12 March 2020
In the space of just a few years, the UK build-to-rent (BTR) sector has come into its own. While not a new phenomenon globally, it has cemented its position in the UK as a distinct asset class, evolving away from the pre-existing private-rented sector.
Triggered by the introduction of buy-to-let mortgages in the 1990s, owning rental property has been a popular investment for small businesses and individuals for decades. However, a lack of investable assets at scale, the absence of investment vehicles with a robust track record, and the intensity of day-to-day management tasks have historically held back institutional investment.
Today's landscape for rental investment has significantly changed. Demand has continued to increase, with 1.7 million more rental households in 2017 compared to 2007, according to the ONS. This means that rental homes need to be built at scale, something that smaller landlords cannot do meaningfully. Tax and regulatory changes have also started to bear down on amateur landlords, leaving a gap in the market that has been seized upon by long-term institutional investors.
This has come in the form of purpose-built BTR: a distinct investment type, with different physical and operational characteristics compared to converted stock. Large, multi-unit blocks offer the scale to attract large investments, which ensures schemes are built to meet tenant needs and designed to the most operationally efficient specification possible.
Economies of scale reduce overall running costs while increasing net income flows. This allows operators to provide a variety of facilities and amenities, such as free WiFi, private cinema, gyms, a 24-7 handyman service and resident lounges, giving residents access to lifestyle services that home ownership and rental of converted stock cannot. Operators also retain tenants by offering a customer-focused service and running developments in a way that encourages tenants to build networks and establish roots, for example offering social clubs or having a communal roof terrace. This institutional approach means that the UK's rental sector is being professionalised, setting new industry standards in management.
As the sector has matured, it has attracted alternative sources of capital into the residential market. Unlike traditional house building, typically adopting a short-term investment approach, BTR focuses on long-term income streams. This has made it attractive to pension funds, helping to meet long-term liabilities, while providing a hedge against inflation. Greystar, for example, is planning to raise capital from major pension funds and insurers for its BTR fund, and will leverage Greystar’s vertically integrated platform to establish a best-in-class portfolio focused on London.
The investment rationale for purpose-built BTR is a strong one: investments are underpinned by stable occupancy rates, producing consistent cash flows; rental growth continues to outstrip inflation; and needs-based demand is decoupled from economic volatility.
Building large schemes has a number of advantages. Sites can be cherry-picked in areas of potential high growth and demand, maximising returns, while providing homes in areas that need it. Legal & General, for example, has focused on key regeneration areas, such as Salford, that have been transformed with improved services and infrastructure, attracting new residents.
Purpose-built BTR can also be delivered much faster than other forms of housing. Compared with 'For Sale' developments, investor capital can be deployed and start generating returns much more rapidly.
BTR caters for a wide variety of investment models. Investors can opt for an equity or debt holding, and can take an exposure to the construction and/or operational phase:
Investors can gain an equity exposure directly, via funds or by purchasing shares of a listed Real Estate Investment Trust (REIT), such as the PRS REIT.
Investors can choose to invest through the development and operational cycle. Under this model they provide upfront funding to cover the costs of the site, the construction and initial operational costs. In return, they receive an income stream that typically starts once the development is operational and return of capital (at eventual sale).
Investors can take a capped exposure to the construction phase through a forward-funding arrangement. Typically, the investor pays for the build up to a set amount and commits to buying the development at an agreed price, once it has reached a critical stage.
Those investors less familiar with construction phase risks can opt to provide take-out funding whereby, they only provide funding once the build is passed a critical phase (allowing the developer to ‘take out’ its initial capital).
In general, the earlier in the development cycle one invests, the higher the potential for returns, but the larger the risk.
BTR has the potential to provide an asset with a favourable yield, a long-term income stream, significant collateral backing and well-diversified credit risk.
Net initial yields on BTR deals averaged 4.3% from 2015 to 2017, according to Savills Operational Capital Markets. Over this period, 18,500 units with an aggregate value of £4.1 billion (US$4.9 billion) changed hands. Two-thirds were forward funding deals and the remaining were standing stock. Whilst the initial yield may give investors a sense of the income return available, that is only part of the picture. Savills’ research found that over the last 15 years, capital growth has contributed a further 5.2%per annum to total returns on UK BTR assets (however, this is based on relatively small portfolio of existing assets).
Risk exposures can be separated into four main buckets:
- the construction phase considers the design and the physical build. It is capital intensive, subject to regulatory risk, and can suffer from time and cost overruns. Whilst planning permission is also a major factor, the majority of funding agreements are implemented once planning permission has been granted.
– macroeconomic and demographic risks impact the rental market as a whole. For example, the impact of changes in house prices, population growth, wages, and government initiatives for first time buyers etc.
– risks specific to the property, both in terms of its value and desirability for tenants. For example, what if the location of the property becomes less desirable or the facilities outdated?
– risks relating to the ability of the operator, including reputational risk and the ability to maintain a high utilisation rate whilst minimising costs.
The speed of delivery for purpose-built BTR means that the sector has received wide Government support as a means of tackling the UK's housing crisis. In terms of new and upcoming construction starts, purpose-built BTR has 110,000 homes currently in the pipeline, according to the British Property Federation and Savills. The sector will inevitably make a powerful contribution towards delivering the 300,000 new homes needed each year in the UK. This should have knock-on effects on both rental and ‘For Sale’ home affordability, beginning to address the current supply-demand imbalance.
With BTR, the reality for investors is that you need residents who want to stay and pay premium rents – that’s how the model will drive the return on investment. The main impact on the operation of BTR during the pandemic has been on amenity spaces, which have been closed during the lockdown period and are a key part of the value proposition associated with this sub-asset class.
Therefore, investors really care about who the operator is and making sure that they have the relevant experience, the platforms and technology are in place to respond to the needs of the residents, and that flexibility is built in. It is the collective responsibility of the developer and operator to know their customer base and try to interpret their needs, their desired amenities they want and what services are important to them.
On-site BTR teams have built strong relationships with the residents to create a community during the pandemic and introduced a strong virtual suite of options on demand, whether that be fitness, health and well-being, cooking challenges or book clubs. This has proven successful, and it is reported that the same percentage of people that showed up to in-person events are participating in virtual events, which is a strong statistic given the current climate.
At the current level of relative market maturity, BTR operators can adapt quickly and if an amenity space is not being used for its current function, they can quickly change it to something else. Ultimately, the goal is to provide facilities and amenities that are tailored to the preferences of the customer base, which in turn leads to them staying. Therefore, the turnover of the rental product is low, because BTR provides amenities that appeal to the resident and overall, lead to a better quality of environment for them. As a result, BTR gets fewer void periods, and therefore, higher returns.
Through being flexible around consumer needs during the pandemic and the realisation of the ‘new normal’, the product can very quickly embrace innovation, which continues to create reliable investor returns.
As the BTR market matures and more operational data becomes available, long-term investors are likely be enticed by the opportunity to receive a long-term stable income stream, collateralised on a significant tangible asset.
BTR provides an interesting opportunity, both in terms of meeting investment objectives and its social contribution. Whilst a number of institutional investors have contributed to BTR to date, the investor profile is likely to significantly evolve over the next few years, as the sector builds up a tangible track record and the BTR debt market matures.
The continued structural shift towards renting-only further reinforces demand for purpose-built BTR. Long-term, transparent leases will continue to attract residents looking for flexibility and security, as well as those looking for a more lifestyle-led proposition. In a time of economic uncertainty, diversification benefits from more cyclical investments also continue to attract capital from an increasing number of alternative sources, meaning the future looks bright for purpose-built BTR.