A UK government review into institutional residential investments will not tell the market anything it does not already know, says Shayla Walmsley.

Adrian Montague, 3i chairman and adviser to the UK government's nascent Green Investment Bank, has issued a call for evidence of how to encourage greater institutional investment in private-rented housing.

Montague has come at the task with two questions. First, has enough been done to encourage investment into housing with, for example, changes to regulations of real estate investment trusts (REITs)? Second, if not, what should the government be doing to make it better?

The Montague review, whose panel comprises industry leaders including Graham Burnett of the £33bn (€39bn) Universities Superannuation Scheme, is looking for "new evidence and fresh thinking". But what it really needs is a new residential market.

Investment Property Databank (IPD) estimates that institutional investors account for just £4.5bn of the UK's £840bn build-to-let sector. But these meagre allocations are perhaps less a reflection of the lack of investment will among institutions per se than a weakness in the current investment case.

The private rental sector is fragmented and is dominated by owner-occupiers and small landlords. UK residential comes in single assets and small lots, not institutional-scale portfolios. Touchstone Residential managing director John Midgley pointed to not only the time and cost, but the risk associated with building a sizeable portfolio piece by piece over time. This means there are insufficient suitable assets for pension funds to invest in.

Compare the private rented sector with social housing, which has long been a draw for UK pension schemes - despite low returns - not least because of its liability-matching potential. In fact, some social housing capital providers, including Aviva Investors, see the sub-asset class not as real estate but as a long-term cash-flow-generating alternative to gilts.

In contrast, total returns from private-rented residential investments are made up predominantly by capital growth, with the income component much smaller. IPD's newly launched UK residential index shows that the sector's 11.3% total return for 2011 owed a lot to a capital growth of 8.4%, while income was just 2.9%.

Just this week, Development Securities sold a development site in Eastbourne with planning permission secured for a 21-unit social housing residential scheme. At the same time it, announced the sale of a residential plot with permission for the construction of a single residence.

The upshot is that new models are emerging to exploit likely investor appetite for private-rented residential. Among them is a £150m build-to-let fund announced last year as a joint venture between UK property firm Grainger and French construction firm Bouygues. Under the terms of the partnership, Bouygues will build the assets and Grainger will provide the capital for developments on sites already acquired.

Although this model might address some of the problems around institutional investment in the sector, a couple of caveats are in order.

First, developing new assets is an expensive and risky proposition. David Toplas, CEO at Mill Group, said his firm had invested in both existing assets and development, not least because it would be less constrained by local planning rules that require developers to build infrastructure along with new housing - a potentially significant dent (along with planning permission recently significantly down as a result of uncertainty over upcoming changes to the rules) in the economic case for development.

Second, the Grainger-Bouygues fund is predicated on what the partners believe is a long-term demographic trend away from how homeownership towards renting. According to Andrew Cunningham, CEO at Grainger, the private-rented sector could make up 30% of the London market within five years.

The question is whether this perceived shift is a long-term trend at all. Cultural trends tend not to change particularly quickly, and it could equally be a short-term response to tougher mortgage conditions. Mill Group's Investors in Housing project, for example, is looking to plug the mortgage gap with a model that implies continued appetite for home ownership.
On the other hand, if undersupply continues, high prices would exclude more people from (presumably preferred) owner-occupation. Chegwidden is more cautious than Cunningham and believes the rented sector is likely to make up 20% of the market.

Even if the market can get the investment model right, pension funds will be asking themselves what it is they are expected to invest in. In the same way that a 1960s concrete office block in Salford is not the same asset as the glass-and-steel HSBC headquarters in Canary Wharf, UK residential has granular prime and secondary markets. And, in most cases, macro factors are the determinants. International interest in residential, as in commercial, is focused on London. There is demand for homes pretty much nationwide; there is demand for residential investments only in economically active areas.

Still, broadly speaking, the industry has welcomed the review. The British Property Federation (BPF) described it as "a golden opportunity to articulate why residential investment could be an attractive asset class for institutions". The BPF's real estate policy director Ian Fletcher is a review panellist.