BUILDING HOMES FOR GENERATION RENT:CAN INSTITUTIONAL INVESTMENT MEET THE CHALLENGE?

Resolution Foundation and Social Finance

10 October 2013

Social Finance is authorised and regulated by the Financial Conduct Authority FCA No: 497568

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2THE PRIVATE RENTED SECTOR IS NOW THE ONLY OPTION FOR MANY LOW TO MIDDLE INCOME HOUSEHOLDS

Source: Whitehead et al. (2012) Housing in Transition: Understanding the dynamics of tenure change, London: Resolution Foundation and Shelter.

Household projections by tenure, low to middle income families with dependent children

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3BUT THE PRS OFFER HAS NOT KEPT PACE WITH THE CHANGING NATURE OF TENANTS

• Rents are now more expensive than the on-going costs of ownership in many parts of the country

• Rent increases are ‘lumpy’ and unpredictable

• Properties are not purpose built for rent – most are built for sale and sold to buy to let landlords

• Sector still dominated by small landlords who offer variable quality – only 10% of landlords have more than 10 properties

• Standard contract is still a 6 to 12 month AST creating a perception of insecurity

• Lack of transparency in the fees charged by lettings agents

• Many landlords do not provide any flexibility for tenants to make their house a home.

WE NEED A DIFFERENT OFFER IN THE PRIVATE RENTED SECTOR TO MEET THE NEEDS OF LONG TERM TENANTS, ESPECIALLY FAMILIES WITH CHILDREN

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4THE POTENTIAL OF BUILD TO RENT TO CHANGE THE PRS OFFER

• Important source of new investment to support much needed new supply

• Underpin development of purpose-built, professionally managed market rent sector in the UK similar to US and other European countries

• Potential alignment between interests of long term tenants for greater security of tenure and long term investors who want fewer voids

• Potential alignment between long term housing providers and income-focused investors in developing rented portfolios not predicated on quick sales

MARKET ACTIVITY IS EMERGING AND GOVERNMENT HAS PUT IN PLACE SIGNIFICANT SUPPORT BUT QUESTIONS REMAIN ABOUT THE VIABILITY OF RETURNS FOR INVESTORS, ESPECIALLY OUTSIDE HIGHER RENT DEVELOPMENTS IN LONDON

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5OUR AIM

To demonstrate that institutional investment in the private rented sector can deliver a better quality, more secure rental product for low to middle income tenants at the same time as viable returns for investors using development and management costs and rents provided by housing providers on actual or advanced pipeline developments.

More specifically:

• To test the viability of an RP-led model for institutional investment in build to rent that would allow RPs to recycle their balance sheets

• To identify the sensitivities that affect investor returns in the model

• To identify the most appropriate financing structures for build to rent investment

• To identify who the build to let model can serve – population segment and location

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6PROJECT BACKGROUND AND PARTNERS

Housing Partners

Other support

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7HOW WE DEVELOPED THE FINANCIAL MODEL

• Housing partners used a standard template to provide detailed quantitative and qualitative information on each development

• Site visits conducted with each housing partner to analyse and test the data provided with input from operational as well as finance specialists

• Tested data rigorously in on-going discussions with housing partners and against industry benchmarks including ARLA, Hometrack, HouseMark, IPD, social housing data and with input from industry specialists such as EC Harris

• Developed a financial model with sensitivities to test returns at different assumptions

• Conducted a series of peer review meetings with investment experts to validate the assumptions underpinning the financial model and seek views on returns.

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8OUR APPROACH TO BUILD TO RENT

Theoretical model using real development data from 6 housing partners

• Units built using housing partner balance sheets in areas where they have significant existing operations

• Units let out predominantly at market rent

• Units offered on a three-year tenancy

• Once rental income stream stabilised with over 95% occupancy, housing partners sell the units to an investment vehicle to create a large scale national portfolio

• Investment vehicle funded by institutional investors

• Housing partners provide long term management services and insulate investors from day to day issues such as lettings and maintenance but do not provide ongoing rent or void guarantees

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9THE NATIONAL PORTFOLIO

• Diversified portfolio

• 16 unique developments located across the country

• Total number of units: 778

• Total development cost including land value: £140 million

Scotland: 60 units

NW: 270 units

SW: 164 units

London: 256 units

The Midlands: 28 units

– development

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10THE NATIONAL PORTFOLIO

Distribution of Houses by Number of BedroomsDistribution of Flats by Number of Bedrooms

Total: 482Total: 296

Studio, 4, 1% 1 Bed, 62,

21%

2 Bed, 223, 75%

3 Bed, 7, 3%

2 Bed, 118, 24%

3 Bed, 288, 60%

4 bed, 76, 16%

• Of the total, 482 (62%) are houses and 296 are flats (38%)

• 2 and 3 beds are most common, comprising 82% of the portfolio

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11THE DEAL FOR TENANTS

Affordability assessed from perspective of three different income levels for family with one child.

• Two affordability thresholds assessed – 35% and 50% of net household income

Working age HH income distribution

Net income after tax and benefits

Low income 25th £18,583

Modest income 35th £21,962

Middle income 50th £27,584

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12THE DEAL FOR TENANTS

Modest income couple with one child on £22,000

Middle income couple with one child on £28,000

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13THE DEAL FOR TENANTS

• Rent rises annually in line with long run CPI of 2.5%, providing predictability and transparency

• Three year tenancies for those who want to stay for longer

• Professional management from an experienced housing provider

• Purpose-built properties

Build to rent unlikely to meet the needs of low income tenants without substantial support from government eg. 1/3 off the price of land. But if subsidy is required, government has choices to make about whether build to rent or affordable housing is the priority for this group.

