For Professionals only Investment case: The UK private rented sector (PRS)

The value of an investment and the income from it can fall as well as rise and you may not get back the amount you originally invested. The UK PRS has doubled in size in the past decade and is increasingly attracting the attention of institutions including pension funds and insurers. There are now 95,918 Build-to-Rent homes complete, under construction or in planning across the UK.1 We expect this figure to grow thanks to the sector's potential to generate a strong, stable income stream and proven diversification benefits. Our research suggests that the investment case for UK PRS is backed by:

• Low correlations with commercial real estate, • A long-standing supply/demand imbalance in the equities and bonds UK housing market backed by strong population • Defensive characteristics with improved capital growth preservation • Scope for professional investors to add value through • PRS is the fastest growing tenure type and economies of scale

is likely to fuel demand for rented accommodation – Demographics and demand a sector which was dominated by private landlords. Demographic trends suggest that demand for housing The PRS has been growing over the past decade, will continue to rise. The UK population is expected to and – at 4.5 million households – now represents expand by around 0.5% per annum in the medium term 20% of the English market,4 up from 10% in 2001. In (2017-2026)2 – much faster than the European Union addition, a significant proportion now see themselves average of just 0.2%.3 London is growing even faster. as permanent renters, with the 2015-16 English Housing At the same time, household size is continuing to fall, Survey suggesting that only 60% of the PRS households with more people living alone. surveyed expect to move into owner-occupation, with most only expecting to do so after five years or more. The government estimates that some 300,000 new homes need to be built annually. However, supply is The rising demand for private rentals in the UK lagging behind, with 217,350 homes built in the 2016/17 contrasts with the situation in continental Europe, financial year. where in many countries the sector is now fully mature and has stopped growing or is even shrinking. Indeed, The resulting supply/demand imbalance means in a report by the London School of Economics and the upwards pressure on house prices over the long run. University of Cambridge, the UK was the only European Barriers to home ownership remain high, with significant country out of 11 studied where the general trend affordability constraints (particularly in London). This pointed to ongoing PRS growth.

Housing supply in England Tenure over time (England) 300 Housing need 80

70 250 60

200 50

40 150 30

100 20

10 50 Housing completions, England (’000s) England completions, Housing Tenure as a percentage of all households (%) 0 1918 1928 1938 1948 1958 1968 1978 1988 1998 2008 2015-6 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 20202021 Private renting Owner occupied Social renting Private enterprise Housing associations Source: English Housing Survey. Local authorities Forecast completions

Source: Department for Communities and Local Government (March 2017), JLL (November 2017), Autumn Budget 2017. 1Savills, British Property Federation. 2ONS. 3Eurostat. 4English Housing Survey 2015-16.

1 Strong risk-adjusted returns Investment opportunities: London vs the regions According to IPD, UK residential property has outperformed London is an obvious focus for PRS investors, commercial property over each decade since the 1980s. reflecting the City’s very strong underlying It has also fared well against other asset classes. fundamentals. However, some bigger regional cities are now drawing the attention of big players thanks Total returns by asset class to their potential for significant house price growth, 20 while others also look attractive from an investment 18 perspective due to robust rental fundamentals. 16 London will no doubt continue to see the most 14 extreme supply/demand imbalances and the 12 greatest issues around housing affordability,

10 therefore ensuring it should remain a fundamental (%)

