Almost a year after REITs' introduction in the UK, legislation on investment in residential property is still work in progress. Rupert Dickinson reports
During the past 30 years, total returns from UK residential property have outperformed those of other asset classes and there is still a strong argument that residential property remains relatively low risk, if only because of demographics and the rate of home formation arising out of trends that are extremely unlikely to reverse. Latest estimates suggest a need for at least 223,000 new units per year from 2004 to 2026, against current supply of about 160,000 units.
This soaring demand has led to a remarkable growth in the highly leveraged buy-to-let market. Total mortgage debt in the buy-to-let market has risen from £27bn (€39bn) in 2002 to £94.8bn, according to a February 2007 CML Market Briefing. Based on an average loan to value of around 70%, this equates to a buy-to-let market with a gross value of £135bn.
However, during this time mainstream or institutional investors have not followed the UK public and have shown a clear reluctance to invest in the residential market. They were driven from the market by draconian controls introduced between the 1960s and 1980s and cite reasons of scale, poor management and low income yield as reasons not to return. But as commercial property has become overheated and as investors follow the constant quest for exposure to new alternative sectors, residential is moving into their sights.
Residential offers a deeply liquid market with the possibility of adding value through management activity as well as the ability to finance efficiently through the debt markets. Residential ownership is an operational business and costs of management are higher than in the commercial sector because of the legal structure and the property's fragmented nature, and as a result net yields are lower. However, the smaller lot sizes diversify the risk and total returns have been and continue to be strong.
In January the UK REIT structure was introduced after years of discussion and lobbying and received whole-hearted support from investors and listed companies alike. But as with all such ventures it is impossible to make one size fit all.
The genesis of the UK REIT was the political desire to significantly alter the dynamics of the residential sector in terms of the current supply imbalance and also in the rented portion. It is truly a missed opportunity.
So what is the key problem? Underpinning UK REIT legislation is a strict reliance on rental income to determine the level of taxation and to set the gearing level. However, the return generated by residential property is only to a small extent net rental income, up to 4%, with capital appreciation contributing the rest. The low net rent is partly a function of the price of residential property in the market being set by the owner occupier, who is making a lifestyle investment, whereas in the commercial market the value is arrived at by professional investors capitalising the net rent. These investors find it hard to understand the high adjustment from gross to net rent in residential, which can be more than 30%.
This is because it it has to cover replacement of depreciating fixtures and fittings, maintenance costs, loss of rent through voids, property management costs, letting costs and other property related expenses, only some of which are passed on to the tenant in the commercial sector under an FRI lease. Consequently, for a residential operator to generate a comparable level of return it will, and usually does, have to use a combination of the net rent and gains on the sale of assets. If these gains are then taxed the residential operator finds itself at an immediate disadvantage to the commercial property REIT. In addition, the residential operator is at a further disadvantage from a gearing perspective because the interest cover is again predicated on the net rental income and disallows the gains from the sale of assets from the calculation. This means that the residential operator is unable to leverage shareholder equity to the same level as the commercial REIT.
If we consider some of the political requirements being placed on the sector, such as affordable housing and shared equity, all of which are based on the premise of making property affordable in both price and rental terms, then we would expect that lower rents and values will only compound the disadvantages referred to above and make the regime increasingly unattractive to residential operating companies.
If the government is truly serious about creating a successful and growing private rented sector it needs to support it as a viable alternative to social rented or shared equity housing. There needs to be a better understanding of the factors that drive investment in residential assets and an acknowledgment that investors who take a less speculative and longer-term view could be encouraged to look at alternative forms of tenure to support provision in the current housing sector.
The main issue is that the Assured Shorthold Tenancy Agreement does not provide any long-term comfort to tenants. Perhaps a new form of tenure should be introduced to provide longer-term security for tenants but not the full security of tenure provided by an assured tenancy. Fiscal incentives are required to encourage landlords to accept that tenants require more security to overcome the loss of flexibility and the understandable and justifiable valuation difference. An assured tenancy, while generally seen as a better long-term housing option, values a property at just 80% of vacant possession value.
I strongly believe that a publicly listed vehicle is the most effective way of creating the large-scale, professionally run residential market that addresses both the barriers to entry cited by investors and the political and social requirements of the country. Some relatively minor changes to REIT legislation could be made to enhance the prospects for UK residential REITs, including an alteration to the gearing restriction and distribution requirements.
I am convinced that the creation of such a large scale and professionally managed private rented residential property sector is critical in securing the housing market's long-term health. It is the catalyst for all other areas of development and innovation, and for attracting finance from the capital markets, institutions, individuals and overseas investors. But can policy makers be convinced that changes need to be made?
Rupert Dickinson is chief executive of Grainger plc