The case for UK Private Rented Sector...Source: DCLG, Private Landlords Survey 2010 65% 17% 7% 4% 5%...

Robin GoodchildInternational Director –Global Research & [email protected]

Contacts:

Andrew StanfordUK Residential Portfolio [email protected]

The case for UK Private Rented Sector

European Research & StrategyMay 2015

LASALLE INVESTMENT MANAGEMENT | RESEARCH & STRATEGY THE CASE FOR UK PRIVATE RENTED SECTOR | 2

Investing in UK residential property throughits Privately Rented Sector (PRS) is acompelling opportunity today. The sectorhas a place in a balanced diversifiedinvestment portfolio, given its low historicalcorrelation with other asset classes and thepotential to deliver attractive risk-adjustedreturns. PRS is backed by strong marketand demographic fundamentals, a long-standing supply and demand imbalanceand, more recently, broad governmentsupport to its development as a sector forinstitutional investors.

It is widely recognised that the UK has along-term housing shortage,1 which haspersisted for over 40 years.2 This lack ofsupply has caused house price growth toexceed general price inflation by 2.1% p.a.since 1970, in comparison with commercialproperty whose capital value has undershotinflation by 1.6% p.a.3

The UK is viewed by many internationalinvestors as having one of the mostdeveloped real estate markets globally.Given that the residential sector is asignificant part of most developedcountries’ institutional investment universe(see chart below), it is reasonable to askwhy UK institutions have largely ignored it– until very recently.

Room for growth

Residential as a % of Institutional Real Estate Portfolios Globally

Source: IPD, 2014

Switzerland

Netherlands

USA

Japan

Finland

France

Sweden

Germany

Denmark

Canada

UK

Australia

0% 10% 20% 30% 40% 50%10%

4%

6%

10%

12%

12%

12%

18%

19%

25%

46%

47%

Skyline Central, Manchester

History and background

UK pension funds and insurance companieshave mostly ignored the PRS for historicaland operational reasons.

The PRS was a ‘political football’ throughoutthe post-war period until the mid-1990s.During this time, Labour governmentslegislated to provide PRS tenants with bothsecurity of tenure and controlled rents. Ifincreases were permitted at all, they wereseverely below inflation levels. Conservativegovernments reversed this legislation tomake letting attractive again for landlords.However, the proportion of the total housingstock in the PRS steadily declined to just 9%in 1992 from 20% in 1971 (see chart right).

The first indication of a change occurred in1997 when the new Labour government (led by Tony Blair) announced that it wanteda vibrant PRS, recognising that the AssuredShorthold Tenancy and other changesbrought in by the Conservatives in theprevious decade should be preserved.

This change encouraged one or twoinstitutions to invest in the PRS, for example,the Wellcome Trust. However, mostinstitutions remained sceptical that Labourwould not interfere eventually, and /ordecided that investing in the PRS was justtoo difficult, especially relative to commercialreal estate.

Commercial property leases in the UK areprobably the most landlord friendly in theworld: the tenant virtually always bears the cost of all repairs, insurance and taxes.Investors are used therefore to the grossrent paid by the tenant equating to the NetOperating Income.4

By contrast, residential property is let ongross rents with the landlord responsible for all outgoings including repairs and taxes, in common with residential lettings in most countries. This lease structure is a management challenge to investors whoare not used to optimising net operatingincome from their real estate. Moreover,residential leases are typically annualtenancies, so much shorter than commercial,thus requiring more reletting activity.

Evolution of UK Housing Tenures1971- 2014

Source: DCLG, LaSalle

1971 1978 1985 1992 1999 20060

10

20

30

40

50

60

70

80

% o

f U

K H

ousi

ng S

tock Owner-Occupation

PRS

Social Rent


Skyline Central, Manchester


The UK PRS has grown significantly since1997 and now comprises 18% of the housingstock (see chart right). Having said that, thevast majority of this growth has come fromprivate individuals deciding to become ‘Buyto Let’ landlords. Landlords that own only asingle property hold 40% of the PRS stockand just 8% describe themselves as full-timelandlords. Thus, the market is highlyfragmented and landlords with over 100 units hold only 10% of the PRS stock (see chart right).

