Guest view: ​Three questions DC schemes should ask when allocating to housing

UK pension funds are increasingly turning to housing as they seek to align with government efforts to unlock up to £25bn (€29.4bn) in defined contribution (DC) capital for investment in UK private markets by 2030. 

Much has been written about how housing and social housing allows pension schemes to help tackle a growing societal issue — the lack of access to high-quality affordable homes – and achieve their social and carbon targets. Importantly, our findings show that these benefits do not detract from expected financial outcomes — housing offers stable and diversified inflation-linked returns within a real estate allocation.

However, housing is not a homogenous asset class and there is wide variation across the sector as increasing numbers of investment managers have entered the space. We believe DC investors weighing an allocation should ask three key questions to ensure they make the right investment for their scheme.

1. How does the manager decide where to invest?

Since 2013, residential rental growth has averaged 4.7% per annum, almost 2% above CPI1 – a major reason for its appeal. However, a broad dispersion of financial outcomes lies beneath that headline result. 

For investors seeking to make an allocation to housing, it is therefore essential to understand a manager’s underwriting criteria. What is driving the rental growth in the areas in which the manager invests? Why did they choose those areas? How do they ensure that rental income is sustainable? 

An understanding of the local housing market must also be factored in. As rents have risen, managers must reassess where they look to deploy capital. This process is essential for schemes to understand, as lax investment decisions will likely have a material impact on returns. To deliver effectively for investors, managers need to excel with big data, analytics and qualitative research, as it increasingly holds the key to effective capital deployment.

This analysis also extends to social housing, and a need to understand the dynamics of the local housing market.

Despite the substantial need for social housing, the underlying rental markets determine if rents will remain affordable in the long term. Trustees should recognise that social housing is not immune from the dynamics in the broader housing markets. If you are a long-term investor and inflation is rising faster than underlying rental growth, in these terms the value of your asset is declining.

In social housing, the value of the asset stems from its affordability relative to the market. If that asset starts to become less affordable relative to the market, its value both as a financial asset and social good starts to diminish. Location matters. Questions ranging from “how long a property is typically on the market?” to “how many times the price is reduced on average?” or “how elastic is a market?” must inform the investment making process.

2. How is proper governance ensured?

While financial considerations are essential to DC investors, good governance is equally paramount. In recent months, high-profile incidents of poor governance in the affordable and supported housing sectors have come to light, underscoring the importance of ensuring managers have robust governance structures in place.

We suggest DC investors take a number of steps as part of their due diligence process. 

First, they should look at the composition of the board. If it lacks the heft trustees might expect, it could suggest doubts about the strength of the manager’s model.

Second, they should consider the stakeholder partners. For example, a credible social housing manager should have a track record of working with large institutional housing associations. If they do not, trustees should ask why.

Third, they should explore how committed the manager really is to social and environmental impact. Most managers make similar claims. But it is important for trustees to satisfy themselves that the manager does not view residential or social housing as just another asset class. One way to tell is whether they have a properly audited independent impact framework where investors highlight both their successes and areas of improvement.

Fourth, how transparent is the manager about social outcomes? This can vary. If a manager has an impact assessment, who conducts it? Is it the manager or an independent third party? If it is the latter, who pays them? Does the manager have any editorial control over it?

In our view, schemes should pay as much attention to the social audit as the financial audit.

3. Does the manager have sufficient scale? 

Residential and social housing is a relatively new sector. This comparative lack of maturity relative to other real estate asset classes means there are some players with limited assets under management.

While that is not a concern per se, DC investors will be committing capital over the long term and need to be sure that the manager will still be around in and over the long term.

Large asset managers automatically offer this reassurance. But if the manager’s residential funds are subscale, trustees have a new risk factor to consider, which is the manager’s ability to raise additional capital.

Broadly speaking, we think managers need over five hundred million pounds of assets under management for the economies of scale to work. If they manage less than this, their long-term viability may depend on them raising more money. Not everyone can, or will, do this.

As the market evolves, we anticipate consolidation within the residential sector will result in a handful of winners, which will be those who can provide the most robust investment and management processes needed to deliver successful projects. 

Residential housing and social housing can be a compelling investment for schemes seeking to make attractive financial returns while helping to tackle a growing societal issue. But they should ensure they choose the right manager to make the most of their allocation.

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