Institutional investment has long been the life-blood of the UK’s commercial property sector. But despite our ongoing obsession with owning our own homes, the exposure of pension funds and insurance companies to residential property is negligible. Just 1% of the UK’s housing stock is owned by institutions, compared to between 10% and 15% in most European cities.
Pension Funds don’t have the capability [to manage the property], and therefore direct investment into residential has been quite problematic.
Ben Jones
There are several clear reasons why British investors have yet to move in on the residential market, but a heady combination of favourable regulatory changes and a lack of income from traditional sources suggest this is slowly but surely changing.
“I think funds have been talking about going into residential for quite a few years now, but none of them have actually necessarily jumped in to it,” says PRUPIM senior research analyst Emma Harding.
“Partly there’s always been a lack of transparency around what’s been going on in terms of performance. IPD launched their Residential Index a few years ago now, but before that there wasn’t really anything which could necessarily tell investors how the market was performing, what rental levels were, what the net to growth costs were, and that side of things.”
Another stumbling block has been income. While capital values have skyrocketed in recent years, rents have failed to keep up. And out of these low yields owners must spend a significant sum on management fees – an additional cost not found in commercial property.
A hands-on approach
“Generally residential is a low income returning asset class,” adds Harding. “If you look at it I think all property income return is about 6% to commercial property and that compares to an income return of, perhaps even nearer 3% or 4% for residential. So that’s one mayor deterrent to start with.
“Part of the reason as well that the income return is so low is because, obviously, residential is a very management-intensive asset class. I think the rule of thumb is that the growth-to-net ratio for residential is about 30%, so you’re losing 30% income just on management and maintenance costs.”
Mayfair Capital chief investment officer James Thornton agrees: “It’s a very different model to commercial because residential is absolutely hands-on, which is why you need the management infrastructure.
“The commercial market has tended to be five, 10 or 15 year leases, the tenants look after the building and you get a relatively high yield. The problem at the moment for a lot of the commercial market is you’re not getting any rental growth because the economy is flat-lining.”
But while residential property may once have struggled to match the income gained from commercial, a broader comparison of asset classes suggests it is a good diversifier and an attractive bet. At the end of last year, Islington Council hit headlines when it allocated £20m (2.5%) of its £810m pension fund to residential property, becoming one of the first UK schemes to do so. Explaining the move, Islington Councillor and pensions sub-committee chairman Richard Greening said: “If you compare the housing market to equities over the last 10 years it is a no-brainer; the housing market did correct in 2008/9 but has shown strong growth the rest of the time. It strikes me as mad to ignore this sector.” (see last page for more).
However, as the need for more rental property is becoming ever greater, deals are being made which see the investor divested of management responsibility, such as the agreement struck by M&G Investments when it acquired the Stratford Halo, 43-floor residential development at the main entrance to the Olympic Park in East London in January. As part of the deal M&G paid £125m for the property before leasing back the 401 apartments to housing association Genesis. The lease will see Genesis making rental payments for 35 years that rise annually in line with inflation (RPI). The association will also be responsible for sub-letting the properties to residential tenants and ongoing management of those tenancies, including all outgoings, maintenance and repairs. The purchase was the first residential investment by the £1.5bn M&G Secured Property Income fund, but another block is already in the pipeline.
“I think generally the issue for pension funds is that they don’t have the capability [to manage the property], and therefore direct investment into residential has been quite problematic,” says M&G Secured Property Income fund manager Ben Jones. “What we did here is essentially split up the transactions between us and our investors and Genesis; that left each party with the pieces they were best at and which were attractive to them, and left them without the bit they didn’t want. From our investors’ perspective it’s given them a long-term ownership interest in London residential real estate, which is attractive because people feel there are good long-term growth prospects out of that. It also gives them a 35-year index-linked cash flow stream, which is incredibly attractive to pension funds. Any sort of long-term index -linked cash flow is like gold dust to pension funds.”
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