As a result, the residential propertymanagement industry has developed toservice multiple ‘Buy to Let’ small landlordcustomers rather than institutions.Institutions looking to invest in the PRShave found it find it hard to appoint amanager capable of servicing their moredemanding requirements. As the demanddevelops, existing managers are adaptingtheir business models to meet the needs of institutional investors. We are expectingto see new service providers emerge asthis demand develops, just as hashappened in the UK student-let market.

In the last 10 years, the Government hasintroduced a number of measures toencourage institutional investors to enterthe PRS market. These include theintroduction of Real Estate InvestmentTrusts in 2007,5 the amendment of StampDuty Land Tax (SDLT) in 2009 so thatportfolio buyers pay the same SDLT as ‘Buyto Let’ investors acquiring a single unit and,in 2013, the creation of a PRS Taskforce,staffed with high-calibre professionalsexperienced in the sector, to identify barriersand promote solutions. These actions arestarting to bear fruit and a number ofinstitutions are entering the market, forexample, local authority pension funds.

Ownership Structure of UK Residential

Source: DCLG, Private Landlords Survey 2010

65%

17%7%

4%

5%

2%

Owner occupiedSocial housingPRS landlords with one propertyPRS landlords with 2-4 propertiesPRS landlords with 5-100 propertiesPRS landlords with >100 properties

18%

The UK PRS has grownsignificantly since 1997and now comprises 19%of the housing stock

City North, London N4


Despite the lack of institutional investment, residential property has outperformed bothcommercial property and the other main UK asset classes over the long term. Thesereturns have been achieved both with lower volatility and low correlations versus otherUK asset classes so that residential can play a very valuable role in a multi-assetportfolio (see table below).

These high returns have been driven more by capital appreciation than income. UK House Price Inflation (HPI) has consistently exceeded general price inflation andmatched wage growth so provides an excellent hedge for inflation-linked liabilities.

Such price outperformance is attributable to the lack of house building since the 1970s.The UK government drastically reduced funding for new social housing after 1975 andthe private sector has not increased its output to meet the shortfall. This is widelyblamed on the UK land use planning system that severely restricts the release ofgreenfield sites for urban development and for housing in particular.

Diversification and access to inflation-correlated investment

Correlation of Annual Returns(1971-2014)

UKResidential

UKEquities

UKGilts

UKCash

UKCommercial

UK Residential 1

UK Equities 0.06 1

UK Gilts -0.22 0.52 1

UK Cash 0.05 0.12 0.22 1

UK Commercial 0.69 0.28 0.03 -0.01 1

Average Total Returns (% p.a.)

11.8 12.6 10.1 7.8 10.8

Historic Volatility (Standard Deviation - %)

10.9 28.6 13.5 4.2 16.7*

*Unsmoothed, 11.1% smoothedSources: IPD, Datastream, Nationwide & LaSalle

6

Correlations, Risk and Returns from main UK asset classes (1971-2014)


Various government-commissionedreports7 have advised that 240-250,000dwellings per annum need to beconstructed merely to keep HPI at a levelto match general price inflation but thislevel of output has not been deliveredconsistently for 40 years. Moreover, outputrecently has been below (see chart right)150,000 units p.a. We therefore expectHPI to continue to grow faster thangeneral inflation and for rents to increasesimilarly, so ensuring that the attractivehistorical performance trend of the sectoris continued (see chart right).

Furthermore, given the fragmented natureof the PRS market, there is ample scopefor institutional investors to provide anenhanced product and customer serviceto the tenants.

UK Housing Completions by Sector: 1949-2013

Source: DCLG

Level required tostabilise real HPI

Ann

ual O

utpu

t

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

1949 1959 1969 1979 1989 1999 2009

Local AuthoritiesHousing AssociationsPrivate Enterprise

UK dwelling output iscurrently running about40% below advised rates.

London Apartments

Differential between London & UK House Prices 1973-2015

Source: Nationwide, LaSalle

1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 20131.0

1.2

1.4

1.6

1.8

2.0

2.2

Ra

tio o

f Lo

ndon

to U

K H

ouse

Pric

es

London/UK

Linear Trend


Location and market dynamics

Demand for residential in the UK tends to be strongest in London and its immediatecommuting hinterland. This is due to twomain factors: employment opportunities aregreatest there and the constraints on newdevelopment are at their tightest. However,today we believe the returns prospects aremuch better in the rest of the country. This is because prices have increasedmuch faster in London than the rest ofthe country over the last five years,stretching the differential to recordlevels. We expect this pattern to reverseas the regions catch up (see chart below),because the same fundamental driversare present. Moreover, rental yields arematerially higher outside the capital andare currently adding to the regions’expected outperformance.

