH and 2% for Up&Up (inferring a 66% chance of avoiding brokerage by selling to a user).
If Up&Up’s “friends-helping-friends” deal structure prototype is fair, the product it offers consumers is markedly better for PropCo investors at the expense of consumers. The sole sources of incremental (unlevered) returns to this model over that of long term SFR investors like INVH, are that R&M and capex could be lower, users might be willing to slightly overpay for the home rather than forfeit any equity they have amassed, and that brokerage fees would be 0% when exiting to a user (assuming it can achieve this 2/3 of the time ==> 4% reduction in fees). It doesn’t seem worth the ethical compromise of telling users they are better off self-funding repairs when basic math says it isn’t (pay $100 to save $10 in monthly profit ==> -$90), but I’ll assume users comply. I won’t attempt to quantify the margin by which users might overpay at exit (too speculative). Modeling SFR economics based on INVH’s OPEX (INVH 2Q’20 Earnings Release and Supplemental) and a condo currently listed in LA, if Up&Up can spend $2,500/home/year less on R&M and replacement reserves (an aggressive assumption) and if expected brokerage fees on exit = 2%, that could boost Up&Up’s deal-level unlevered IRR to approximate parity with my estimate for the home under INVH’s ownership.
Achieving return parity as an upside case, for a model that presents greater operational risk, may not be good enough for prospective PropCo LPs. Its true that comparing unlevered returns overlooks Up&Up’s asymmetric structuring with the user (user pays debt service but doesn’t receive levered returns or benefit from principal paydown). While this structuring could improve Up&Up’s levered returns derived from appreciation by ≈10%, I’m okay overlooking it as I believe the artful structuring is unsustainable if Up&Up is to drive user growth or enjoy the 0% brokerage fees it can only access when it exits to users that have amassed down payments. It can’t have low expected brokerage fees and user-subsidized returns.
In terms of risks to Up&Up delivering, users might not buy their homes because they cannot amass the equity while subsidizing Up&Up. Up&Up will likely fail to reduce R&M as markedly; $2,500 is an aggressive number that drives R&M to zero and reduces reserves also. Lastly its start-up execution likely won’t be as tight as that of a stabilized public company. The countervailing advantages to INVH, including the ability to purchase with greater precision, exit based on market conditions, and operating precision / scale economies, render it a superior way to obtain SFR sector exposure.
Value for Society
Does Up&Up create value for society? Unless it does so as a positive externality, this firstly depends on whether Up&Up’s mission is virtuous. While Up&Up’s mission statement focuses more on “building toward homeownership” than elevating homeownership as financially superior, its “about” page does the latter (about which I expressed my opinion in Divvy). Does Up&Up live up to its mission and name? I think it fails in terms of model fairness (in stark contrast to its “friends-helping-friends” genesis), transparency, and efficacy.
I would have difficulty asserting that Up&Up presents positive social impact. As with Divvy, there is a narrow use case wherein Up&Up could, e.g, allow a family to live in a school district with good schools but no rental product. In that case Up&Up could solve the location issue but only while presenting a bridge to homeownership that the user will likely fail to fully cross. One is better off renting conventionally and investing savings in other asset classes.
Conclusion
Up&Up derives from the classic “rent-to-own” model. While it presents modest improvements to RTO transparency and alignment of interest flaws, it introduces a new set of creatively devised flaws in each category. Its product falls short of the fair deal archetype to which it aspires. Worse, it’s utilizing of user capital to subsidize its own returns renders it improbable that Up&Up’s initial cohorts of users will manage to amass down payments, creating a negative feedback loop that should 1), inhibit user growth perhaps more so than does the narrowness of the set of prospective users for whom it offers a value-creating solution and 2), destroy its PropCo’s economics by forcing it to incur brokerage fees in selling homes. Thus, I believe it will struggle to convince PropCo LPs that it can offer more favorable risk-adjusted returns than those available through publicly-traded SFR operators like INVH.
Unknowns
Whether User and Up&Up are responsible for their pro rata share of transaction costs / fees
Whether rents in the 4 year lease mark-to-market annually or involve fixed bumps or other terms that advantage either party
Whether asset level or financing related transaction costs or fees are charged to the user
User doesn't mandatorily come out of pocket for "unexpected R&M,” but by omission, Up&Up implies user is expected to fund recurring R&M. It is clear that Up&Up wants to deceive the user into believing its in the user’s best interest to pay 100% of a repair job instead of reporting it to Up&Up paying its pro rata share.
Whether Up&Up earns fees from partner lenders on exit.
What happens if market rent descends below the mortgage PMT? This is only likely if the 4 year term has mark-to-market resets, if repairs and maintenance is high and the user is rightly charging it to the joint ownership structure and/or if Up&Up maximized leverage and amortization.
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