Panellists discuss the UK private rented sector and the opportunity residential property presents for pension scheme investors.
M&G Real Estate
Alex Greaves oversees and manages the residential investment capability across M&G Real Estate. Prior to joining the company in 2013, he spent seven years as a fund manager at Grainger.
Hermes Real Estate
Philip Nell leads Hermes' fund management activities for the Vista UK Residential Real Estate Fund. He was previously head of European retail funds at Aviva Investors.
Why should pension schemes be investing in the UK residential market?
Philip Nell: It gives a very interesting opportunity to access an asset class that offers attractive yields compared to gilts and fixed income as well as a strong inflation hedge. So you are getting some good inflation-linked returns, very closely correlated to CPI and very low correlation to gilts and other asset classes. So it's a strong diversifier.
Alex Greaves: Another important point to note is that investing in the residential market offers a measure of downside protection. In the last two recessions residential has dipped less steeply than commercial property and has actually recovered a great deal more quickly, so it is a very defensive type of asset into which to invest.
Why the interest in residential right now?
Philip Nell: As Alex says, there is a benefit from a defensive perspective and I think the commercial sector, which has seen strong performance for the last few years since the end of the global financial crisis, probably is seeing a little bit of slowing down, as other asset classes are. It is a very low-yielding environment out there generally, and residential yields have mostly been lower than commercial property yields. Consequently, investors are now much more willing to take on those yields with the downside protection that Alex referred to.
Alex Greaves: I agree. Over the last ten years we have seen a structural shift in the private rented sector and have seen an increase of 180,000 to 200,000 new households in the sector every year for the last ten years. The private rented sector now comprises 4.4 million households - this is no longer a small ignored sector, this is one that is here to be recognised for the long term. As a result of that, we see significant opportunity there for investors as the sector continues to grow.
What sort of investments are typically included in these strategies?
Philip Nell: We have tended to see much more activity in the apartment block type of asset than we have in the family housing market, although I think that's an area a number of institutions are keen to get involved with.
Alex Greaves: We're focused on 25 to 34-year olds. We're focused on employment, places of employment and access to those places of employment. So that typically manifests itself in those urban-type locations, predominantly apartments, at this stage. But it is well known that there are migratory patterns - individuals move out of city centres in the search for space. As this happens, I can see houses constituting a more important part of institutional portfolios as time goes on.
To what extent are pension schemes exposed to development risk when they're investing in these strategies? Are there other risks?
Alex Greaves: The exposure in reality is to the covenant strength of the firms that are developing and constructing, the deal structures and the quality of the contracts we have with them. So it's quite different from direct development.
We mitigate the risk through fixed price, fixed duration contracts. Having these sorts of contracts means we have to assess the covenant of the companies we are dealing with and make sure they have the capability and balance sheet to be able to develop out these particular schemes.
The other way we structure the deals is to purchase the land and to fund developments in arrears - leaving quite a high level of profit payment at the back end of the development, which acts as an incentive to developers.
Philip Nell: It is interesting to compare residential to commercial real estate - especially when it comes to the letting risk. In residential, you have a much more granular letting up process. Obviously, take-on is going to be critical and how you market the scheme and how you get tenants in the early days is going to be very important, but you've got a much more diversified risk base and I think that's a really key important point to make.
What makes a good private rental home? What do you need to provide to attract the right sort of tenants and encourage them to stay?
Alex Greaves: You need to look at individual markets. But it has to offer value for money and it has to be close to places of employment and transport.
One way we try to offer that value is to create some form of community. So, for example, we are developing a scheme at North Acton where we have allotments on the roof. The idea is that people can grow food - and get to work together and talk to each other. We find that communities where people engage with each other are happier places and people prefer to live in happier places. They'll stay for longer so occupancy levels increase.
We also have car sharing schemes, bicycle parking, amenity rooms which can be used on a day-to-day basis, to work from home or book it for an exclusive dinner party or to watch sporting events with friends. But if these sorts of amenity rooms don't work, we'll convert it back to a flat because it is all about getting income streams for every square foot that sits within the building.