In the past, residential prices haveincreased first in London and this growthhas rippled out to the regions. The gapbetween London prices and the rest of thecountry has only once been as wide duringthe last 40 years.8 LaSalle expects thatcapital value growth is likely to be superiorin the regions over the medium term,despite London’s economy continuing to expand at a faster rate.

The demand for renting is strongest amongthe 25-40 year old cohort, and it is a trendrecognisable all across UK. This cohort isforecast to grow by 6% until 2025, twice therate of the general working population. This group both appreciates the flexibility thatthe PRS offers and it is finding it extremelydifficult to become owner-occupiers.Mortgage lenders have introduced far morestringent lending criteria following theMortgage Market Review and now requirehigher deposits than in the past.9

Furthermore, most graduates are paying offstudent loans as university tuition fees havebeen increased significantly; this is furtherimpeding their ability to save for a depositand the proportion of people saving for adeposit has dropped by 6% over the pastyear to 43%.10

The demand forrenting is strongestamong the 25-40year old cohort.

Pan Peninsula, Isle of Dogs, London


Drivers, approach and attractive risk adjusted returns

Virtually all UK PRS housing today has beendesigned for sale to owner-occupiers ratherthan rental and ‘Buy to Let’ landlords tend toinvest in individual units. As a consequencelet apartment blocks typically have a numberof landlords competing for tenants and nooverall management plan. Institutions seek toinvest in stock designed for rent and at scale,with multiple units within the same building, sothat management can be much more efficient.

While existing PRS stock is occasionallyoffered for sale on the investment market, itis unrealistic to presume that an institutional-scale portfolio can be assembled by relying on market offerings of standing assets alone.We believe that engaging with developersand housebuilders to secure stock in scaleahead of its construction is the rightapproach to executing a successful UKPRS strategy today.This can ensure that thedesign of the property meets the needs of thetarget customers (i.e. its tenants), will achievethe best energy performance standards andcan be managed cost effectively. Moreover,the construction risk can be substantially laidoff to the developer through not paying for theproperty before practical completion thoughfirst letting risk is assumed by the investor.

LaSalle believes that there are currentlybetter prospects for PRS investing outsideof London because pricing has becomestretched within the capital, especially inCentral London. The cities with the bestPRS prospects outside London includeBristol, Manchester and Milton Keynesthat have vibrant business serviceemployment opportunities in combinationwith a well-established PRS market.

LaSalle has developed a multi-factor modelthat ranks locations as PRS target markets,based on demographics, employment andeconomic prospects. The key variables are:

size of the PRS market, as an investorneeds to be confident that there issufficient demand to absorb a largenumber of units in a short period,

large urban locations where 25-40 year olds, the principal target cohort,want to locate,

areas with growing populations particularlyamong those of working age, and

centres with strong local employmentprospects particularly in business andfinancial services, where wage levelstend to be highest.

London continues to be a strong PRS markettoo; we favour the more peripheral suburbswith improving transport links rather thanCentral London. There has been a significantincrease in new supply in the centre, partly in response to a sharp price rise. A supplyresponse is less evident in the rest ofLondon, where 82% of 20-45 year olds inLondon say they will never be able to buy aproperty and the lower levels of value makerents much more affordable for youngprofessionals. Thus, the prospects for rental growth are enhanced.

High class asset management is essential withall real estate but especially so with residential.The objective is to maximise net rental incomein a sustainable manner through minimisingvoids and controlling costs. Investors shouldpartner with managers who understand thestandards that institutions expect andrecognise that returns can be enhanced by providing excellent customer service to occupiers so optimising net income,replicating the US multi-family model.

We believe that the resulting PRS investmentshould deliver returns of 8% p.a. at theasset level, with significant contribution fromrecurring net income and income growth.

This forecast assumes that rents will grow ataround 3% p.a., which we believe is realisticfor new residential properties designed to berented and in good locations. We forecastreturns at a level likely to outperformcommercial property over the next fiveyears, as residential has consistently done over the last 40 years (see table on page 5).


Conclusion

Supply, demand and location

The UK PRS offers institutionsa compelling combination ofreliable income growth androbust capital values.

