Does it pencil?

In January 2022 I wrote a blog post about British fund manager Terry Smith and his three step investment strategy:

1. Buy good companies

2. Don't overpay

3. Do nothing

At the time, with a little creative license, I speculated as to how this investment strategy could be applied to real estate:

1. Buy good real estate (think high quality assets in supply constrained growth markets)

2. Don't overpay (ensure that unlevered yield on cost is always greater than your cost of debt capital, resulting in positive leverage)

3. Do nothing (hold for the long-term and let compounding do the rest)

However, even casual observers of global interest rates over the last 18 months might spot a problem with the second point.

The current two year treasury note yields slightly over 5% whilst two-year gilts offer more than 4.5%. Low-fee money market funds from companies like Vanguard and BlackRock provide a nearly risk free way to earn close to 5% on your cash, with near-instantaneous liquidity. The cost of debt capital available to real estate investors is materially higher. Of course, it varies depending on geography, asset class, property, sponsor and loan-to-value but it starts at a minimum of 6.5%+ and goes materially higher from there.

Contrast that with the net yield available on UK residential investment property. In Knight Frank's 'Prime UK Yield Guide' from August, the net investment yield in UK build-to-rent (BTR) assets ranges from 3.6% in prime central London to 4.5% in smaller regional cities.

Assuming no use of leverage, it is apparent that one can earn a better cash return (at least initially) by depositing funds in a money market fund and sitting on a beach in the Maldives rather than investing in (and managing) Class A residential investment property.

The surge in interest rates since the beginning of 2022 has unsurprisingly resulted in price declines across many asset classes. Most notable perhaps, are long-dated bonds and high-growth, largely unprofitable technology stocks. Both are high duration assets among the most sensitive to changes in rates. Some areas of real estate have not been immune either. For instance, office properties have been squeezed due to higher rates and increased vacancy resulting from a shift toward remote work. Even industrial & logistics property, a favourite of real estate private equity for much of the last 10 years, has not been immune. The share price of Segro, the UK's largest industrial property REIT, has fallen 50% from it's all time high at the end of 2021.

For private residential real estate however, the story is different. What's intriguing is how little values have adjusted to the higher interest rate environment. The Halifax House Price Index suggests that on a national level, average house prices are less than 5% below their peak. Properties targeted by institutional investors are not much different.

Several factors could explain this phenomenon, but I'd argue that the following two are the most significant:

1. Fund flows: A considerable amount of funds were raised in 2021 and early 2022 when liquidity was abundant, and asset prices were soaring in the zero-interest-rate era. Much of that capital remains uninvested, with a significant portion targeting residential real estate. Moreover, office and retail real estate have become unattractive to many institutions, leading them to reposition their portfolios away from these asset classes. For instance, in 2007, U.S. office sales volumes were twice that of apartments. Apartments overtook offices as the top-selling commercial real estate sector in 2015 and were three times as large as offices in 2022. While every real estate sector is currently experiencing lower transaction volumes, apartments are likely to outpace offices again in 2023 by a factor of three. Where the US leads, the UK usually follows, albeit from a lower historical base of apartment investment volumes.

2. Residential real estate is also a consumption good: The value of residential real estate in the UK is fundamentally underpinned by the owner-occupier market. For these buyers, the investment prospects of the property they are purchasing are a secondary consideration. Primarily, they are buying a place to live, making the potential rental yield and its comparison to the return on cash largely irrelevant.

All this brings me back to the title of this post: does it pencil? That is, does a deal appear worthwhile based on initial underwriting. It's not as simple as being profitable in absolute terms. With risk-free returns of 5%+ available in money market funds, investments must make sense on a relative basis. In essence, are you being rewarded with an adequate return relative to the level of risk and the illiquidity of your investment?

For UK residential property investors today, the answer likely varies depending on the investor's circumstances:

If your cost of capital is low, your target return is reasonable and your investment time horizon is 10-20 years or more then the answer might well be yes. Many pension funds aim for annual returns in the region of 7% and would like nothing more than a stream of secure, index-linked cashflows tied to wage growth that closely match their long-term obligations. High-quality residential real estate in today's market fits well in this context.

