Guy Nixon explains why institutional investors should pay attention to what is a growing sub-sector that sits somewhere between hotels and private rented housing.

The serviced apartment sector in the UK provides investors with an attractive alternative to mainstream residential investment and the opportunity to take advantage of an emerging market with significant growth potential, particularly in London.

Serviced apartments combine hotel-like flexibility and service with the increased space and privacy afforded by a more traditional long-term rented apartment - they are a hybrid of the two sectors, providing clients with much desired choice and flexibility. The presence of established professional operators and managers and a significant and growing stream of corporate demand has led to institutional interest in the sector, which offers significant opportunities for investment across the risk spectrum.

Typically offered for periods of one week upwards, serviced apartments provide guests with a home-from-home, fully equipped with kitchen facilities and internet, and a minimum weekly clean and linen change. The model is particularly well liked within the corporate market for which serviced apartments provide a cost-effective option for short to-medium-term stays for their employees. Many employers now mandate the use of serviced apartments over hotels for stays longer than a week.

For investors, the market presents a significant opportunity for both income yield and capital growth. In central London, serviced apartment yields are in the region of 6.5% (as of Q2 2011), with recent transactions pointing towards prime yields of 4.75%.

In its recent report produced with Go Native, Savills forecast that strong operating conditions in the serviced apartment sector, coupled with limited new development, would help to drive capital value growth above that forecast for the mainstream residential rental market. The report forecast growth to average 6.3% per annum until 2015 in the serviced apartment market, as opposed to the 5.9% forecast for the mainstream residential sector. Further, serviced apartment rental forecasts suggest that rental growth will gather pace over the next three years, exceeding that forecast in the private rental sector.

Growth for 2011 is expected to hit 13.5%, followed by a further 14% increase in 2012, determined by improving economic conditions driving corporate demand, coupled with the anticipated positive effect of the Olympics. This will place significant pressure on a relatively undersupplied market.

Current supply in central London stands at just over 8,100 units, which equates to 1.2 units per 1,000 users. When benchmarked against other international markets, London appears to be lacking: Hong Kong and New York having 5.3 and 5.2 units per 1,000 users, respectively. Indeed, London has the lowest level across all the international markets benchmarked. Based on this analysis, there is a potential supply gap in London of as much as 25,700 apartments.

The significant potential to expand in central London supply will be driven by a combination of greater corporate demand, which currently far outstrips supply, as well as from the growing demand from the private rented sector, as people increasingly seek flexibility and see serviced apartments as an attractive alternative to traditional renting, as witnessed in Hong Kong.

The lack of supply of new-build residential and the continued difficulty of obtaining mortgage finance, which has restricted access to the owner-occupier market, are combining to put pressure on the central London private rented sector. This is set to continue over the medium term and could feed serviced apartment demand and expansion.

There is also significant potential in the market to develop a stand-alone branded operation to attract greater demand from the independent traveller market, which remains largely unaware of serviced apartments in London and the UK, and for whom branding plays an important role in providing confidence.

Serviced apartments are an interesting emerging sub-sector of the wider UK residential market. The presence of professional operators and managers removes the day-to-day management responsibility from investors, and the significant proven corporate demand provides confidence in occupancy and rental income, both of which are proving attractive to investors.

As a young market, there is significant opportunity to drive return through product and brand development and the consolidation of what is currently a fragmented and under-developed market. In this way, parallels may be drawn between the serviced apartment market and the student housing market as it was 10-15 years ago. The latter has matured into a well-established part of the UK institutional real estate investment market.

Guy Nixon is CEO at Go Native