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14THE DEAL FOR HOUSING PROVIDERS

• Opportunity to recycle capital by selling units onto investment fund. Revenue from sales can be used to build more market rent units or affordable units according to organisational priorities

• Low development risk due to guaranteed exit to investment vehicle

• Long term income from Operations and Management contract

• Ability to benefit from fund’s performance through 10 per cent equity stake

• Opportunity to extend social mission to modest and middle income working families

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15THE DEAL FOR INVESTORS – BASE CASE RETURNS

TOTAL DEVELOPMENT COST £140M

GROSS RENT £7.8M

LESS

MANAGEMENT COSTS £1.9M

(24.9% GROSS RENT)

LESS

VOID AND BAD DEBT £0.4M

(5.2% GROSS RENT)

NET OPERATING INCOME £5.4M

5.6% GROSS YIELD

3.9% NOI YIELD6.5% TOTAL INVESTOR

RETURN (2.5% INFLATION)

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16THE DEAL FOR INVESTORS – OPTIMISED PORTFOLIO

Optimised portfolio:

1. Site selection – 7 developments with initial net operating income >4%

2. Land costs – 15% reduction in line with ‘PRS only’ covenant

3. Build costs – 5% reduction

4. Tenancy length – doubled to 38 months from 19 months

•Portfolio reduces to 405 units•2 and 3 bed properties still predominant unit size (86%)•Increased, but not exclusive focus on London and North West

PORTFOLIO BETTER SUITED TO MIDDLE INCOME TENANTS

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17THE DEAL FOR INVESTORS – OPTIMISED PORTFOLIO RETURNS

TOTAL DEVELOPMENT COST £71M

GROSS RENT £4.5M

LESS

MANAGEMENT COSTS £1.1M

(23.4% GROSS RENT)

LESS

VOID AND BAD DEBT £0.2M

(3.4% GROSS RENT)

NET OPERATING INCOME £3.3M

6.4% GROSS YIELD

4.7% NOI YIELD7.2% TOTAL INVESTOR

RETURN (2.5% INFLATION)

INCREASE IN YIELD COULD ALTERNATIVELY FUND 15% REDUCTION IN RENT TO DELIVER SAME RETURN AS BASE CASE PORTFOLIO #betterrenting

18LEVERAGE AND THE ROLE OF A GOVERNMENT GUARANTEE

Robust and credible government guarantee:

• Increase the leverage tolerance of investors• Reduce finance costs on debt

6.5%7.0%

8.3%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

No leverage 30% leverage at 5% interestrate

50% leverage at 4.25%interest rate

Tota

l Equ

ity In

vest

or r

etur

n

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19SUMMARY OF FINDINGS

• National portfolio can be assembled through pooling developments

– Offering a better deal for modest and middle income tenants

– Supporting an increase in housing supply

– Achieves the scale preferred by institutional investors

– But not within reach of low income tenants without subsidy

• National portfolio achieves a steady state yield of 3.9 per cent and a total investor return of 6.5 per cent over a 10 year period based on 2.5 per cent rental and cost inflation

• Optimised portfolio can deliver an attractive income return of 4.7 per cent and a total return of 7.2 per cent on a comparable basis

– Increased weighting towards London

– Higher rents on average

– Better suited to middle rather than modest income tenants

• Returns can also be improved if a robust government guarantee is available and gearing added. Assuming an interest rate of 4.25 per cent and 50 per cent gearing, the government guarantee would push up the equity return in the national portfolio from 6.5 per cent to 8.3 per cent.

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20MAKING IT HAPPEN – RECOMMENDATIONS

For housing providers

• Develop a stronger understanding of build to rent as a bespoke product, including site selection, design, build, marketing and management.

• Use existing balance sheet capacity to help fund the development phase of new build to rent assets, recycling capital where necessary by passing ownership onto institutional investors. This will help grow the sector and in the case of Registered Providers, reduce overall funding costs.

For investors

• Assess the viability of build to rent principally on the basis of income returns as part of a commitment to invest in this asset class for the long term rather than on the basis of quickly realising capital value through sales.

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21MAKING IT HAPPEN – RECOMMENDATIONS

For government

• Take a broad strategic view of how different tenures, including build to rent, work together in a local area to meet different needs

• Adopt an approach to planning that recognises the different economics of build to rent and build for sale in setting affordable housing and other requirements. This will ensure fair competition for land between the two tenures

• Designate some public land as ‘PRS only’ to kick start build to rent, particularly for low to middle income tenants

• Adopt a proportionate approach to regulating the market activities of Registered Provider that does not limit their ability to diversify their funding base, recycle their balance sheets and extend their social mission

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BUILDING HOMES FOR GENERATION RENT:CAN INSTITUTIONAL INVESTMENT MEET THE CHALLENGE?

Resolution Foundation and Social Finance

10 October 2013

Social Finance is authorised and regulated by the Financial Conduct Authority FCA No: 497568

#betterrenting