8 and, arguably, the most significant part of any investor’s portfolio. However, selected major regional 6 cities are also suffering from similar challenges 4 and therefore offer the potential for healthy rental 2 growth. Cities such as Manchester and Bristol are 0 also seeing strong PRS growth, driven by population 1986-1996 1996-2006 2006-2016 30 years to 2016 Residential All Property Equities Gilts growth and housing affordability. This is putting pressure on housing prices, suggesting a healthy Source: IPD, Residential Digest, IPD Annual Digest, Bloomberg, ONS. outlook for rental growth. However, investors should be wary of overpaying for the income streams on While capital values in commercial property have offer in the regions, particularly as yields in some declined by 30% in real terms since 1980, those for cities start to rival London pricing despite the fact residential property have increased significantly, likely that their supply/demand imbalances are generally reflecting a combination of restricted supply and strong less acute. demand fundamentals. Going forward, our research forecasts healthy investment performance for the UK PRS. basis. This is because the long-term income stream from residential can be maximised through more efficient Attractive rental growth prospects property management. The residential sector offers a strong stream of long-term Diversification benefits income, backed by attractive rental growth prospects as well as capital preservation and capital growth. Property has different market drivers to those of more We forecast average residential rental growth of 3.8% traditional such as equities and bonds, pa in Greater London and the South East over the and consequently shows very low correlation with those next five years, supported by continued supply/demand asset classes. imbalances and continued economic growth. Multi-asset correlations The prospects for generating an income return from Residential Commercial Equities Gilts residential are supported by the sector’s lower level real estate real estate of voids. In 2016, the vacancy rate for All Market Let Residential 1.0 0.7 0.3 -0.2 residential property was just over 6.5% – slightly below real estate that of commercial property – or only 3.7% for All Commercial 0.7 1.0 0.3 -0.1 Market Lets excluding central London. The length of real estate residential leases is shorter than in commercial, but the Equities 0.3 0.3 1.0 0.2 gap is getting smaller. Although the standard initial lease length of an Assured Shorthold Tenancy (AST) is Gilts -0.2 -0.1 0.2 1.0 one year, the average actual tenancy is in fact 4.3 years, according to the 2015-16 English Housing Survey. Source: IPD UK Residential Property Index, IPD Annual Property Index, Bloomberg. (Inflation-adjusted total returns, 1981-2016). For private landlords and individual buy-to-let investors, management costs typically eat up around one-third of Analysis also suggests that residential could prove the income from privately rented residential. However, to be a suitable portfolio diversifier for commercial these costs can be reduced through the economies property investors, based on its much lower correlations of scale available to institutions and other large scale with most traditional property segments than those investors, compared to management on a “flat by flat” segments show with each other.

2 both raise the profile and viability of BTR and institutional Intra-property correlations PRS in the short to medium term. Residential Retail Office Industrial

Residential 1.0 0.6 0.7 0.5 Purpose-built, efficient stock Achieving the necessary scale to make institutional Retail 0.6 1.0 0.8 0.8 investment viable is one of the prevailing barriers to Office 0.7 0.8 1.0 0.9 entry for the PRS. While the equivalent US sector (known as multifamily) is mature, this took time to develop. Industrial 0.5 0.8 0.9 1.0 Brexit and the PRS Source: IPD UK Residential Property Index, IPD UK Annual Property Index. (Inflation-adjusted total returns, 1981-2016). As Brexit negotiations are ongoing, the impact of exiting the EU on the economy and the property market Adding residential property into a multi-asset or is still far from certain, but this may benefit the PRS, in commercial property portfolio would therefore be the short term at least. Since the referendum, housing expected to improve risk-adjusted returns. transaction volumes have fallen (although they remain well above pre-Financial Crisis levels), as uncertainty Defensive characteristics deters households from making life-changing decisions, such as moving into owner-occupation. People always need somewhere to live. Therefore, if there is a downturn in the economy, the robust With 29 March 2019 as the official date Britain is nature of the rental market is demonstrated as expected to exit the EU, further uncertainty is likely to it counteracts the sales market when the economic persist. Ongoing lack of clarity over the future of the environment encourages, or even obliges, people to UK-EU relationship means the housing sales market rent. This potentially lessens capital decline for rented will likely remain subdued for some time. Households accommodation investments. will therefore likely stay in the PRS for longer than anticipated, underpinning rental growth. The statistical volatility of the commercial and residential property types has been similar over the The PRS is the key tenure for new and short-term past 30 years, which mainly reflects the upside volatility migrants, so any fall in EU migration would subdue of residential property. However, when looking just at rental demand. However, 51% of migratory inflows downside volatility (in this case, the risk of negative come from outside of the EU and are unlikely to total returns), residential has actually shown a much be affected by Brexit. Indeed, restrictions on the lower level of risk than commercial. During the steep number of EU citizens who can work here may market downturns of the 1990s and 2000s, residential result in pressure to increase the number of non-EU property recorded a smaller capital decline than international immigrants as UK employers seek to commercial and also recovered its initial value faster. fill vacant roles. Moreover, the critical importance of EU migrants to the labour market should ensure Government support that immigration will be allowed to continue, albeit to a lesser extent. In its White Paper, the government first signalled its growing awareness of the importance of the PRS as a Any restriction on migration would be unlikely to tenure type and of Build to Rent (BTR) specifically, as cancel out the supply/demand imbalance, especially opposed to traditional buy-to-let, as a way of creating as lower housing demand would likely spark a similar better-quality, professionally-managed rented stock on a reduction in activity from housing developers. So, large scale. This shift away to a more multi-tenured view while rental growth prospects may be relatively should help provide the impetus to boost housing supply weaker post Brexit, the persistent supply-demand in aggregate. imbalance and the high levels of house prices relative to incomes will position the PRS as a key, In the recent Budget, housing supply continued to and growing, tenure. be a high priority for the government and it built on foundations laid out by the Housing White Paper. A number of measures and solutions were announced to Forward-funding and forward-purchase offer an drive housing supply to an ambitious target of 300,000 attractive route for large-scale investment in the sector, homes per annum. Measures include extra funds to with housebuilders and developers increasingly open to increase activity among small and medium housebuilders, such transactions. This is illustrated by the partnerships unlock development opportunities through the provision between M&G Real Estate and Crest Nicholson, and of infrastructure, and for Help to Buy. M&G Real Estate and Telford Homes, which have created much-needed PRS units across the UK. In particular, the government sought to proactively support BTR with £8 billion of new financial guarantees By focusing on blocks and units designed specifically for to drive private housebuilding in the sector. This should rent and taking an active interest in the development of

