Private rented sector: Heading for a fall

The housing sector faces one pretty insurmountable challenge right now.

Put aside the worries over planning, affordable housing and access to development finance: it’s mortgages, stupid. The latest figures from the Council of Mortgage Lenders show that the volume of mortgage lending is still running at not far above half its long-term average. Any desire to return to 2007 - or, God forbid, sixties - levels of housebuilding, runs up against this problem. Namely, how to replace the approximate £75bn a year that until 2008 was being invested in the sector. Because lending volumes are not predicted to improve any time soon. And forget any notion of affordable housing filling the gap - with spending more than halved by the coalition and recent announcements promising little more, government funding is just not there.

No surprise then that almost everyone in the housing sector - builders, developers, politicians - are looking to the private rented sector (PRS) as the great hope for growth. The idea is that if a way can be found to attract institutional investors - pension funds, insurance funds, sovereign wealth funds - to put money into rented housing schemes, a new source of funding for house construction can be found. New buyers, in the form of institutions who then let the properties privately, will mean more homes built. Supporting this view is property data expert the Investment Property Databank (IPD), showing that over the last 10 years investment in housing to rent by commercial investors has outperformed money put into commercial property or the stock market - both darlings of the institutional sector.

This interest has prompted a flurry of political and developer activity around the issue - including the possibility of hard cash from the government and up to £10bn of guaranteed returns for investors, underwritten by the taxpayer. But despite this talk, so far very few deals have been signed. So is the private rented sector really the white knight ready to ride to the rescue of the UK housebuilding sector, and, if it is, what are the barriers it needs to overcome?

Everyone’s bright idea

This week a commission set up by the RIBA - the Future Homes Commission - has become the latest to endorse the private rented sector. It found local government pension schemes, which have around £180bn under management, have the financial capacity to put £10bn into the sector with a “local housing development fund”. And why wouldn’t they? The IPD data shows the total return on private rented housing stands at an average of 9.6% per year over the last decade, compared to just 6.9% for commercial property, and just 4.8% for shares.

Sir John Banham, previously both director general of the CBI and controller of the Audit Commission, who chaired the Future Homes Commission, says investors “can’t wait” to get their hands on this investment opportunity.

“Once you get 10% returns,” he told the Home Builders Federation’s (HBF) annual market intelligence conference, “you’ll be amazed how many investors there are who claim it was their idea in the first place.”

Once you get 10% returns, you’ll be amazed how many investors there are who claim it was their idea in the first place

John Banham, Future Homes Commission

The RIBA report follows a government-commissioned report on the issue by venture capitalist Sir Adrian Montague, which was published in August. Following detailed consultation with the industry, it laid out a vision of private investment in rented housing encouraged by greater flexibility from local authorities over the requirement for affordable housing on private rented sites, and greater use of surplus public sector sites.

In response the government not only endorsed this vision, on 6 September it said it would underwrite investors’ returns into private rented schemes, to the tune of £10bn, and set up a £200m equity fund to help get marginal schemes over the finish line (see box overleaf). So with UK domestic rents at an all time high according to the IPD, and with uncertain stock markets and low UK interest rates, proponents of the idea say housing for rent has the capacity to generate the kind of decent low risk returns that institutions are looking for. If funds do decide to buy new-build schemes for rent, it could provide a new class of customer for housebuilders held back by the mortgage drought.

John Stewart, director of economic affairs at the HBF, admits the body’s members are looking very seriously at it.

“Our members are quite happy to sell to institutional investors. This is very serious stuff, and a number are working away very hard at investigating it, engaging in a lot of creative thinking,” he says. So what is the industry waiting for?

Investment gap

First, the appetite for investment by UK financial institutions is reduced as they have little track record in investing in rented housing, meaning there are few of the all-important comparators required by risk-averse investors. A spokesperson for the Pension Protection Fund, for example, said it was “too early” for them to offer an opinion on whether their members would be keen to invest in the PRS. But it has been more than three years since the Homes and Communities Agency launched its Private Rented Sector Initiative, a forerunner to the current push, and the issue has drifted on and off of the political agenda for the last three decades.

In addition some institutions, such as local authority pension funds - suggested by the RIBA commission as a key investor - have other barriers. According to a report by the Smith Institute, published in September, local authority pension fund managers’ fiduciary responsibilities to pension holders mean there are potential conflicts of interest in investing in local housing schemes in their own area, and bar them from making decisions based on social considerations. There are also fears over loss of control stopping them from teaming up with other pension schemes to create bigger, more flexible funds.

The most obvious barrier, however – contrary to the headline figure from the IPD – is financial: private rent doesn’t provide enough of the right kind of return for institutions looking for regular income. This is because the IPD figure for total return includes the growth in capital value of the house invested in - by far the largest portion of the return on any investment in rented housing. The actual return from the rent is far smaller than the 9.6% overall return - in fact it is just 3.5% on average over the past 10 years, only just over half the 5.8% rental yield an investor would have received from putting its money into commercial property. And in 2011 it was smaller still - only 2.9%. This is vitally important because, as Montague’s report accepts, pension funds and insurance funds, unlike individual buy-to-let investors, require high regular cash flow as well as long-term returns, to repay their customers.

Montague admitted that “there seemed to be a reasonable consensus that the base historic net yield of 3.5% per annum would be too low to prompt much investor appetite, without the boost to total returns from capital appreciation.”

