Crawthorne

Fund managers and property developers are ready to meet institutional investor demand for UK residential real estate. But investors are moving slowly, says Maha Khan Phillips.

In January, Legal & General Property announced that it plans to deliver 1,000 new homes in Crowthorne, on the site of the former Transport research Laboratory. “By investing long-term capital in housing and infrastructure, we believe Legal & general has an important role to play in helping to address the UK’s chronic housing shortage, and supporting its social fabric,” said nick Baker, fund manager. The firm also announced that it had received planning permission to convert an office building in stoke Poges into residential accommodation.

Also in January, Voltaire Financial, the real estate finance advisory firm, launched Voltaire equity, which will source equity from high-net-worth individuals, private family offices, and private equity real estate funds. The money will fund property developers that operate in the residential sector.

“Institutions are starting to understand the market dynamics much better”

Laure Duhot

Other deals are in the pipeline. Grainger, the UK’s largest listed residential property owner and manager, announced that it had planning permission from The royal Borough of Kensington and Chelsea to build 84 new homes in the borough, while Urban exposure and Letterone agreed to the joint funding of a super prime residential scheme in London. Meanwhile, Walls & Futures announced the launch of its London residential investment Fund ii. its predecessor is generating an unleveraged return of 27.6%.

Overseas companies have made their presence felt. Hong Kong-based real estate developer, the Peterson group, took a share in the London residential developer Hadley Property group, through a strategic joint venture with the global multi-family office, the LJ group. Peterson wanted to expand further into the London property market, it said, and Hadley will look to deploy £100m (€122m) of available equity into London residential development projects over the next two years.

APG, the Dutch pension asset manager has also got in on the action. Last year, it acquired a UK residential property portfolio along with Grainger. it has now formed a joint venture with property developer Delancey to deliver rental homes in large-scale clusters at strategic London locations. “This investment adds to APG’s existing London residential exposure and we have the ambition to grow them further,” said Robert-Jan Foortse, head of European property investments at APG. “At APG, we have prior experience with investments in regeneration sites in London, such as south Village, and we think they provide excellent investment opportunities, whilst simultaneously enhancing the area for the benefit of the local community.”

With all this market movement, it would be easy to assume that the UK residential sector is awash with institutional cash. But it isn’t.

“The difficulty has been pricing; that is the central issue”

Chris Urwin

“The housing market is the largest asset class in the entire market, at something like £4.5trn in value,” says Mark Weedon, head of UK alternative real estate at IPD. “But the large-scale professionally managed investment market is absolutely tiny. it is probably less than 1% of the market. The whole market is probably not worth more than £15bn. The vast majority of rental property is owned by private small buy-to-let investors.”

On paper, the UK residential market should be a good fit for institutions. “A lot of institutions, including ourselves, are taking an interest in the residential sector,” says Chris Urwin, global research manager, real estate at Aviva Investors. “Potentially, it is the source of very stable income, the type of income stream that is appealing to institutions.”

Rob Martin, director of research at Legal & General Property, says there are three dimensions to the rented residential sector that attracted the firm. “The first is prospective returns; they look very healthy compared to commercial property,” he says. “There is also a lower degree of income volatility in the residential sector. Thirdly, there is a diversification from the core commercial property sector which is very useful in any balanced fund.”

residential is also a long-term investment play. “investors are seeing the big picture and we are cumulatively short of about a million homes in the UK, there is a significant lack of supply,” says Ian Fletcher, director of policy, real estate, at the British Property Federation (BPF). “Institutions are looking at the longer-term picture of a country that has not delivered the housing that it needs.”

Residential property returned 8.9% in 2012, according to IPD, and 10.2% in the three years to the end of 2012 (the figures for 2013 were expected shortly after going to press). Over 10 years, it returned 8.5%, comfortably outperforming the commercial sector. Commercial property returned 3.4% in 2012, and 8.7% in the three years to the end of 2012. over 10 years, it returned 6.3%.

But for all the excitement, there are plenty of challenges for institutional investors. These have given many pause for thought. The first is the fragmented nature of the market. it is difficult to access stock which is in the hands of individual investors. “One of the things that has happened is that there has been a large growth of people buying extra properties to supplement pensions,” explains Andrew Pratt, senior adviser, UK residential, at Patrizia, the German real estate service provider and investor.

Patrizia expanded into the UK last year to build a residential investment proposition because it believed there was plenty of scope for growth. The firm is looking to build apartments and family houses, targeting cities where there are strong underlying local economies, excellent transport services, and lack of supply of rented property.

Pratt says it is early days for the market, though it has immense potential. “There have been few residential investment funds set up in the last 20 years. ironically, those that have been launched have been successful. But residential investment in the UK is still seen as a cottage industry.”

