This is notwithstanding the relative property outperformance offered by the residential sector, where returns over the 10 years to end 2012 have averaged 9.3% pa; a better return than that from the main commercial asset classes and the all property index.
Difficulties in accessing the market
There are particular risks inherent to the private rented sector (PRS) that have traditionally proved a barrier to investment and deterred investors. One of the main obstacles is the investor’s ability to acquire a critical amount of stock in one location. Institutions do not want to buy a scattered portfolio of individual assets and prefer large developments, where they can minimise management costs and other overheads. But accessing this type of stock from developers can be difficult.
Another disincentive is the short term tenancies typical in the PRS. This might not be the barrier it seems for well-located properties that can be re-let easily; however, the income risk is greater than the commercial market, especially with the lower covenant strength offered. The costs involved in managing a residential portfolio are also disproportionately large relative to a commercial portfolio, as there are generally more, smaller, management-intensive tenancies to deal with.
Finally, while total returns have outstripped the main asset classes, the income portion of the return is much smaller for residential than for commercial assets. Consequently this puts pressure on the owner in terms of the management costs and an over-reliance on capital growth to achieve their desired level of return. This and the other reasons cited mean that institutions have generally preferred to leave the asset class alone, until now.
Institutional interest growing
Institutional interest in the residential sector has started to increase over the last 12-24 months. Investors like pension funds and insurance companies require long-term index-linked income to match their liabilities; however, the low yields in bond markets are not sufficient to achieve this. Therefore they are looking towards alternative asset classes, like property, which have the potential to provide this income profile. At a time when tenant demand in the PRS for longer term leases is growing because of demographic change and greater difficulties accessing mortgage finance, the residential sector in particular, is being cited as an area of opportunity for these investors.
Following the German example
In Germany where 60% of households are in rented stock, a mature, stable and well regulated rental market has developed. German residential tenants have a higher security of tenure than that enjoyed by those in the UK: contract lengths are often unlimited; there is a three month notice period for tenants; and rental levels and increases are governed by regulation. Therefore, residential investment is viewed as comparatively low risk. The majority of rental stock is still in the hands of private individuals (62%), but institutions play a major part in the market: they own 17% of the rented sector, which is equivalent to over four million dwellings.
Major market for residential investment in Germany
These differences explain why there is a substantial institutional investment market for German residential property. Figures show that total capital invested in 2012 was approximately €11bn (c. £9.3bn). Capital values for German residential property show a much higher degree of stability than in the UK and this, when combined with the size of the market and the depth of tenant demand for long term lets, makes the market an attractive option for long term investors.
Indeed, institutional demand for large residential blocks is such that a shortage of the most desirable assets in the traditional investment markets in West Germany has emerged. Investors are now looking to the larger cities like Berlin, Leipzig and Dresden in the former East Germany for investment opportunities.
UK renters in a growing minority
The overall proportion of households in the UK renting privately is still relatively low in comparison with Germany, although at 17% it grew from 12% of the total in 2001; a 40% increase over the ten years between the 2001 and 2011 censuses. Unsurprisingly, the majority of this increase was in London. The combination of high house prices, demographic changes and restrictions on mortgage availability mean that the percentage of London households in private rented accommodation increased from 17% to 25% during this time period, a figure that is higher than for the rest of England and Wales. In real terms this equates to an increase of 300,000 households. Similarly, there was an 80,000 increase in the number of households in social housing over the 10 years.
There are demographic factors which underline the reasons behind this growth in demand for private rented housing stock in London. Typically, the age-group mostly likely to rent is those in their mid twenties to mid thirties and London has a greater number of people in this age group than any other in England and Wales; they also make-up a greater proportion of London’s total population than in any other region. London also has more “multi-person” households than any other region of the country, i.e. more people living in flat-shares, the majority of which will be in the PRS.
Private rented sector increases in the regions
The move towards the rented sector is more pronounced in London but there was an increase in the proportion of households in private rented accommodation in the rest of England and Wales: all regions saw at least a 5% increase in households in the PRS between 2001 and 2011. While the decline in mortgage availability has affected the regional markets too, the gap between average income and average house prices is not as acute in the regions as it is in London.
Notwithstanding government schemes like ‘help to buy’, the large deposit required by mortgage lenders; the rising gap between average incomes and property prices; and a growing population, all mean we anticipate the growth in demand for private rented residential stock will be maintained. Bank of England data shows that despite increasing since the trough in 2008-09, mortgage approvals are still well below average and the difficulties in saving for a mortgage deposit and accessing finance are still the main barrier to home ownership throughout the UK.
Demand for social housing on the rise
Not only is demand from the PRS going to remain on the increase, there is a large amount of latent demand for social housing. Despite the fact that the percentage of households in England and Wales in social housing increased from 19% in 2001 to 23.5% in 2011, there remains a shortfall in provision and over 4.5m people are on the waiting list for social housing, an 80% increase over the last decade. Consequently we only see the demand for social housing continuing to increase too.
Increase in investor and tenant demand coincides
Investor demand for residential property, both socially-rented and private, is therefore increasing at a time when structural changes are taking place in the housing market and demand for long-term rented housing is on the increase. Therefore, if we believe that more households will be looking to rent on a semi-permanent basis, rather than as a stop-gap on the route to home ownership, then one of the main impediments to residential investment, the short term nature of the income stream, is removed.
Some investors have recognised this opportunity and are already starting to move into this space: Prupim completed the purchase of a portfolio of 534, mostly South East and London residential units from the Berkeley Group for £105m in April; while Legal and General are currently participating in the senior debt market for social housing; and others like Aviva have formed joint ventures with housing associations. Direct investment, with its associated risks, is therefore not the only route to market for the institutions interested in the residential market: debt, housing association bonds and joint ventures all provide other means of exposure.
While the UK will remain some way short of the German housing model and their 60:40 split between renters and owners, the likelihood is that the increase in demand for rented housing will be sustained and investors will look to profit from this shift by seeking greater exposure to residential property.