PRS is becoming an area of interest for institutional investors. Why?
First of all, what is it?
Private Rented Sector (PRS) is residential property that is not occupied by the owner but rented out by private (as opposed to social) landlords. The English Housing Survey suggests it currently represents 19% of the English residential market.
According to PIA Property Data Report (2014), the UK Private Rented Sector market is £839bn in size. To put that into context, the UK commercial property market is £683bn.
Why is it interesting for potential investors?
There are effectively three major factors at play: general housing demand, home-ownership affordability and general housing supply.
With continuing demand in the UK housing market, pressure is growing.
The Office for National Statistics (ONS) expects the UK’s population to rise from 64m at present to 67.1m by 2020.
In addition to this, the walls are quite literally closing in as the average household size is decreasing. ONS data suggests that the average household size has fallen from 2.42 to 2.35 over the last 2 decades.
According to the English Housing Survey (2013-14,) 48% of households in the 25-34 age bracket in England rent their accommodation.
For context, a decade ago this figure stood at 21%.
Over the same period, home-ownership in this age group has fallen from 59% to 36%. This is a natural result of house price inflation exceeding wage inflation for many years. In the meantime, average deposit requirements have been increasing (from 17% in 2000 to 22% in 2013).
There is a continuous and chronic lack of housing supply in the UK.
It is estimated that between 2004 and 2014, a cumulative shortfall of 1,154,750 dwellings has built up.
According to the famous Barker Report, we should be building 250,000 dwellings per annum in England just to keep house price inflation at 1.1% p.a. Yet we are currently building at a rate somewhere closer to 140,000 p.a. Time consuming factors such as the planning permission framework and land release issues have contributed to this.
The current government is very supportive of increasing both the housing supply and institutional investment in PRS. Over the last few years, a few policies have been introduced to facilitate this.
Examples most often quoted are the “Build to Rent” and “PRS Guarantee” schemes. These essentially act as provision of cheap financing for building new dwellings and investing in newly built PRS properties respectively.
In addition to this, in 2011, the government introduced a Stamp Duty Land Tax Relief, which allows investors who wish to acquire multiple flats to pay a reduced tax rate.
Finally, in 2012, the government published a revised and simpler National Planning Policy Framework. Since then, approval rates for planning permission have improved (from c. 150,000 dwellings p.a. before the change to around 219,000 p.a. at present.)
An enduring problem for the UK PRS market is that it is extremely fragmented.
Only about 2% is owned by institutional investors and the vast majority is owned by individual private landlords who own 1-2 units.
In order to access this market as an institutional investor, you will most likely have to invest in the development of new stock. We have reviewed a number of investment managers in this space and conducted due diligence on the development risks inherent in this proposition. It turns out there are reasonable risk mitigating mechanisms in place for a large number of these risks (details in the table below).
|Development Related Risk||Mitigating Factor|
|Planning risk||Sites are acquired with planning permission already in place.|
|Risk of construction costs rising||Fixed price contracts.|
|Risk of delays||Construction partners pay penalties to investors if delays occur.|
|Risk of construction partner not sticking to the specification||Investment managers have step-in rights to take over the project if the construction partner does not adhere to the specification.|
|Risk of the construction partner going bankrupt||Adequate due diligence of the credit quality of construction partner before starting the project.|
The non-development related risks should also be considered. As a risk oriented firm, we have carefully summarised them in the table below:
|SourcingInstitutional PRS investing is still in its infancy. We expect capital deployment to be slow, in particular where strategies focus on development of new stock (it takes 2 years to develop a new block of flats).||Investors should understand that this is one of the features of this opportunity. We advise to work with experienced investment managers who have deployed capital in this asset class in the past.|
|Exit RiskTypically investment managers in this asset class make an assumption that the institutional investment in PRS will increase significantly over time. The idea is that by the time the Portfolio Manager needs to exit from its positions, the market will be robust and active enough to facilitate this.
We hold a much more conservative view of this, as PRS investment could be impacted by a number of adverse events: change in government policies, house price shock, etc.
|Although the process is much more time-consuming, it is still possible to exit via selling individual units in a block. In fact, this is likely to attract higher prices than selling the entire block. It is estimated that it is possible to sell 50 units per annum in a block of flats.However, it is important to ensure that the selected manager acquires sites, where owner-occupier ownership is allowed in planning permission documentation.
|Regulatory RiskThe current UK government is very supportive of greater institutional investment in PRS and the policies introduced so far have generally been supportive of this. However, this could change in the future.
|Unfortunately, this risk is very difficult to control. We note that the current government remains committed to supporting PRS development.|
|Occupancy/Letting RiskResidential leases are typically shorter than commercial. In weaker occupational markets, it might be difficult to attract tenants.||We advise our clients to focus on strong occupational markets.|
|House Price RiskIn the event of an adverse shock to the housing market, returns in this strategy may suffer.||The shortfall in UK housing is considerable and growing. The strategy is underpinned by a fundamental imbalance between demand and supply.|
|Leverage Risk||Investors should focus on strategies employing low or no leverage.|
This could be an attractive asset class for investors looking to increase their expected returns going forward. We would advise, however, that investors get comfortable with all inherent risks and the potential for slow capital deployment before they invest.