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Aon Retirement and Investment Blog

The Private Rented Residential Sector as an Asset Class

Many UK pension schemes invest in commercial property through pooled funds and sometimes directly through segregated accounts. On the other hand, very few schemes have direct exposure to the UK residential sector, a market estimated to be around £5.8 trillion in size in the UK according to the property firm Savills.

If you look further afield toward Europe and North America, you find that institutional investors often make higher allocations to the private rented (residential) sector (PRS). In Europe, the amount of housing owned by institutions is much higher than in the UK and stands at almost 50% in the Netherlands and Switzerland. This compares to institutional ownership of less than 5% of the housing market despite the number of households privately renting in the UK doubling to around 20% since 2000.

Why is this so? And should pension schemes consider the UK private rented sector as an investment?
Firstly, let's consider the lack of current institutional investment in the UK residential sector.

Commercial real estate is a mature asset class in the UK and can hardly be considered as an alternative investment anymore. There are a number of excellent fund managers with well-established track records that pension schemes can invest with. Importantly too, the UK has a large stock of institutional quality assets to invest in and a relatively transparent and liquid market.

Although residential property is an asset class that trustees will be familiar with from their personal experience, the vast majority of existing housing stock is simply not appropriate for institutional investors. The UK market is currently dominated by small scale buy-to-let landlords owning houses or flats. These are typically expensive to run without material economies of scale and are usually not modern buildings, which are more attractive to PRS investors.

To make PRS investable in the UK, suitable stock has to be first created and then managed efficiently. This is quite different to the US and Europe where purpose built stock already exists and is well managed, and there is also less desire and hence demand for home ownership.

Large, modern purpose built schemes reduce the otherwise relatively high costs of investment and can allow for other ancillary sources of income to be generated by supplying ultra-fast broadband, gym facilities, or other limited on-site commercial uses such as coffee shops or small metro supermarkets. These initiatives increase returns and help overcome lower net initial yields compared to commercial property.

Funds exclusively focused on PRS are looking to do just this – build bespoke stock and ultimately create an institutionalised market. The UK continues to face a housing crisis, and the government has been looking for ways to incentivise the building of new stock. A growing and undeniable need for more high quality rented accommodation, a more supportive political backdrop, and a growing level of expertise has meant that a number of fund managers have launched PRS funds. None of these drivers previously existed together to allow the residential sector to be attractive to institutions.

Why should a pension scheme invest in PRS?
Although there are many different real estate strategies, core balanced commercial funds look to offer a combination of attractive income return and capital appreciation. Over the long run, income has accounted for around two thirds of total real estate returns, albeit over the last two years strong capital appreciation has skewed performance.

But, as we saw in 2009, commercial property can suffer large falls. Although we believe that commercial property will be the core property investment of pension schemes for many years to come, an allocation to PRS will help to diversify a property allocation. In general, the residential property market tends to suffer from smaller downturns compared to the commercial property market and recovers faster.

PRS managers are looking to produce net returns in the order of 7% to 9% per annum with a target annual distribution yield of around 4%. Expected returns are forecast to come from strong rental growth rather than through a fall in yields (i.e. investors willing to pay more for a property all else being equal).

The rental growth forecasts are driven by social and demographic changes. This includes:

  • A continued chronic shortage of new homes being built;
  • Increase in demand for rented accommodation:
    • The government estimates that c. 70% of new homes will be single-occupier housing.
    • UK population growth - forecasted to grow by 0.7% per year due to inward migration and people living longer. In London, the population growth is expected to be even higher at 1% per year.
    • House affordability. Many first time buyers are now in their late 30s or early 40s as household price to earnings ratios continue to be at all-time highs.
The UK needs more housing and the institutionalisation of the asset class will also produce better quality housing. Better quality housing means happier tenants – who are then more likely to stay – but also reduced running costs. Both of these factors will help to increase the returns of investing in the sector.

High quality property management not only reduces costs, but also mitigates reputational risks. These managers have strict credit checks and guarantor policies in place to help mitigate the chances of a tenant being unable to pay their rent.

There are investment risks of course; these include the illiquidity of property in general and the inability of the manager to source and deliver suitable purpose built (or existing) PRS schemes. Liquidity is important to highlight since many of the PRS funds will be structured as closed ended vehicles or offer limited redemption windows and terms. As such, the overall liquidity requirements of a pension scheme must be considered carefully before investing, but we feel the risks of investing in PRS can be carefully managed by a suitably skilled manager.

We believe that PRS offers a pension scheme the opportunity to diversify its property holdings without compromising the long term expected returns of its property portfolio.

Oliver Hamilton is a property specialist in Aon Hewitt’s Global Asset Engine in London.

Content prepared for UK subscribers, but available to interested subscribers of other regions.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.

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