UK residential has long been considered an untapped investment opportunity for institutions. The debate has finally moved on from ‘why' to ‘how', writes Shayla Walmsley
More than a decade has passed since proponents of the UK residential market began predicting an imminent influx of institutional capital into what has for some time been a fragmented and mainly owner-occupied real estate sector.
The market is still fragmented 10 years on and still dominated by owner-occupiers. But new investment propositions are targeting the sector. On the one hand, there is a build-to-let model predicated on substantial growth in the private rented sector and an overall decline in home ownership. On the other are co-investment propositions, such as the Mill Group's Investors in Housing mortgage scheme, which has identified demand for non-rented housing among individuals at a time when first-time buyers are struggling to obtain traditional mortgage financing.
Which model investors prefer will depend on whether they see the current shift towards renting as a short or long-term phenomenon. If they believe the former - largely the result of mortgage lenders' capital constraints - it makes sense to step in and provide capital. If it is a more fundamental, long-term trend, the build-to-let model is more likely to appeal.
Major undersupply of housing in the UK points to an underlying demand that only strengthens the investment case. But in the private rented sector it is one of the main reasons investors have been hesitant to invest. The UK government has exhorted pension funds to divert some of the £120bn (€144.9bn) invested in commercial into residential, primarily new housing stock. Yet in its November submission to the UK Parliament, the British Property Federation pointed out that much of the stock held by existing investors was acquired rather than built.
Where assets are available, they tend to come in small lots. Despite being one of the largest property managers in the country, property management firm Touchstone Residential has a portfolio of around 20,000 units, compared with a US property manager with, say, 200,000 units.
"How do you buy a large enough portfolio," asks Touchstone Residential managing director John Midgley. "Compiling a portfolio three houses at a time is a long and risky process."
Investors with experience of dealing with the intricacies of residential still want large portfolios. When Swedish foundation Akelius moved into the UK residential market last year, it did so by acquiring a 16-unit portfolio from Terrace Hill. But, in the medium term, within three to five years, it plans to acquire 10,000 units in and around London.
"There are people who definitely see that our rented sector is less developed, somewhat more archaic than other centres," Chris Lacey says. "Akelius can see there is a gap in the market and there is something to be done."
David Toplas, CEO of the Mill Group, claims local planning regulations and local authority requirements that developers build infrastructure along with new housing make it difficult to launch large-scale developments. "One of the benefits of investing in both existing assets and developments is that there are no constraints," he says. "Investors can make a strong economic case for buying existing assets."
Yet with little prospect of a flood of new-build assets onto the market, the implication is that to invest in the residential sector investors will have to build it. Lacey observes that, once large investors such as Akelius get comfortable in the UK residential market, they could expand into financing, developing or pre-committing to acquire developments in the build-to-let market. "Investors haven't said they are going to do that, but once they get comfortable in the market, it might be a logical step," he says.
One of the advantages of the £150m build-to-let fund announced last year - a joint venture between Grainger and construction firm Bouygues - is that it provides the site, the asset, and its management in one vehicle. The fact that both companies will co-invest is perhaps less significant than the fact that it will be the first development fund to manage the whole process in-house. With existing development-ready land in place, Bouygues will build the assets and Grainger will provide the capital.
Grainger spokesman Kurt Mueller says discussions with potential institutional investors in the fund are going well but the contours of the fund itself have yet to be agreed. "It isn't a question of their being in or out," he says. "It's a long process. You go to them with what you think will work, then it gets refined. It's a learning curve for all parties." Among the issues yet to be agreed with investors are the extent of their investment, the terms of the arrangement, the length of commitment and the likely return.
The availability of assets, fund terms and post-acquisition management are all concerns for pension funds. But what about reputational risk? According to Mueller, despite the protracted negotiations necessary to allay pension funds' concerns about investing in a residential development fund, the sources of anxiety themselves have changed. Notably absent from the discussions leading up to the Bouygues fund has been the issue of reputation.
"They are clearly concerned about economic circumstances and the housing market - what will happen to capital values over the next 10, or 20, or 30 years," he says.
Midgley highlights some of the differences between managing housing and commercial real estate. For the latter, looking after the property is the tenant's responsibility.
"There is a lot of management hassle with residential," says Neil Chegwidden, director at Jones Lang LaSalle. "In commercial, you're dealing with corporates so there's less risk of not getting rent and you're dealing with a 10-15-year lease with a secure income. In residential, tenants rent for 12 months and you're dealing with individuals. The income streams are not as long and they're less secure."
Moreover, if valuing commercial real estate is relatively straightforward, residential is what Midgley describes as "slightly fractional", with distinct and even contrary trends between London and Northampton, say, and between city-centre apartments and family-occupied houses.
The fractional character of UK residential is important in another sense. It is accurate to talk about a UK market only in the sense that the same regulations govern residential investment in a number of discrete locations, for example. Below that level, investors will be looking at micro-trends that are regional or even local in character. Toplas says there is significant demand for housing only in economically active areas. International investor interest, driven by international upheavals, is looking to London.
On aggregate, those local private rented mar-kets account for around 16% of UK housing, compared with an average of 35% elsewhere in Europe. Yet the UK trend is moving in a mainland European direction. "I would argue that 15 years ago renting was seen as socially and financially inferior. You only rented until you could buy," says Midgley.
"That's changing. People are going back into the private rented market after owning their own homes. They don't want the worry of a mortgage and they want repairs taken care of. If you're working on a one-year contract, it makes sense to rent because you can move at a month's notice."
There are still a couple of unknowns, says Chegwidden. First, if the UK continues not to build enough homes, prices will remain high and more people could be excluded from owner-occupation. Second, although freer mortgage lending is likely, Basel III effectively limits banks' ability to make risky loans, so the flexibility to provide riskier, higher LTV mortgages will be constrained.
Grainger CEO Andrew Cunningham recently claimed rental could make up 30% of the London market within five years as a result of a structural shift over the past three. Chegwidden reckons it's more likely to be 20% - double what it was 10 years ago, "though it may slip back a bit".
Even if you side with the build-to-let champions and see this increase as a permanent shift, it is worth remembering the modest promise of the return on scarce assets.
Lacey points out that, in contrast to property companies with higher return requirements, institutional investors such as Akelius are looking for "long-term, relatively safe, almost like index-linked income streams".
"There's been a strong case for residential for the past 10-15 years because of capital growth," says Chegwidden. "The problem is that it is mainly made up of capital growth rather than income return. We're talking about 2-3% in central London, and even better yields further out are only 4-7%."
Institutions are unlikely to take over the market, in any case, which will still be dominated by owner-occupiers and buy-to-let, according to Chegwidden. "Once the economy picks up people will feel more secure," he says. "Now lenders are risk averse. In two years' time, lenders will become more liberal-minded on risk and LTV ratios. Then owner-occupiers and first-time buyers will be a bigger part of the market again."