It is also about service - and we are trying to make sure we offer an element of service in our schemes. For instance, in a traditional flat, a customer will have to wait in for a repair to a washing machine. In one of the built-for-purpose buildings they simply drop the keys downstairs with the person manning the front desk or the leasing manager and someone will come and repair and deal with that issue.
Philip Nell: I agree. It is also important to make the difference between the build-to-rent and the build-to-sell model.
With build-to-sell the developer is incentivised to maintain quality for the initial risk period until they sell the asset. After that, the service charge tends to be minimal as most of the occupiers - be they owner-occupiers, or private landlords - will be looking to effectively keep costs to a minimum.
Build to rent buildings have to be constantly refreshed. Our occupiers will be able to leave if they're not happy. That means we've got to have adaptive buildings that are able to flex with changes in demand. If one thing doesn't work, we need to be able to put that space back into a different use, rather than just simply delivering it into a market and sitting there and waiting for the units to sell.
Can you talk me through some of your current investments?
Philip Nell: We've got a couple of larger schemes, one in Liverpool, one in Manchester; both are on site at the moment.
The one in Liverpool, we decided we wanted to go for a more premium offer; we felt there was demand in that market. So it is in an excellent location in central Liverpool and we have invested heavily in the scheme. It will have a gym as well as shared facilities for dinner parties and things like that. It will also have very high car parking accommodation. We think this offer will work there.
Whereas the scheme we're doing in Manchester will be priced slightly lower. The scheme is well located - half way between Salford Quays and the city centre and accessible via the Metrolink. But, while it will have central accommodation in terms of concierge and front desk, it won't have any other shared facilities, something that allows us to price it more effectively.
It is all about the right offer for the individual market and judging what the market will want to pay and will want to receive.
Alex Greaves: Currently we have around 800 ‘live' income-producing units in addition to a number of schemes we are on site with.
Our North Acton scheme is live in just a few months and we have agreed a scheme with Telford Homes. We have tweaked their build-for-sale scheme into something that is now a rental product and we now have amenity space and so on. It is right next to a Docklands Light Railway station, two stops from Stratford - we are really focused on the transport nodes - and will have on-site management along with a service provision such as a gym.
Our on-site schemes also include one in Crawley, which we're doing with Crest Nicholson, where we've got 230 homes. That is a much higher car-based environment and probably towards the upper end of the age demographic we work on, 25-34. We have a clubhouse there which is 2,500 square feet with a gym and we are going to build a tennis court there too.
Can you summarise your key points?
Alex Greaves: For pension scheme investors, it's important to look at the supply/demand characteristics of the UK residential market. Some 95% of the 4.4 million UK rental properties are currently owned by ‘mom and pop' investors and less than 5% by institutions. Compare this to the Dutch, Swiss, German or US markets, where up to 50% of rental properties are owned institutionally - they have a significant amount of capital in this space and they wonder why British institutional investors are not doing more in this space.
When we consider supply/demand, we need to build 240,000 homes a year but are only currently building 150,000. There's a significant shortfall and that's not going to go away.
So I think this is a very exciting asset class and one that both presents a fantastic opportunity for pension fund schemes to get into and creates much needed affordable homes for people in and outside of London and around the UK.
Philip Nell: I'd reiterate what Alex has said. But it is important to recognise this isn't just a property offer but also an alternative yield asset class that offers both inflation-hedging but also long-dated income streams as, while the leases themselves may be short, the income stream over time is very, very certain.
We see this as a long-term income asset that is going to give scheme investors a good measure against inflation, very low correlation against other asset classes.
But I think we also need to recognise this institutional investment is not just about providing high-quality homes for high-end professional workers and people on very high salaries. This is about providing accommodation across the piece - it just depends on what level of service and what type of accommodation people want to see.