Is 'Build-to-Rent' Top of the Asset Class?

There’s been a coup in the UK Buy to Let market recently with big institutional investors ploughing money into the private rented sector (PRS), until now dominated by amateur buy to let landlords.

The fact that bricks and mortar as an asset class outperforms most others consistently year-on-year is well-known but with rising urban populations and stable, long-term returns available in the PRS, pension funds and other large investors are increasingly buying up blocks of existing rental accommodation to provide large-scale properties with longer term tenancies and more predictable rents.

Institutional investors are increasingly getting involved in ‘build-to-rent’ which is a trend familiar with investors and tenants in the US, Canada and continental Europe but relatively new in the UK. As the term suggests, large buildings are constructed specifically for the purpose of renting out in the private sector and the trend is set for considerable growth with the UK housing market falling significantly short of affordable property.

The development of PRS in the UK could give tenants an alternative to the traditional small landlord, creating opportunities for UK investors to put their money to work in the rented sector without the risks of buying a property themselves.

London and the southeast share the spotlight

According to Savills, significant investments in London and the southeast are being made by large financial institutions. The value of rental property deals for large-scale investment rose from £1.6bn in 2012 to £2.5bn last year.

One of the largest build-to-rent projects is the construction of 1,439 homes in what was the 2012 Olympic Village in Stratford, east London. The project is funded by the property arm of the sovereign wealth fund, Qatari Diar and on completion the flats will be rented out on long-term three-year tenancies, with no management or agents’ fees.

Also in London, M&G investments last year bought 534 homes for rent from Berkeley Group in a £105m deal. The one or two bed flats are in different locations mainly in London and the south, including 401 rented homes at the Stratford Halo development beside the Olympic Park and 233 homes, some for rent, at East India Dock.

Private rental sector shows increased institutional appeal

Many consider that ‘build-to-rent’ is set to take over the UK property market with ready-made blocks of rented homes such as those offered by Berkeley being the preferred target for institutions, as they avoid the upfront costs and risks associated with planning and construction. However, the supply for this market is heavily outstripped by demand and so purpose-built developments are few and far between.

Alex Greaves, residential fund manager with M&G says, “If we have the opportunity we would like to buy another one but the reality is they don’t come up that often and if you can’t buy it – you have to build it.”

Most institutional investment to date has come from overseas, where the model of large-scale managed rental properties is already well-established. Fizzy Living, a private sector arm of the Thames Valley Housing Association is funded by Australian investor Macquarie Capital and Essential Living, a UK specialist in PRS development, is backed by M3 Capital Partners, which is in turn funded by US pension schemes.

Andrew Allen, head of global property research at Aberdeen Asset Management says that “investors are increasingly aware of this market. It feels like there’s momentum in it”. He expects the fund manager to be “significantly more invested” in the next five years.

Dutch pension fund APG has invested a £430m fund with Grainger, the UK’s largest listed residential landlord, for developments amounting to 1,700 homes and Akelius, the Swedish pension fund which owns 34,000 flats in Sweden and Germany, has invested £200m covering 950 homes in the UK.

Economic drivers

There are several factors behind the heightened sentiment from institutional investors for the private rented sector. Housing supply is widely reported to have been at critically low levels for a number of years keeping prices buoyant, particularly in London.

First-time buyers face a number of affordability obstacles in their attempts to get on the housing ladder as average earnings have not kept pace with house prices. Mortgage lenders have now further tightened their lending criteria and often require larger deposits and higher monthly repayments in the absence of lower-cost mortgage products such as interest-only mortgages.

Data from Resolution Foundation shows that the sector has grown rapidly in the past decade with more than 50% of under-35-year-olds and low to middle-income households now living in rented accommodation, up just over 25% from 2003-4.

However, due to the PRS being dominated principally by amateur landlords, rented accommodation is often poor with tenants complaining of damp conditions, low quality fixtures and fittings and landlords who fail to fix problems, respond promptly or return deposits. A survey by Savills from 2012 found that 25% of tenants left their last rental property because of poor management.

More hurdles to overcome

Although conditions would appear to be perfect for big investors to commit to the large-scale rental market, many consider that talk of an ownership revolution in Britain’s tenanted accommodation sector is exaggerated.

Deputy chief executive at Resolution Foundation, Vidhya Alakeson, says the efforts to bring city money into the rental scheme have been ongoing for several years “but the number of actual deals going through is very limited. It’s going to be a slow burn.”

She believes the biggest hurdle is in changing the mind-set of institutional investors: “Build-to-rent falls between two stools. It doesn’t have the low-return but highly secure nature of social housing investments but nor does it have the high returns that equity investors typically look for. Traditional property investors don’t quite know where to put it.”

