Is a large-scale institutional asset class finally going to emerge in the UK? Yes, because investors cannot afford to ignore the benefits, writes Rob Martin
The case for UK residential property depends on its ability to deliver long-term, sustainable income growth. Few dispute that net entry yields are lower than commercial real estate, but analysis suggests that the growth case is compelling.
The occupier dynamic can be summarised as one of long-term growth in demand alongside a tight supply environment. The UK has one of the fastest growing populations among developed countries. This is matched by a tight supply-side. Completions of new dwellings (ignoring conversions of existing stock) have averaged just 0.7% pa, compared with a higher and more cyclical 2.7% for offices, for instance.
Forming expectations for future rental growth is complicated by a lack of historic data covering residential assets. We have drawn on different perspectives to calibrate our views. One consideration that resonates in the long term is affordability. Ignoring short-term flucuations in supply and demand, rents cannot grow faster than the ability to pay. This ability can be proxied by average earnings growth, itself a combination of productivity growth and inflation.
Productivity growth in the UK has averaged over 2% pa historically, though it has been lower since the global financial crisis. The recent slowdown is cyclical but nonetheless assumes a lower rate of 1.75% pa, going forward. We assume that over time, the Bank of England will meet its target of 2% consumer price index (CPI) inflation. Taken together, the average earnings growth is 3.75% pa.
Our investment outlook is based on the assumption that residential rental growth averages 4% pa over the long-term, broadly in line with earnings. This compares with the past when expenditure on housing rose faster than earnings. In comparison, experience suggests that commercial real estate rents are likely to rise in line with CPI at 2%.
Depreciation rarely receives attention. Real estate depreciates as a result of functional obsolescence and the erosion of value that takes place as leases shorten. Residential is let on short leases, changes in tenant requirements are gradual and annual maintenance requirements are lower than for commercial property. Our work points to future depreciation of around 0.5% pa for institutional residential against 1.2% pa for a blended commercial exposure.
Netting depreciation from rental growth gives a long-term capital growth profile of 3-4% pa for residential versus approximately 1% pa for commercial real estate. In overall investment performance terms, this offsets the drag from a lower starting yield.
If the investment performance story is so strong, why has not the sector taken off before? Rather than any single explanation, it is the result of factors, including:
- Lack of investible assets and appropriate scale;
- Lack of suitable investment vehicles;
- Lack of investment track record;
- Negative market perception around management intensity/reputational risk;
- The role of private ‘buy-to-let’ investors.
The first four create a classic chicken-and-egg problem. Without assets in which to invest and the vehicles through which to do so, the track record cannot be created and the market struggles to emerge and mature.
With regard to buy-to-let investors, their participation has been supported by generous tax treatment and ample mortgage credit. Tax and regulatory changes are starting to bear down on both of these. Looking ahead, their cost of capital is likely to move closer to institutional levels.
With the UK voting to leave the European Union, an important dimension of the UK’s trade and economic framework is now subject to change. It will be years before we understand the full ramifications, positive or negative, not least because the shape of the UK’s new relationship with the EU will be the subject of protracted negotiations.
The potential implications for residential property will derive from the supply and demand and changes to the outlook for productivity growth. There are scenarios in which changes to UK policy on immigration reduce the pace of population growth. However, even in population projections prepared by the Office of National Statistics which assume lower migration, the UK population continues to increase.
The implications for productivity are complex. Migration, particularly of educated individuals, is a source of knowledge transfer that plays a role in productivity growth. On the other hand, there are arguments that there are a number of economic rigidities created through EU membership that, if removed and replaced with a more flexible regime, will enhance economic growth.
At this stage, we see the potential for a cyclical slowdown in rental growth caused by weaker hiring and wage inflation but view the implications for long-term rental growth as modest.
The fact that an institutional residential sector has not emerged before is testament to the existence of barriers. But, a combination of events coming together change this. There are an increasing number of vehicles through which non-specialist investors can gain exposure and a growing pool of institutional grade assets, including an emerging build-to-rent sector.
Broader changes to the commercial real estate universe, particularly the shift to shorter leases, have meant investors have to become more comfortable with higher management intensity, even if many choose to use specialist managers to deal with the operational dimensions.
And lastly, the structural changes that pervade wide swathes of the commercial real estate universe, from the disintermediation of traditional retail stores to the scope for artificial intelligence to threaten large numbers of middle and back-office jobs, mean that investors can no longer afford to ignore it.
Rob Martin is research director, real assets at Legal & General Investment Management