UK residential property: From capital to cash flow

As it becomes more institutional, investment performance will come more from income. Richard Donnell explores the PRS evolution

Over the past 14 years, returns from UK residential property have outperformed those from commercial property. This is largely down to strong growth in capital values. But as the market grows and evolves, the focus will shift to the value within the underlying cash flows from privately rented housing. 

The 2014 results from the IPD UK Annual Residential Property Index showed a total return of 13.5%, of which 10.5% was capital growth over the year. Over the past 14 years, capital growth has accounted for, on average, two-thirds of annual total return reported by the index. Only in 2008 was capital growth negative.

This return profile is not a surprise, given the valuation approach for rented-residential stock, which has seen investment values running at a variable discount to vacant possession values. Falling mortgage rates explain a significant proportion of the growth in house prices since 2001, which has fed through into returns. With mortgage rates as low as they can go, the level of house price growth is set to track lower – much closer to the growth in earnings over the medium to longer term. 

Capital growth of rented residential stock recorded by the IPD index has averaged 7.4% per annum since 2001. This is double the projected average growth in earnings in the next five years (3.5% pa according to the Office for Budget Responsibility). However, as the market for rented residential stock evolves, so the reference point of capital value looks set to change. An information paper published by the Royal Institution of Chartered Surveyors (RICS) in September 2014* provides much greater clarity for investors and valuers on the valuation approach for let residential stock. 

The growth in build-to-rent will change the profile of rented residential stock with less potential for break-up into the owner-occupied market as an exit route. A growing proportion of assets will start to be valued on a discounted cash flow basis, forcing a greater focus on optimising net operating income through rental growth and efficiency of operations to drive value and investment returns. 

Information on the performance of rents and operating costs is only now becoming more available. Understanding the drivers of rents and how this influences returns will be increasingly important as build-to-rent grows and valuation shifts towards a discounted cash flow basis. The transition should been seen as an opportunity, as the performance of residential rents over the long run looks attractive, especially for those looking for assets where income tracks earnings.

One of the challenges for any emerging market is the availability of robust information on performance. The lack of a reliable index for residential rental growth in the UK has created an information vacuum filled by often conflicting reports over the levels of rental growth. Mixing trends in London with the rest of the country can deliver headlines that reflect neither market and result in a view that rents have been running ahead of what tenants can pay.  

To provide the necessary perspective, Hometrack has created a stock-weighted, regional time series for private rents stretching back 10 years to measure rental growth and affordability. While rents have been rising for the past four years, they fell between 2008 and 2009 as accidental landlords boosted supply. Residential rents today are still below their 2007 levels in four out of 10 regions – figure 1 shows the aggregated trend over time. Over the past 19 years, rental growth has averaged 2.7% pa compared with 2.9% growth in earnings.

The affordability of private rented housing has remained relatively constant over the past decade with rent as a proportion of single-person earnings averaging 33%. This measure has tracked in a narrow range of 31% to 37%. This is to be expected since occupiers can only afford to pay a certain proportion of earnings towards housing or rental costs. 

The affordability of renting varies between regions and looks far from stretched across the majority of areas outside London, implying potential for rental growth as the economy recovers and earnings continue to rise (figure 2). Only in London do affordability levels look stretched as a result of higher rents. However, accurately tracking the affordability of rents in London is made more challenging by the trend towards higher occupancy with tenants sharing rental payments. 

The relationship of rents to earnings should deliver comfort to investors, especially with the seemingly persistent challenges facing younger households accessing home ownership. 

“The lack of a reliable index for residential rental growth in the UK has created an information vacuum filled by often conflicting reports over the levels of rental growth. Mixing trends in London with the rest of the country can deliver headlines that reflect neither market and result in a view that rents have been running ahead of what tenants can pay” 

Looking at the factors behind these headline trends in rents, our analysis reveals significant opportunities for investors based on a more detailed, empirical understanding of the drivers of rents and tenant demand – including the degree to which bespoke rental buildings, with the correct offer in terms of accommodation and services, could outperform the wider rental market.  

For example, a recent analysis of rents in 30 new residential buildings in inner London revealed rents trading at a 15-20% premium to rents in the local market. None of these buildings were designed for rent and some buildings in the sample had no premium at all.

A better understanding of how the location of – and services within – a building can deliver outperformance will be increasingly important for investors, their operators and asset managers. Building design has been a major area of focus in recent years and the Urban Land Institute (ULI) has made major strides with its Build To Rent best practice guide, which is based on lessons drawn from the US.

The growing acceptance that developing bespoke rental stock is the primary route to expanding investment creates further opportunity. As the understanding of tenant requirements grows in terms of services, local amenities and location, and the link to rental income, so we are likely to see build-to-rent increase in locations that are less attractive for speculative developers.

Unlike the sales market, the rental market is more rational and explained by fundamentals, which allows fund managers to identify mis-priced markets.  

^{*Valuing Residential Property Purpose Built for Renting, 1st edition – September 2014, RICS} 

Richard Donnell is director of research at Hometrack