Institutional interest in UK housing seems finally to be translating into investment. Will 2013 be the year the sector takes off? Maha Khan Phillips reports
Back in January, the €325bn Dutch pension asset manager APG demonstrated its commitment to the UK residential property market. It acquired part of a £350m portfolio, alongside listed property company Grainger. APG is making an investment of £158m (€183m) in GRIP, a UK market-rented residential property fund established and managed by Grainger. Grainger will co-invest £59m.
The acquisition comes at a time when many pension schemes say they are considering investing in the sector. Grainger will be seeking additional equity from one or two other “like-minded institutional investors” to grow the fund further. Although the firm has had interest from several UK pension funds, as yet no commitments have been made, primarily, it says, because the timing did not work out.
For many UK institutional investors though, UK residential is problematic. Part of the issue is cultural. Another is more structural. “The barriers to entry are huge,” says Duncan Owen, head of property funds at Schroders, which has invested in residential on a limited scale in the past. “Simply put, over 90% of what Schroders have done and what other institutional real estate fund managers have done is commercial property, because amassing a meaningful portfolio in terms of liquidity is difficult.”
To date, the vast majority of UK institutions have shunned the residential market, with most acquisitions coming from foreign institutions and sovereign wealth funds. Last year, Dutch pension fund asset manager PGGM acquired a majority stake in UPP, provider of student homes and infrastructure at campuses in the UK. Qatari Diar, the real estate development and investment arm of the government of Qatar, has been a significant player for some years via joint ventures in large projects such as Chelsea Barracks and the Olympic East Village.
In a number of European countries, 10-15% of institutions’ overall investment in real estate is in residential property, with the Netherlands and Switzerland, where close to half of all real estate investment is in housing, leading the pack. This is in sharp contrast to the UK where less than 1% of institutions’ real estate investment is in the residential sector, according to a 2011 report from Resolution Foundation.
Countries where institutional investment in residential property is strong tend to have relatively large rental markets, according to the report. In Switzerland and Germany, private-rental housing makes up approximately 50% of overall housing stock. Rents in several countries are also regulated, creating transparency and certainty for investors and tenants. In the UK, individual-owned property has been a cultural norm for some decades now. Institutions, which left the residential market in the 1980s, were keen to return, but were crowded out by smaller investors when buy-to-let mortgages became more available.
The number of buy-to-let mortgages increased tenfold between 2000 and 2007, with the buy-to-let mortgage market worth approximately £122bn in 2010, according to the report.
“Residential is already an established real estate investment medium in Asia, the US, and part of Europe. It is more in their life blood,” Owen says.
In August last year, The Montague Review, commissioned by the government to look at the barriers into institutional investment in private-rented housing, warned of an undersupply of large-scale projects and said there was a need for greater confidence among investors in the ability of good projects to show acceptable secure returns.
Therein lies the rub. “The institutions have always seen the UK residential market as very fragmented,” says John Midgely, managing director at Touchstone Residential. “They have also felt that there are not many managers out there. Historically, the big boys have not gotten involved in residential because it is far too detailed and fragmented for them. You might have a portfolio of 2,000 properties, meaning 2,000 families who might leave or have issues.”
Scale is also an issue, he explains. “The idea that an institution can come into the sector and suddenly find two, three or four thousand houses to add to a portfolio is whistling in the wind.”
Another challenge is the actual cost of capital. “Pension funds have a cost of capital to focus on. Residential property has a high gross yield of around 5%, which can compare to commercial property, but when you net it down with all the management charges and management aggravation you get a very low net distribution,” says Kiran Patel, CIO of Cordea Savills.
Research from Investment Property Databank (IPD), however, suggests something different. Using comparative management cost analysis, the firm argues the residential sector has maintained a large proportion of rent after management costs, more than previously supposed (70%, compared with 73% for offices and 79% for industrial). At the time of writing, IPD was due to publish its full-year index for 2012.
