A huge pool of potential investment could become accessible for the first time through the application of financial tools honed in the capital markets, as Steve Hays reports

The huge flows of capital into European real estate investment markets over recent years has sent yields tumbling and led institutional investors and fund of funds managers increasingly into alternative property sectors  and the emerging markets of eastern Europe and Asia to get capital deployed.

Robert Page, founding partner of London-based Alpha Beta Fund Management, argued in a recent interview that one real estate  area that has been neglected by institutional investors - outside small niche areas such as senior housing and student accommodation - is UK residential property.

Institutional investors have long been frustrated in accessing the UK housing market because of the perceived high costs of managing multiple small units in physical portfolios, low yields, and competition from home-owners and small private buy-to-let investors. Yet the sector constitutes an asset class much larger than the total UK equities market, he says.

"These structural impediments to direct investing in residential property have also meant that the level of experience and expertise in the sector hasn't developed among institutional fund managers to the same extent seen in mainstream commercial real estate," he adds.

The proportion of residential property in UK institutional portfolios is a tiny fraction compared with commercial real estate assets. In continental Europe residential property makes up a much bigger part of institutional real estate portfolios, but has been declining, from about 60% to 40% in the Netherlands and 20% to 13% in Germany over the past decade. This is partly because of relatively low returns, not helped by strict government rent controls in many countries, but also the attractive arbitrage opportunities for capital gains offered by institutions and fund managers selling to home-owners.

"UK residential property would represent an ideal asset class for institutional investors as house prices are more closely correlated to trends in wage growth than commercial real estate and equities and therefore provide a much closer match to pension fund liabilities," Page says.

Over the past 24 years the UK Halifax House Price Index and UK wages growth were 50% correlated. Capital appreciation has also been robust, with the HHPI returning 10.6% in the 12 months to May this year, when the average UK house price was £196,893 (€292,287).

The HHPI is the UK's longest-running house price series, with data covering the whole country going back to December, 1982.

The index typically incorporates around 15,000 house purchases per month. From this data a "standardised" house price is calculated on a like-for-like basis.
Since inception, the index has averaged returns of 8.1%, ranging from a peak of 34.4% in 1988 and a low of -7.8% in 1992.

The HHPI returned  15.5% and 23.1% in 2001 and 2002, at the height of the post-dotcom equities slump, possibly reflecting the flow of capital from stocks to bricks and mortar.

Institutional investors and fund of funds investors can now access these returns via newly emerging funds, which invest in derivatives on house price indices such as forward purchase agreements, Page says.
Residential derivatives have been around for about five years, but have only been actively traded in the last couple of years and there's probably about £2bn notional on the Halifax index in the OTC (over-the-counter) derivatives market by banks hedging their risks.

"There has been much focus in the fund management industry around the new field of property derivatives. This can broadly be divided into two categories: ‘Alpha', which targets returns through individual active management, and ‘Beta', which represents returns from the broader market. In my opinion the market isn't yet sufficiently mature to support alpha strategies, with their relatively high transaction costs. I think we are still at the stage in the development of this market where investors will opt for low to medium cost beta funds, where returns can be boosted through leverage tailored to investor requirements," Page says. 

"As the market grows, more and more institutional investors and fund of funds managers will be able to rapidly deploy their capital in a tax efficient way. I believe we are going to see strong growth in this area of residential investment and fund management," Page concludes.

Steve Hays is a founding director of Bellier Financial based in Amsterdam