New avenues in residential
UK residential investment offers investors low risk high returns. Residential has many attributes that lead us to recommend it as a core holding for a balanced investment portfolio. The UK residential market has largely been ignored by commercial property investors (residential accounts for 2% of UK property investment according to Investment Property Databank). This has been at a significant cost as the out-performance of residential over commercial has been considerable, some 7.1% pa over the last three years. It is worth placing this in context – over the same period the UK office market achieved total returns of just 4.7% pa.
Commercial investors have been sceptical of investing in residential property, citing the cost of management, reputation risk, illiquidity, market size, exposure to capital growth and short leases. As a consequence investors have avoided residential property, from the IPD data we can see that returns have more than compensated for the perceived risks.
Cordea Savills has undertaken work to segment the residential market, investigating the distinctive sub-sectors and assessing investment prospects and components of future returns. We found investors are able to choose from a range of investments that match their appetite for risk and return. Often these prospects are better than those available in the commercial market.
One of the simplest arguments in favour of residential is the scale of the opportunity. The UK residential market is valued at around £3,000bn (€4,300bn), by comparison the commercial property market is worth just £550bn according to IPD. Whilst much is owner occupied there are investment angles within this.
The Pension Commission highlighted insufficient saving by the UK workforce and underfunding is a growing issue for health too as the UK demographics skew to the elderly. Whilst homeowners may see their home as part of their pension (those retired have around £700bn of equity; those aged 50 to 60 years old have £570bn of equity in their homes) it is unclear as to how they plan to release the equity.
Life tenancies allow retired homeowners sell a share of their property to a co-investor in return for a right to live in the property rent-free for life. Homeowners benefit from known income and future certainty, investors see both parties’ interests aligned, as each retains equity in the property. There is a discount between the open market value and the payment received by the homeowner to reflect the lack of payment of rent during the tenancy and life expectancy of the homeowner. Legislation over the selling of these policies is programmed by the government and will raise confidence levels.
There are upsides for investors. Early vacation of the property boosts returns; either from early death of the resident or vacation of the property as the resident moves into care. It may also be possible for investors to price their expectation of long-term house price growth into the original agreement when payment is decided. Thus, whilst the investment is allied to house price growth, risks of changes in house price growth can be offset.
Finally, as performance is linked to age and life characteristics of the tenant, the investment is attractive from an asset-liability matching (ALM) angle. It is possible therefore to structure a portfolio of tenancies that ultimately matches the liabilities of an investor and their income requirements. Cordea Savills considers that high return at low risk underpinned by long-term house price growth with strong ALM characteristics is available to both institutional and private investors through investing in life tenancies. In terms of the market size, the Council of Mortgage Lenders estimates that the current equity release market is £2.85bn but could reach £50bn within 10 years.
Good investment prospects, driven by strong demand from both occupiers and investors, are available through investing in managed student halls. On the demand side, student numbers will rise sharply, a further 150,000 to 250,000 students by 2010, additionally; the UK is attracting considerable numbers of foreign students from Europe and Asia.
On the supply side, as public finance is squeezed we envisage a greater likelihood of universities looking to private sector finance to provide housing and fund their expenditure programmes. Liquidity will improve rapidly as a result. We estimate that the sector has a property value in excess of £12bn. Varying lease terms are offered, from direct student lets to long-term (20 years plus) leases to universities themselves. With long leases direct to universities often with indexed rents, security is unrivalled by opportunities in the commercial sector, by comparison, the average unexpired lease term in the commercial sector is just 12 years according to IPD.
The UK population is undisputedly ageing rapidly. Whilst this suggests a boost for demand for senior housing there are complications. Care homes are faced with sharp wage rises for staff and tightening public spending on such care. As such, the performance of investments in care for the elderly may be held in check.
The segments within the senior housing sector can be distinguished by the level of care required. At the simplest, sheltered housing may provide strong returns and limited cost risks, at the most complicated, nursing homes - where health care is provided - are likely to show more limited returns unless funds are available from the occupants themselves to meet the required cost of care.
Investment can be made on the basis of secure income streams in the private market. There are opportunities in ground rents and regulated tenancies, both are considerable segments. Of interest to investors are the known and certain income from rents and the significant potential upsides from reversionary capital uplifts.
We estimate there are some £1.5bn of ground rent and £8bn of regulated tenancies. This little discussed area of investment is therefore valued at around half the size of institutional investment in UK shopping centres. There are also substantial opportunities in housing association and key worker residential too.
And of course there is the private rented sector. We estimate the UK buy-to-let market alone is valued at around £53bn, approximately the same size as commercial investment in all UK retail property. Performance data from IPD referred to earlier illustrates the outperformance of the limited institutional investment in this sub-sector.
There are many opportunities to capitalise on the benefits of investing in the UK residential market. Commonly perceived risks, most notably an expected slowdown in the growth of house prices, are not of material concern for many segments and there are many opportunities for high returns at low risk. We forecast house price growth of just 3.4% pa for the five years (end 2004 to end 2009) a sharp slowdown from the preceding five years when 15.8% annually was achieved.
Paradoxically, whilst commentators reiterate the slowdown in house price growth, we should not forget that the housing market does not work in economic isolation. Buoyant house prices have supported consumer confidence, boosted retail sales and enhanced retail property returns. As a consequence, we believe slowing house price growth will have a greater impact upon retail property returns than for secure and high-income residential investment.
Andrew Allen is head of research and strategy at Cordea Savills