Willis Towers Watson’s Jayasingha says typical returns investors can expect from the asset class are in the region of 6-8% per annum net for an unleveraged PRS strategy, although evidence shows returns can be significantly higher. The M&G Residential Property Fund, for example, produced total returns of 19.5% in 2015 and 16.3% in 2014.
Matthew Abbott, principal in Mercer’s real estate boutique says over the last few years returns have been well into double digits at around 13% to 14%. He considers an appropriate return for residential real estate to be roughly RPI +3%.
The IPD UK Annual Residential Investment Index has shown annualised total returns over three, five and 10 years of 11.6%, 11.1% and 9.2% respectively, which far outstrips equities (5.2%, 4.8% and 4.7%) and bonds (2.3%, 5.4% and 5.6%). Importantly, on the same basis, inflation has been 1.8%, 2.7% and 3% respectively.
The inflation-proofing characteristic of residential property is a key aspect of what makes the asset class attractive to institutions. Rent levels tend to be closely linked to wages, rather than GDP, which gives them their inflation-proof nature.
However, as many residential funds target 25-34 year old professions, which is the demographic with the highest wage growth, M&G’s head of residential real estate, Alex Greaves, believes the asset class is likely to see higher rent growth versus standard inflation.
STABLE INCOME
Residential real estate has also demonstrated relatively low correlation to other asset classes and areas of real estate. As a result, returns have fallen less steeply and recovered more quickly than commercial property during recession periods.
The IPD index (excluding transaction and developments) shows residential returns significantly outperformed the commercial property market between 2007 and 2013, for example. Total returns for residential were 19.2% in 2007, -14.7% in 2008, 11.9% in 2009, 10.4% in 2010, 10.9% in 2011, 9.2% in 2012 and 13.5% in 2014.
Comparative total returns for all commercial property were -3.4%, -22.1%, 3.5%, 15.1%, 7.8%, 3.4% and 10.7%. Of the sectors within the index, residential has shown the lowest volatility between 2001 and 2015 of 7.9%, versus 10.8% for industrial, 11% for retail and 11.7% for office. Volatility for all commercial property was 10.7% over the same period.
Islington’s Greening says, although the residential sector is still subject to the housing market as a whole, the lower volatility it experienced during 2008 versus many other asset classes mean an investor’s risk allocation is “improved by allocating to residentialproperty”.
WTW’s Jayasingha says stable income is one of the key attributes of residential property.
“Unlike offices, for example, which can see meaningful gaps in income from vacancies and rent free periods, residential property can be managed on a more granular basis to lead to more stable income streams,” he says.
DIVERSIFICATION
To a large extent, the stability of residential returns is derived from the greater diversification it offers versus commercial real estate, which is due to the more granular nature of the underlying tenancies. A residential property development will typically house individuals working in a broad selection of industries, from across different career and life stages, and with different ambitions. The exposure to any one sector in comparison to commercial is therefore significantly reduced.
“The power of granularity is extraordinary, which gives powerful diversification across any one site and then also across different sites,” M&G’s Greaves says.
Historical returns from UK residential have shown it to have a low correlation relative to many other asset classes, according to WTW’s Jayasingha, which, he says, makes it “appear an attractive addition to a portfolio”.
The low correlation to equities and bonds, and the close link between rents and wages, rather than GDP, mean current UK residential shows a correlation with commercial of roughly 60%, although Abbott believes this may exceed 80% in future.
“The correlation between residential and commercial real estate will increase as residential becomes more institutional,” Abbott says. “That is what happened in the US.”
SO FAR SO LITTLE?
So why has the UK residential market taken so long to get going? In large part, the issue stems back to the rent controls of the 1970s, which hampered return potential and raised the political risk associated with the asset class. Accordingly, institutions did not typically show much interest and the UK housing market developed very differently from many of its international counterparts, with the majority of landlords being buy-to-let investors.
Historically the UK has also had a strong culture of buying rather than renting, which Jayasingha says has “limited investment in the development of new PRS stock”.
