Safer foundations in residential
While several European markets, notably the UK, have considerable reservations about residential property as an investment class, viewing commercial property as a safer bet, the general view in the Netherlands is that commercial is more risky than residential. The rationale behind this reversed perception is that residential property is less subject to the business cycle than commercial and therefore less volatile.
“From the investor’s perspective the main reason to invest in the residential sector is the low-risk environment and its flexibility,” says Rober Spaan, portfolio manager real estate with Amsterdam-based SFB Group. “In addition, there is an annual income return from the portfolio and if you invest in residential units your investment in each unit is relatively small.”
SFB is the asset manager of the sector-wide pension fund for the building industry, the Bouwnijverheid, whose total weighting in real estate is about 26-27%. The value of the real estate portfolio is approximately e3.5bn, of which some 80% is invested in the Dutch residential sector. The pension fund owns 20,000 residential units in the Netherlands.
“Historically there is a 4.5% to 5% annual cash return and opportunities for capital growth,” Spaan says. “However, the Dutch property market, and especially the residential sector, has boomed in recent years giving the pension fund double-digit returns on the residential portfolio with an income return of 5-6% and a capital growth of also 5-6% and in some years even 10%. While there are claims that the market is overheated and overpriced and there will be a correction, the same was being said two or three years ago.”
He adds that while a lot of capital is needed to invest in apartment blocks, the unit price is lower. “There are two ways to exit from the investment if needed; selling off blocks or selling off individual units.”
But according to a recent paper by Ian Hally, head of property research at Scottish Widows Investment Partnership, managing residential portfolios in the Netherlands is both costly and time consuming compared with commercial real estate because of the relative smaller unit sizes and the ongoing refurbishment required in residential units in order to maintain both the rental and capital values at perceived market levels.
Hally asserts that the operating costs for Dutch residential property as a percentage of gross income was around 27% between 1998 and 2003 while the commercial asset classes’ operating costs ranged between 12-14%. He adds that the cost differential also has an impact on the key drivers of total returns for the different property asset classes, with income providing some two-thirds of the total return for the commercial property sectors but only one-third of the total return of residential property, with the higher risk capital growth providing the majority of the total returns.
Spaan concedes: “Income return is about 200 to 250 basis points a year higher in the Dutch commercial sector than residential and yes, managing a residential portfolio is indeed costly and time consuming compared with commercial real estate. But given that commercial property is far more dependent on the economic cycle it is considered more risky. So although cash flow return is lower for residential compared to commercial we consider it to be still attractive given the low risk involved.
“It's true that there is a fundamental difference in demand drivers, and that also gives rise to a differential in performance, and especially in volatility. If you look at the market from the perspective of a Dutch investor the most risky investment class is offices, because they are highly correlated with economic conditions, and after that it’s the retail sector, because everybody has to do their shopping, while the lowest risk is the residential sector because people still have to live somewhere.”
Spaan agrees that the government is still very influential in the residential market, “especially with respect to tenant protection and rent review. But the part of the residential market where institutional investors hold their investments is mainly in the more liberalised area with respect to pricing, although of course tenant protection is still in place”.
An evolution in the market has been the spin-off of pension fund property portfolios. “Major pension funds like ABP and PGGM which were initially the owners of their real estate investments subsequently decided to be purely an investor and not an operator, so they outsourced the property to a new entity in which they were at first the sole shareholder but in which they have gradually diluted their stake. This has enabled smaller Dutch pension funds that wanted an exposure to the residential market to get into vehicles offering good quality product.”