Institutional investors at home in the residential rental market

If an Englishman's home is his castle, powerful institutional investors may finally be storming the ramparts.

Just 1 per cent of the UK's private rented housing stock is currently owned by institutions, compared with 13 per cent in the US, 17 per cent in Germany, 23 per cent in Switzerland and 37 per cent in the Netherlands, according to IPD, the data provider.

But recent months have seen a flurry of deals, with APG, the Dutch pension manager, and M3 Capital Partners, an Anglo-US group funded by US pension schemes, at the forefront. The Abu Dhabi Investment Authority is believed to be poised to follow suit.

Already this year, the pace of activity has risen even further. Insurer Legal & General unveiled plans to build five new towns at a cost of up to £5bn, on top of a deal to regenerate five inner-city areas and a series of other projects involving 16,000 homes in all.

M&G, the asset management arm of Prudential, has also scooped up almost 1,000 apartments in two separate deals.

Last year Martin Moore, at the time chairman of Prudential's property arm, described institutional investment in the UK's private rented sector as being "at a tipping point; the journey from niche to mainstream is just beginning".

Chris Taylor, chief executive of Hermes Real Estate Investment Management, echoed these sentiments last week.

Andrew Hearn, a consultant at Residential Sector, a property advisory company, and a former director at CBRE, the real estate consultancy, says: "There is clearly an enormous undersupply of affordable rental properties in London and a historic lack of investment in this area. Population growth and rising house prices are likely to make the problem a lot worse in coming years, so it is not surprising that investors are looking at how to meet the demand.

"The imbalance between demand and supply means there is potential for good performance from rents going up and capital growth occurring on a long-term basis, and a lot of investors are familiar with the sector, having invested for a long time in their own country," Mr Hearn adds.

Although the institutional rush into residential property may appear novel, in reality it is a return to a bygone era. Until rent controls became widespread in the early 1970s, pension funds, insurers and charities were all significant landlords.

"For the next 15 years there was either the reality or the perception of rent controls and that was what, more than anything else, scared private capital away," says Bill Hughes, managing director of Legal & General Property.

However, institutions did not return even when rent controls were swept away in the 1980s.

"The deregulation of the mortgage market in the mid-1970s led to more private [home] ownership and the creation of buy-to-let products has moved it further into private hands," says Rory Hardick, partner at M3 Capital, which is involved in developing eight schemes, with 1500-2000 residential units in total, all in London.

Mr Hardick says institutions struggled to compete with the tax efficiency enjoyed by private homeowners, who pay no capital gains tax on their first property, and buy-to-let investors, who can offset interest payments against property income for tax purposes.

Industry figures point to a range of factors that have encouraged institutions back into the fray.

Mr Hardick says cutbacks in government funding for housing associations has opened the door for insurance companies and others to provide debt financing to the sector.

Mr Hughes says the current low interest rate era makes the rental income available from the private rented sector attractive, in relation to yields from other asset classes, such as fixed income.

Mr Hearn also points to the strong historic performance of the UK's residential sector, which generated annualised total returns of 10.1 per cent a year in the 12 years to 2012, according to IPD, compared with 6.9 per cent for retail property, 6.4 per cent for industrial and 6 per cent for offices.

Institutional investors have long been active in these segments of commercial property, but Mr Hearn believes concerns over future returns from commercial buildings has been a factor in their pivot back to residential. For instance, the length of the average commercial lease has fallen from 25 years to just 4.8 years, eroding certainty for landlords.

"The traditional asset classes have been retail, where there are big problems with the high street; offices, where there are concerns about teleworking; and the industrial sector, where big boxes are less important for the high-tech world and knowledge-based industries.

"There are issues of obsolescence and depreciation, but when did you last see a Victorian house become obsolescent?" asks Mr Hearn, who adds that residential has started to be seen as a "socially responsible" area of investment, which is "important to the pension industry".

For APG, which has an interest in around 1,900 properties in London's Olympic Park and Elephant & Castle areas via two joint ventures, the motivation to enter the UK market was driven by a perceived undersupply in the southeast that should underwrite unleveraged total returns of 6-8 per cent a year.

ABP, APG's largest client, has long invested in the Dutch and US residential sectors, and Martijn Vos, a senior portfolio manager in the property team, says APG's interest in the UK was piqued three years ago.

"There is a significant undersupply, especially in the mid-market rented sector. We are confident that there is demand, especially from young professionals, and we have an expectation that this will be a growth market for years to come," says Mr Vos, who adds that APG is planning to add to its UK portfolio.

Mr Hardick fears that the UK government's controversial Help To Buy loan guarantee scheme could yet scupper the institutional renaissance by pumping property prices to such high levels that landlords can no longer achieve their target yields. Barring this eventuality, he foresees a wave of institutional investment.

"I think most institutional investors would love to own swaths of residential in the UK for all the reasons they have been a great investment for private investors for many years," he says.

Mr Hughes concurs: "It is an asset class for the long term that has significant cross-party political support. It does feel to me that 2014 will be a year of sea change in terms of the amount of institutional investment that will be deployed."

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