Another issue is that while performance has been high, income returns have not. “The difficulty has been pricing,” says Urwin. “To me, that is the central issue. The yield or income return that you get from residential is low, certainly the net yield. The amount of income you take relative to the capital value is quite low, and there are more costs associated with residential property as well.”

IPD data shows that commercial property has outperformed residential on income return. Residential property offered an income return of just 2.8% in 2012, whereas commercial property returned 5.8%. over the 10-year period, residential returned 3.3%, while commercial returned 5.9%.

Investors are concerned about development risk. With a lack of supply available, most of the growth in the residential sector will come through development. “There is a chicken-and-egg situation here,” says Alex Greaves, fund manager at M&G real estate, which has made multiple acquisitions in the last year, including a portfolio of 534 homes from the Berkeley group. “institutions are saying that they can’t invest because there isn’t any stock around, and that there is too much development risk. But if you are working with a developer with a strong balance sheet and reputation, then those risks fall away. When institutions are able to see the dynamics of the market and the track records of others, then they will begin to feel more comfortable.”

Most managers and consultants agree that the build-to-let model will be important. Following the Montague review, the UK government recognised that the private rented sector (PRS) will be an important component of reducing the pressure on housing.

“We’ve been looking into build-to-rent strategies,” says Paul Jayasingha, global head of real estate at Towers Watson. “These buildings are tailored to the rental market and offer little things which can make a big difference. They have elevators which are much wider, allowing tenants to come in and move their belongings more efficiently. There are equal-sized bedrooms, rather than one big and one small one, for the single professionals. They have concierge services and an Amazon drop box, maybe a small shop or gym. so, it is catered to the tenant. This could be quite attractive, and the gross to net spread on these types of buildings could be much narrower.”

Laure Duhot, director, strategic capital markets at Grainger, says that institutions are interested in the sector. “There is definitely interest from institutions in the PRS sector,” she says. “Institutions are starting to understand the market dynamics much better and the risk and returns of these types of schemes, and are getting comfortable with them. The government guarantee scheme is attractive.”

A government-led bubble?

The UK government’s guarantee scheme for PRS supports several investment options, from the building of new homes for private rent, to the conversion of existing commercial properties into rented homes. Projects with a minimum value of £10m are eligible for guarantees and new homes are required to remain in the rented sector until the money has been paid back. The scheme reduces risk for lenders through a guarantee that money will be repaid in the event that the borrower defaults. The government also announced at the end of last year that it would aid housing construction through a six-year, £1bn programme to build the underlying infrastructure required for large residential projects.

“Government initiatives are helping the private rented sector, with government loans and guarantees encouraging the construction of new housing for market rent,” says Duhot. “This has kicked off a lot of interest from institutional investors, though the challenge of finding scale and finding assets remain.”

She says Grainger is benefitting from interest in the sector. “Our share price has increased substantially in the last year, partly because of overall market sentiment and also because of action we have taken, like our PRS fund with APG. We are also actively unlocking more PRS schemes, but these are long-term projects. Not all will come to fruition. Nonetheless, we are busy in the background. Some of the projects we are working on will take a year or 18 months to be delivered.”

Other government initiatives have changed the market, such as the Help to Buy scheme, which, among other things, is providing first-time buyers with government loans of 20% towards deposits on new-build properties.

Pratt certainly sees Help to Buy having an effect. “The house builders are having a heyday at the moment,” he says. “They are finding that because mortgages are easier to get hold of, and the rates are quite competitive, they can actually pre-sell a lot of new homes. so their performance has improved dramatically in the last six months.”

Pratt does not believe the scheme is sustainable though. “If i was a betting man, I would think that Help to Buy will run for a while, but at some point, they will withdraw that scheme. It is artificially underwriting the provision of mortgage finance.”

Urwin agrees. “Things like Help to Buy don’t help the market. They inflate the capital value without doing anything to inflate the income return. government policies aren’t really designed to get institutional interest.”

Investors are also concerned about a potential bubble, particularly in London, but Duhot dismisses the concerns. “We don’t believe there is a housing bubble. The increase in prices has accelerated over the past year, certainly, but we believe growth is going to continue, albeit at a more sustainable pace.”

Research from Savills suggests that prime London residential will return 4.5% in 2014, and 22.7% in the five years to the end of 2018. Meanwhile, prime regional residential properties are catching up with the capital and will return 4.5% this year and 22.7% by end 2018, as well.

Managers believe that institutions are ready to get their feet wet, albeit slowly. “I think institutions realise that there is a lot of potential here. Some of them are making low-level investments in order to educate themselves about the sector and gain first-mover advantages. But, I don’t think that there are many institutions ready to make a big commitment to the sector,” says Urwin.