The public investment is too low to make the private rented sector work. It is an important market potentially, but the drivers are financial, and the interventions so far are simply not enough

Peter Redfern, Taylor Wimpey

In addition, the cost of managing housing stock is also a key barrier - the IPD estimates that about one third of the rental income is spent on management each year, further reducing income yield. The low rental yield of residential property in the UK is the reason that a house with a sitting tenant will command a lower price than it will if it is sold empty - a situation which is bizarre for anyone with experience of investing in commercial property, where conversely it is vital for a property to have an existing let with a strong covenant in order to achieve a good sale price.

Richard Donnell, director at Hometrack, calculates that homes sold for private rent generate about 75% of the value that they would if they were sold outright. Given that at least 70% of the cost of a house is made up of land and construction costs, that makes building for rent a marginal activity. This means that for private rent investment to work, someone - generally either the landowner or developer - is likely to have to accept making a much smaller profit.

Housebuilders - for whom profit margin is a live or die metric - are therefore very cautious about the sector. Because of the way they are structured financially, with relatively short-term loans, they have no incentive to build and retain stock to rent themselves. However, many are considering deals to build homes for private rent which are then sold to institutions - if they can agree a price.

John Stewart says: “Housebuilders have to be able to generate a conventional land value - one that pays for the land - and a reasonable profit margin. At the same time an institution will only buy at a price that gives it an adequate yield. It’s difficult to know how they can do it.”

Those in favour, such as long-time rental expert Grainger, say it can be made to work - particularly in a situation where a landowner is keen to have some ongoing control over the quality of a proposed development. Nick Jopling, executive director at the firm and a member of the panel that helped draw up the Montague report, says: “Yes, it might take a lower initial land value, but if the landowner wants to take a stewardship view, or for a local authority that doesn’t want to sell off its crown jewels, then this can really work.”

Controlling the market

One of Montague’s recommendations is that a local authority can use planning powers or land ownership to designate sites for rented housing, where the landowners have no option but to accept slightly lower values. Jopling says this is the way forward: “For those landowners that want to sell on the open market to volume housebuilders, the numbers don’t necessarily stack up. But we’re saying, through Montague’s recommendations you can change the market so that land for rented housing doesn’t have to compete on the open market against land for sale.”

However, there are complications to this model, because if you designate a site as only available for private rent, then it will not achieve the capital growth in value seen by the rest of the market, which according to the IPD is a key part of the return on investment in rented housing. Grainger says this can be solved by setting a time limit - anything from 10 to 30 years - on the retaining of homes for rent, allowing a buyer an “exit strategy” at that time. But it also means that homes may not remain in the rented sector forever.

Grainger’s experience shows the yield problem doesn’t necessarily rule private rent out - but it does make it difficult to replicate on a widespread basis, in particular without the explicit support of a local authority. Donnell says: “Builders have got a problem finding buyers, so they have to look at this area. They may make the calculation that they are willing to take a lower margin, in return for a guaranteed sale which gives them faster turn on their capital. But the rush to see rental as a panacea to all ills in the housing market is dangerous.”

A question of scale

One housebuilder that has been looking at it is Berkeley Group, which has been attempting to pull off a deal with an institution to buy a portfolio of new-build homes. So far, the deal has not been signed. Rob Perrins, managing director at the firm, says he hopes to “get there shortly”, but even then, he does not see it as something that can be replicated at scale. “We’re really interested in it but there remain barriers to doing it at scale - including the cost of management, and the overall price. It’s potentially a very good way of bringing money into the sector, but we need to bridge the price issue.”

Montague’s other primary suggestion to tackle the financial return problem, which has been endorsed by the government, is for local authorities to waive or reduce affordable housing requirements on rental schemes, thereby increasing the land value. But once again this policy requires the explicit support of the local authority, with Labour politicians at a national level already making it clear they oppose the measure, thereby ensuring any reductions in affordable housing will not be without controversy at a local level, and may be barred if the government changes at the next election.

But builders question whether this and the government’s other measures to help schemes - a £200m fund and government guarantees designed to make raising money cheaper - are enough to tackle this price problem.

The chief executive of the UK’s number two housebuilder Taylor Wimpey, says PRS will never be a major part of the firm’s business unless further incentives are introduced.

Like Berkeley, the firm is dipping its toe in the private rental water, with plans to build four or five pilot sites of about 50 homes in the South-east, but chief executive Peter Redfern says: “The public investment is too low to make the PRS work. It is an important market potentially, but the drivers of it are financial, and the interventions so far are simply not enough.”

Some of those in favour of PRS - who are many - think that only more drastic action will overcome these remaining barriers, with suggestions including the creation of a separate planning use class and tax relief on investment. However, Montague considered creating a planning use class - which could solve the valuation problem - but rejected it on the basis it would be too inflexible.

Jopling says: “If you had a planning use class you’d see stuff happen straight away, but there’d be big problems in the long run. It would be quite inflexible, and wouldn’t help the creation of mixed communities.”

Meanwhile the idea of tax relief, being touted enthusiastically by housebuilder Crest Nicholson among others, while being discussed by government, is currently stuck with the Treasury. Chris Tinker, regeneration chairman at Crest, says: “Private rent has huge potential but our concern is that the policies in the current push might not be quite enough to prompt a big boost in housing construction. With the introduction of tax relief as well you’d see a real
change in housing demand and output in 18 months.”

With figures from the RICS this week showing UK housing construction continuing to fall in the last three months, it seems the PRS is set to remain a speciality game for experienced players such as Grainger, rather than a solution to the current housing crisis.

As the HBF’s John Stewart says: “The government has been looking at this for 30 years. [As it is] it is not likely to be a great source of numbers. For that a solution would have to be replicable. It may be that a replicable model does emerge, but at the moment on a run of the mill site this is very difficult to achieve.”