The UK private rented sector
Institutional property investors are chronically underweight to the UK’s residential private rented sector (PRS), but we believe it has the potential to play an important role in a property portfolio.
- The UK’s residential private rented sector (PRS) has the potential to deliver stable income returns, diversification benefits and rental growth.
- The PRS is fragmented both in terms of its physical composition and ownership, making it challenging for institutional investors to access.
- With near-term risks to capital values skewed to the downside, there are relatively few opportunities to achieve very attractive returns on a risk-adjusted basis.
- Even so, careful site selection, product development and high-quality management can deliver attractive returns in specific cases.
Stellar returns attracting institutional interest
Since the late 1990s, the residential private rented sector in the UK has roughly doubled in size to encompass approximately 4.8 million households – around 18% of the UK total1. The market is currently dominated by private individual ‘buy-to-let’ landlords, but several years of stellar returns have led to growing interest among institutional investors from both the UK and overseas. These have been attracted by the potential for stable, long-term income returns, portfolio diversification and capital growth.
Barriers to entry
The sector’s fragmented ownership and lack of suitable available standing stock may make portfolio construction challenging. This is compounded by the aged and small-scale physical nature of existing housing stock.
The case for the defence
Possibly the strongest argument in favour of the UK PRS is the potential for investors to achieve stable, long-term income returns. The sector has a large and growing tenant base, enjoys relatively low rates of voids and arrears, and is likely to benefit from slow but consistent rental growth in future.
Two groups of tenants
PRS tenants can be divided into two broad groups: those who don’t want to own their own home and those who can’t. The first mainly comprises people with a need for short-term housing or the flexibility to move quickly and easily: especially students, young professionals and temporary workers. But there are also those who choose rental accommodation because it enables them to avoid the burdens associated with home ownership.
The second group mainly includes people who would like to own their own home but who are not able to due to their financial position. This generally comprises people with low incomes relative to the cost of housing in the area they would like to live. The size of this group of tenants is determined by a complex set of interacting factors rather than demographics alone.
Low rates of arrears
The PRS enjoys a very low level of tenant default. According to LSL Property Services, the proportion of tenants in the PRS in arrears on their rental payments remains at around 1-2%2. With the high turnover of lettings in the PRS (the majority of tenancies last less than three years) a certain level of vacancy is to be expected.
Low vacancy levels
According to the EHS, 10% of the 4.2 million homes in the PRS were vacant in 2012-13, a level in-line with typical vacancy levels in mainstream commercial real estate. Purpose-built PRS schemes would typically be targeting slightly lower vacancy rates than this. But as the experience of the apartment sector in the United States shows, these levels are achievable by ensuring stock is well located, well designed and that it employs high-quality intensive management.
Investment in the PRS also offers the potential to diversify portfolios, with return correlations to other asset classes and real estate sectors appearing quite low. For example, over the past 20 years, UK residential real estate has followed a different return profile to equities and gilts.
We believe expert site selection, product development and asset management may be able to offer attractive returns in specific cases.
Rental growth potential
Rental levels have increased steadily and consistently in recent years. The government’s RPI calculations show rents growing at an average rate of around 3% per year since the late 1980s – roughly in line with the growth of wages and salaries over the same period. With growth in household income expected to continue, albeit weakly, it is reasonable to expect nominal PRS rental growth to follow suit.
Potential to differentiate through active management
One important consideration for investors should be the sector’s intensive and costly management requirements versus mainstream commercial buildings. Indeed, the lack of high-quality management expertise has been one of the main barriers to institutional investment. Higher management costs have the effect of reducing net yields: the IPD’s 2014 Residential Index shows around a quarter of gross rental income was lost to operating costs, helping to reduce gross yields from 3.6% to 2.4%.
Reducing management costs
There are, however, a number of ways to achieve a reduction in management costs. As the experience of the US apartment market has shown, efficiencies can be achieved through building at scale, incorporating good design, and employing high-quality customer data management and marketing techniques. As the sector matures in the UK, the availability and cost of asset management should improve. Indeed, the IPD Residential Index is already showing a trend of falling costs as a proportion of gross rent.
The outlook for total returns
With household income growth expected to resume, we expect nominal PRS rental growth to steadily improve in the near future. Few residential assets currently look cheap, however. Given the scale of the economic downturn over the past five years, the level of re-pricing in the housing market has been relatively muted. Residential capital values fell by far less than commercial assets and have since recovered or even exceeded the previous peaks – as in the case of London.
We believe the PRS has the potential to play an important role in a property portfolio. It can provide investors with stable income returns, diversification, and rental growth in line with the expected rise in household incomes. Even so, finding value poses a challenge. With near-term risks to capital values skewed to the downside, there are relatively few opportunities to achieve attractive returns on a risk- adjusted basis. In addition, the fragmented nature of the sector means that new development may be required to create efficiencies of scale.
Given these complications, the sector as a whole should be unattractive to non-specialist real-estate investors. However, we believe expert site selection, product development and asset management may be able to offer attractive returns in specific cases. Furthermore, the PRS looks attractive to long-term investors looking for steady income streams with a degree of inflation protection provided by rents that are expected to rise in line with household income.
- Based on UK Housing Survey Data as at February 2014
- Source: LSL Tenant Arrears Tracker, June 2014
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 1 March 2015. Unless stated otherwise any opinions expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
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