Institutional investors do have a history in the private rented sector having owned rental properties as part of their portfolio of investments for much of the 20^th century. Most investors left the market in the 1970s when rent controls were introduced and although Margaret Thatcher went on to scrap them, she also actively encouraged home ownership throughout the UK which dissuaded institutions at that time from committing to the market – leaving the way clear for individual buy-to-let investors.

Other obstacles in the way of institutional investment are the dearth of large-scale sites and the planning system which favours for-sale projects rather than construction that delivers its return over 20 or 30 years.

Investors favour income stream above capital growth

Recent years have seen rental returns dwarfed by the rise in capital values although institutional investors like pension funds, see benefits in matching their long-term liabilities to a steady income stream. M&G targets a return of 7% to 9% on its residential investments while a study by Resolution Foundation looking at a notional portfolio of rental property found a total return of 7.2% per annum over ten years.

The government is particularly anxious to capitalise on renewed institutional investor interest in UK property, having unveiled a series of measures to kick-start build-to-rent in 2013. Measures included a £1bn equity fund to trigger development; £10bn of loan guarantees for the social and private rented sector; new draft planning guidance on build-to-rent projects and a Whitehall task force overseeing the fund and loan guarantees.

Savills’ Jacqui Daly anticipates that the loan guarantees in particular will boost confidence in the market saying that “the guarantee could have a huge impact on how quickly the market matures. It will help to improve the returns.”

Although the main political parties are agreed on the need for more housing stock of all kinds, there are increasing calls for reforms in the rented sector such as introducing a system of rent rise caps and fixed three-year tenancies, in a bid to provide a ‘fairer deal’ for tenants.

Although for the 9 million renters in the UK, a system to ensure fairness in a market traditionally dominated by amateurs would be a welcome transition, there are fears that these reforms would stall the growth of institutional investors in the sector.

Is build-to-rent the next big asset class?

Over the last 20 years the market for student accommodation has been opened up to public investment with the emergence of listed providers such as Unite and funds specialising in student properties. Many experts believe that build-to-rent could become the next new addition to the marketplace.

Apart from the student population, there is a high demand for affordable rented accommodation and the benefit of build-to-rent is that rental homes are in purpose-built premises with shared facilities such as laundry and games rooms, high-speed broadband and often a concierge service.

Considered a fairly typical arrangement in cities such as New York and Ottawa, serviced rental apartments are the next big thing in the UK’s $200bn global investment market.

Nick Jopling, executive director of property at Grainger believes build-to-rent will change the investment landscape significantly. “We are at a real turning point in the market,” he said, “In time, the rented residential sector will be an investable asset class of scale just as most other real estate asset classes.”

Large-scale rented accommodation has come a long way since the Victorian idea of bare-minimum existence. Shared spaces are a common feature of build-to-rent. For instance, a tenant in a studio flat might be able to reserve the use of a communal upper floor flat for a dinner party, barbecue areas might be booked in advance, repairs might be done by on-site maintenance teams or last-minute shopping might be done in the ground floor supermarket.

Scott Hammond, managing director of Essential Living says that “the idea is that your home doesn’t start at the door to your flat, it starts at the front of the building”.

What makes build-to-rent properties different?

Building a block for ownership over 15-30 years during which time many tenants will come and go, requires different specifications from those that operate in the for-sale market. Property industry think-tank the Urban Land Institute recently published a guide for developers in the sector which sets out recommendations on design, engineering and the use of materials that should be “robust, durable, maintainable and replaceable”.

The report recommends that instead of giving every apartment its own balcony that developers consider a communal roof terrace or garden. Pre-fabricated “bathroom pods” could be installed to save time and reduce costs and hot and cold running water could be sourced centrally rather than each apartment being fitted with boilers, with cookers being vented centrally too.

From a retail investor’s point of view, build-to-rent is an extremely viable option allowing them to participate in a market at a lower entry level than if purchasing a one-off buy-to-let property, thereby minimising risk levels and capital exposure.

Real Estate Investment Trusts (REITS) and property funds provide the vehicles for those seeking reduced capital exposure along with investment opportunities in university student accommodation, one of the biggest growth markets in property over the last decade.

Affordability in the UK housing market is somewhat elusive for the majority and as a result, structured investments managed by reputable firms represent the best opportunity for those investors seeking a steady income stream generated by rental income.

And so it would appear that build-to-rent could well be the market changer of 2014 and the next big asset class for both institutional and private investors alike. For those individuals unable to afford a buy-to-let investment, this option would appear to be extremely attractive alternative, granting them limited but controlled exposure in what is set to be a high-growth market.