For more opportunistic investors, investors with a shorter time horizon or for real estate private equity funds looking to generate the kind of highly leveraged returns which would justify sizeable promote fees, it's a little less obvious.

The demand for high quality, affordable rental properties is a mile wide and a mile deep

We recently had a house which we bought earlier this year come onto the rental market for the first time. We had just finished gut renovating it after several months of work. It's a two bedroom semi-detached Victorian style property with a decent sized outdoor terrace / garden.

The property listing was online for a grand total of 48 hours. In that time we received no fewer than 29 enquiries which produced 15 promising viewings from qualified prospective residents. From those 15 viewings, there were 9 applicants for the property.

Based on those numbers you might think that the rent had been set too low but in actual fact, the monthly rent was set at a higher price than any comparable property in the area, sometimes by as much as 10%.

It is clear that for high quality homes at affordable prices there is a serious imbalance between the supply of available properties and tenant demand. As a result it's not surprising that rents in Greater Manchester have risen by close to 20% in the last two years and in some sub-markets it's significantly more.

Increased demand for properties, especially houses, has been well documented in the media since the covid pandemic began nearly two and a half years ago. Less well publicised are the reasons behind the dwindling supply of properties coming to market. These include:

1. Fewer tenants deciding to move out at a time when they would likely have to pay a higher rent than they are already paying to secure a different property on the market.

2. Landlords exiting the market in recent years due to tax changes (reduced mortgage interest tax relief & stamp duty surcharge on additional property purchases) and additional legislation.

3. Landlords selling up following the recent strength of the housing market.

4. The UK's inability to build enough houses in the areas that people want to live (especially when you consider actual houses vs. apartments). In certain areas such as well connected suburbs close to but not directly inside city centres - there is simply no more land to build on. In the few cases where land is available, there's no desire to change planning laws to replace a few houses with mid or high rise apartment blocks.

For all these reasons and more, it doesn't seem likely that the component of CPI comprised of rental housing costs is likely to be disappearing anytime soon.

For the UK Build to Rent industry, it's still Day One.

The number of completed Build to Rent (BTR) homes in the UK grew by 19% over the past 12 months reaching a combined total of 72,668. London saw an extra 5,802 BTR homes completed whilst a further 5,901 were completed outside the capital.

The UK BTR sector is growing & maturing quickly but it is still very small.

In the US the comparable number of completed multi-family units was over 375,000. That's a multiple of thirty two times more purpose built rental homes completed than the UK in just one year. In Dallas, Texas alone 25,976 units were delivered in 2021 - more than double the number for the whole of the UK.

The pipeline of BTR homes under construction in the UK is growing quickly, especially outside of London, and currently stands at 46,304 units.

Again, however, this figure which is for the entire country is made to look very small when compared to a number of large US cities in isolation. Dallas has close to 45,000 units currently under construction and is closely followed by Austin (41k), Phoenix (38k) and Washington D.C. (36.5k).

The number of UK suburban BTR homes (as opposed to urban high rises) is also growing. Having been a somewhat niche sector in the market historically, the success and maturation of early developments combined with a pandemic induced race for space has seen a large number of firms committing capital to this particular asset class. Blackstone, Legal & General, Goldman Sachs & TPG are just some of the firms with major capital either already invested or announced & ready to deploy into the right opportunities in single family homes.

There are around 8.5k suburban BTR homes already completed and a further 9.5k currently under construction or at the planning stage. These numbers only reflect properties specifically allocated to become purpose built rental homes.

It is highly probable that a significant number of homes in the planning process or at various stages of construction in the "for sale" market may well end up becoming suburban BTR homes. This is in light of the volume of capital chasing this type of stock, the likely winding down of the government's Help to Buy equity loan scheme as well as a possible deterioration in economic conditions and further rises in interest rates and therefore mortgage costs. In such circumstances, it is not too hard to imagine some of the volume house builders in the UK looking to sell larger quantities of homes to deep pocketed institutional investors with long term investment horizons.

Ultimately, whilst the UK BTR industry is expanding quite quickly, it is doing so from a very low base. Compared to the far more mature US market and indeed many European countries, UK BTR is tiny with enormous room for growth in the years ahead. With plenty of capital and investment commitments to support it, the future looks promising.