Changes in the social fabric of the U.K. are driving rapid growth in private real estate rentals, drawing strong interest from institutional investors in that country as well as in continental Europe. “Private rental offers a really nice combination of income and capital growth, good inflation linkage and the benefits of diversification,” says Ben Sanderson, director of fund management at Hermes Real Estate, the property arm of £29.7 billion ($44.9 billion) London-based asset management firm Hermes Investment Management.
Hermes Real Estate plans to launch a residential fund by the end of March in cooperation with property manager Countrywide. Hermes hopes that the fund will garner a return of 10 to 12 percent on a leveraged basis, based on an initial net income yield of 5 to 6 percent, annual rental growth of 3 to 4 percent and 2 percent capital growth, with income and capital growth increased through leverage of 40 percent.
Hermes is among a growing number of institutional investors moving into U.K. rental real estate. The U.K. offers initial yields that are about 0.5 percentage points higher than in other European rental markets, according to Robert-Jan Foortse, Amsterdam-based head of European property investments at APG Asset Management, which manages €396 billion ($458 billion) in pension assets for Dutch citizens. “The U.K. has some of the highest imbalances between supply and demand in residential units of all European markets,” he says.
Institutional investors attribute the growth of the sector in part to the long-term tendency for U.K. home prices to rise above wage growth, forcing people to rent as buying becomes less feasible. Some new tenants see renting as a positive lifestyle choice, opting for flexibility and to be free of typical homeowner burdens such as repair and maintenance — not to mention mortgages. This group of occupants tends to be attractive customers because they demand quality accommodation — and are prepared to pay for it. And if some of the people moving into and out of apartments that Hermes has recently bought in Nottingham, an East Midlands city with a population of 300,000, are any indication, rental customers are a largely international community. Recent tenants include a university lecturer from Canada, a postgraduate medical student from the Middle East and a bunch of athletes from various countries playing hockey for a local team.
Hermes has already used £15 million of its £95 million seed equity to buy apartment blocks in the cities of Manchester, Birmingham and Nottingham.
Scotland-based Aberdeen Asset Management will start adding residential properties to its commercial property portfolio in 2015. Other large-scale investors that have recently moved into U.K. residential property include London-based M&G Investments and APG, which over the past few years has invested about £500 million in U.K. housing, focusing on London’s center and inner suburbs.
The returns that Hermes and other managers are targeting look attractive, particularly compared with low yields in U.K. bonds, with the ten-year gilt offering a rate of only 1.6 percent. Hermes’s Sanderson argues that many institutional investors like the strong correlation between inflation and rental incomes. “Residential rental tends to have a stronger link to the general price level than commercial,” he says. Sanderson puts the positive correlation between consumer price inflation and rental income growth at above 0.5, largely because of the shorter leases, which make rents react more quickly to prevailing consumer price pressures.
Skeptics have argued, however, that the high-income yield in residential rental is largely illusory because of the steep cost of managing residential properties. They also fret that the capital value is vulnerable to the U.K. housing market’s tendency toward periodic crashes. These are usually generated by interest rate rises, and many economists expect the Bank of England to start raising rates this year.
Ed Crockett, residential fund manager at Aberdeen Asset Management in London, acknowledges that when comparing residential with commercial office properties, “there is undoubtedly more management involved.” He questions the orthodoxy that investors must allow for a higher differential between gross and net yields. A key plank of his argument is that, over a period of many years, the average cost of capital expenditure will be lower for residential than for commercial properties, given an imperative to constantly upgrade commercial facilities that does not exist in the residential market.
In any case, investment managers hope to shave the differential between gross and net yields by industrializing the process of property management. Countrywide, Britain’s largest property services group, will manage the properties of its joint venture with Hermes in a low-cost way, using its large U.K.-based and offshore team.
Capital values are more stable in residential than in commercial property, according to Matthew Abbott, real estate researcher at Mercer Investment Consulting in London. He cites the property crashes of the early 1990s and 2007–’09. “It’s a low-risk asset class that offers stable incomes, which pension funds are crying out for, and there’s some implicit inflation linkage, which we find attractive,” he says. Although only one Mercer client has invested in it so far, he adds, “a lot of clients are talking about this sector.”
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