According to a report, ‘Bringing Home Residential Investment’ by law firm Berwin Leighton Paisner, investors will remain cautious about the sector until they are given more evidence that the right returns can be generated on investment. They want to see greater confidence in the willingness and ability of registered providers to develop and manage private rented properties. They also want clearer support from the government to drive investment. This caution, the firm suggests, means that foreign institutional investors, often with more experience of the rented sector in their own markets, are gaining first-mover advantage.
But despite the barriers to entry, the tide is slowly turning. Pension funds need a steady stream of income to match liabilities and the residential market is performing well. UK residential assets continued to outperform commercial property in the first half of 2012, although growth was driven predominately by demand for London stock, according to IPD.
Total return for the first half of the year was 3.1%, against the 1.2% delivered by commercial real estate. Capital growth, which fell in the first six months of the year in the commercial sector, remained positive overall for residential assets, at 1.1%.
IPD says that strong growth in rental values continued to fuel returns as mortgage finance availability and a limited development pipeline, a result of the UK government’s construction cuts, continued to drive demand for the private-rented sector. Residential rents rose by 13.6% over the previous two and a half years, although the market is very polarised between central London, South East, and the rest of the country.
Investors are keen to make allocations, particularly in the build-to-rent market in London.
In August and September 2012, on the back of the Montague report, a survey by property and finance firm the Mill Group of 27 major UK investors revealed that they like residential’s lower correlation with other asset classes. Most see the appeal of investing in residential on a longer-term basis of 10 years-plus. If the right channel were offered today, the 27 institutions would be willing to invest up to £1.25bn in UK residential as a first step, with a majority suggesting over £20m each as acceptable, and a quarter suggesting £50-100m as the way forward. They prefer direct investment options, especially joint ventures, seemingly to spread the risk. Contrary to popular belief, investors were happy to take on measured development risk; 50% saw their optimal investment point into a new-build rental scheme without a brick being laid, but only as part of a balanced portfolio of other types of residential holdings.
“Institutional appetite has definitely improved in the last 12 months from foreign institutions but also from institutional investors in the UK,” says David Toplas, CEO of the Mill Group.
“UK investors have taken time to commit to this market, but most of the investment houses have identified teams that are looking at the best ways in.”
In the wake of the Montague report, the government is trying to develop market opportunities. In September 2012 it introduced a series of measures including £200m state investment in new rental homes. It plans to give a guarantee of up to £10bn for new homes and £40bn for major infrastructure projects. It is also looking at proposals to promote conversion of offices into residential, something that fund managers say is happening anyway, fuelled by high demand for rentals, and it is looking at fast tracking thousands of residential and commercial projects, and bringing management bodies and institutional investors together to broker more deals and bring more rental homes to the market.
“There’s a real political will by the government to help create the market,” explains Laure Duhot, director, strategic capital markets for Grainger. The firm is working with builders and local authorities, trying to produce land at lower cost and building to rent, rather than sale. “We have some models that are being invented as we speak and are being explored,” notes Duhot. She says the UK residential market is “ripe for innovative thinking”. She cites the example of Grainger’s partnership with the London Borough of Kensington and Chelsea, which wanted to create a sustainable lasting income stream from its land holdings. Rather than sell the land, it decided to turn it into high quality rental assets, addressing the local area’s housing needs.
Patel says the build-to-rent proposals are being discussed across the industry. “Rather than have build-to-sell planning permissions, you have built-to-let planning permission. The developer builds it but has to find the investor outright who will own it, and will get the cards in place to make sure it’s managed.”
Adam Challis, head of residential research at Jones Lang LaSalle, believes government support has been extremely important and that the next 12 months will be key. “Over the past five years there has been a lot of rhetoric and even innovation in the sector, but very little has materialised into real pounds and pence being spent on property,” he says. “I think 2013 is actually the year where the conversation turns into genuine activity. We are at a watershed moment. On a fundamental level, it is about the evolving nature of the UK private-rental market from a demand perspective. There is government support, and some legislative changes. So the wagons are circling and a number of different elements are coming together to create an attractive investment environment for institutions as long as they can find stock at the right yields.”
So change is coming, but it is not as rapid as some industry participants would like. “This is a case of evolution rather than revolution. But more and more large-scale investment funds, people like Schroders, will invest in the residential market. It’s logical,” says Owen.