Furthermore, PRS returns have shown low correlationswith those from other assetclasses, making the PRS an ideal component within a UK diversified portfolio.Investors who participate in the early phases of this newmarket are likely to harvest the best rewards.

Pan Peninsula, Isle of Dogs, London

Important Notice:

The sole purpose of this document is to provide information to you as an institutional, sophisticated or professional investor known toLaSalle Investment Management (LaSalle) and its affiliates to assist you in deciding if you wish to request further and more completeinformation in relation to the opportunity described herein.

This document does not constitute an offer to sell, or an offer to buy, any securities or interests in any vehicle, or the advisory servicesof LaSalle or its affiliates (though, if this document is deemed by any law to constitute such an offer, then it is not being made availablein any jurisdiction where it would be unlawful to make such an offer).

To the extent that any investment opportunity relating to any of the matters herein is made available in due course, it would be offeredsolely on the basis of its own terms and offering materials and not on the basis of any information set out in this document.

Accordingly this document does not constitute an offer to sell, or the solicitation of an offer to buy, and is subject to correction,completion and amendment without notice. This document has been prepared without regard to the specific investment objectives,financial situation or particular needs of recipients. No legal or tax advice is provided. Recipients should independently evaluatespecific investments. By accepting receipt of this publication, the recipient agrees not to distribute, offer or sell this publication orcopies of it and agrees not to make use of the publication other than for its own general information purposes.

Any opinions, forecasts, projections or other statements, other than statements of historical fact, that are made in this document are forward-looking statements. Although LaSalle believes that the expectations reflected in such forward-looking statements are reasonable, they do involve a number of assumptions, risks and uncertainties. Accordingly, LaSalle gives no express or implied representation or warranty, and no responsibility is accepted with respect to the adequacy, accuracy, completeness orreasonableness of the facts, opinions, estimates, forecasts, or other information set out in this document or any further information,written or oral, or other document at any time supplied in connection with this document, and nothing contained herein shall be reliedupon as a promise or representation regarding any future events or performance. LaSalle does not undertake and is under noobligation to update or keep current the information or content contained in this document for future events. LaSalle does not acceptany liability in negligence or otherwise for any loss or damage suffered by any party resulting from reliance on this document.

LaSalle Investment Management is authorised and regulated by the Financial Conduct Authority in the UK.

Notes:

1 See, for example, Barker, K (2014) ‘Housing: Where’s the Plan?’ London PublishingPartnership.

2 See Hall, P (1973) ‘The Containment of Urban England’ Allen & Unwin, London.3 Source: Nationwide, Office for National Statistics & IPD. Reliable long-term data onrental growth is lacking but the longest reputable series for PRS lets starts in 2000 andshows a real change of -0.3% p.a. since inception, in comparison with all commercialproperty that shows -2.3% p.a. (IPD UK Residential & All Property Indices 2014).

4 Often the only deduction is the cost of rent collection, though this ignores voids andrent free periods because ‘gross rent’ is usually less than total potential rental income.

5 In fact, all the UK REITs created invest in commercial property even though thiswas not the Government’s intention by permitting this type of vehicle.

6 UK Residential Returns based on Nationwide House Price Index plus long-runincome return of 3.4% to IPD Residential.

7 See, for example, Barker, K (2004) ‘Review of Housing Supply: Final Report -Recommendations’ HMSO and National Housing & Planning Advice Unit (2008)‘Meeting the housing requirements of an aspiring and growing nation: taking themedium and long-term view’ NHPAU, Fareham, UK.

8 As measured by deviation from linear trend.9 Mortgage Strategy (2015) ‘Cover story – MMR: One year, many changes’http://www.mortgagestrategy.co.uk/news-and features/ features/cover-story-mmr-one-year-many-changes/2019888.article.

10 Halifax (2015) ‘Generation Rent – Five Years of Generation Rent: Perceptions of the first-time buyer housing market 2015’.

11 Halifax op.cit.12 i.e. on the basis that IPD measures direct property returns.

Copyright © 2015 LaSalle Investment Management. All rights reserved. No part of this publication may be reproduced by anymeans, whether graphically, electronically, mechanically or otherwise howsoever, including without limitation photocopying andrecording on magnetic tape, or included in any information store and/or retrieval system without prior permission of LaSalleInvestment Management.

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The case for UK Private Rented Sector...Source: DCLG, Private Landlords Survey 2010 65% 17% 7% 4% 5%...

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