3 Rehearsal Rooms, North Acton, London

Liquidity advantage

Liquidity is another potential advantage for residential property over its commercial counterpart. In commercial property, the only exit route is to sell a building to another investor. In a downturn where the large-scale investor interest falls away, it may therefore not be possible to sell a building (at least for a reasonable price) until market confidence returns, potentially years down the line. Although the same problems may apply to selling a whole block of flats at some points in the economic cycle, residential property benefits from the potential to sell flats individually to smaller buy-to-let investors or owner-occupiers. This potential pool of investors likely far outweighs the number of institutions in any market. these products, experienced professional investors can ensure greater efficiencies for operation, energy and Moreover, when selling to owner-occupiers, investors do maintenance. Similarly, by ensuring consistency across not have to sell at investment value as they would to developments, they can maximise economies of scale another investor, potentially enabling them to secure a to reduce costs of repairs and enhance overall returns higher price and thus boosting investment returns. This through greater customer satisfaction, which impacts double exit route makes the PRS increasingly attractive as occupancy. an investment as a result. The forward-funding route also offers greater tax efficiency than purchasing existing properties as the Conclusion stamp duty land tax (SDLT) is based on the lower, pre- development land value. Overall, our research suggests that the investment case for UK residential is supported by the favourable demographic Growth prospects in the institutional PRS are supported trends, the supply/demand imbalance in the housing by the trends seen in the student accommodation sector. market, and attractive rental growth prospects. The sector This has only very recently become a truly institutional also offers diversification versus other asset classes and market as developers started to provide the kind of stock other real estate sectors, defensive characteristics and investors want to add to their portfolios. As a result, the strong returns. Professional investors have the scope student accommodation sector saw investment volumes to further optimise returns through economies of scale of c. £3 billion in 2016 alone according to Cushman & and greater efficiency. Taken together, this makes a Wakefield. It is not hard to imagine a similar future for compelling case for investing in the UK PRS. the PRS in the years to come. For more information Lucy Williams Christopher Andrews, CFA Stefan Cornelissen Director, Institutional Business Head of Client Relationships Director, Institutional Business UK and Europe, Real Estate and Marketing, Real Estate Benelux, Nordics and Switzerland +44 (0)20 7548 6585 +65 6436 5331 +31 (0)20 799 7680 [email protected] [email protected] [email protected] www.mandgrealestate.com

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