Home advantage

Residential property has outpaced commercial property over the years, but barriers to entry are high. Paul Farrow finds pension investment managers looking at ways to get in on the act


All talk of property in pension funds has centred on commercial property evoking images of industrial estates, office blocks and shopping centres.

Residential property, on the other hand, has rarely been mentioned, although the industry did get very excited when Gordon Brown proposed that residential property would be an allowable asset in Sipps – a plan he subsequently abandoned in the 2005 Budget.

But there could be a sea change after it was reported that the £3.5bn London Pension Fund Authority (LPFA) is mulling a £35m allocation to residential property.

LPFA admitted that negotiations with fund managers were still at an early stage but it is understood to be scouting for London-focused funds with multiple investors.

Fund managers are also expressing an interest in the asset class. Aviva Investors has said that it is “exploring” its options with regard to residential property, which it reckons is a viable investment proposition for pension funds.

Neil Gardiner, a property manager at Aviva, says that he is looking at a new fund that will target both UK and overseas investors, although it will hold exclusively UK assets, with a focus on London and the southeast. “It happens that we’re in the market. We’re looking at a number of key investors with a mutual interest in residential.”

If you look beyond the UK, most of the largest economies have a sizeable proportion of their pension exposure in the residential asset class

Go across the Channel or the Atlantic and European and US pension funds will be wondering what all the fuss is about. Residential property is not new to overseas pension funds. According to IPD/Savills more than 40 per cent of residential property investment in Holland and Switzerland, for instance, is by institutional investors.

“If you look beyond the UK, most of the largest economies have a sizeable proportion of their pension exposure in the residential asset class. In fact, in some countries it’s almost on a par with commercial property exposure,” says Adrian Benedict, investment director at European Real Estate Fidelity.

Benedict explains that it was not always that way. He says that residential used to be an institutional asset class until the 1970s, since when it has been in decline for several reasons – initially driven by legislation making it more onerous for landlords. Eighty years ago, 70 per cent of housing stock was rented; today that figure stands at only 30 per cent.

He adds: “Residential is a good diversifier of exposure from equities, fixed income and even commercial property – this has been shown over the short, medium and long term and is a low volatility asset class.”

Is there a demand for residential property investment by pension funds?

In a word, yes. There is a shortage of housing in the UK but for serious development to be successful it needs investment – and that is where institutional investors can come in. It is why the Treasury recently launched a consultation into the private rented sector (PRS).

The Treasury says that although the PRS is playing an increasingly important role in the housing market it has concerns about how this can be supported. Its consultation is considering the contribution the PRS could make to addressing housing demand and increasing supply -and is seeking views on whether there are any substantive barriers to investment.

John Lawson at Standard Life says: “There is a lack of supply of affordable housing in the UK and this could be an opportunity for local authorities to free up land for development to housing associations with build cost financed short-term by local government but then packaged up and sold to institutional investors once it starts generating an income.”

What’s more, the Homes and Communities Agency (HCA) has just launched the Private Rental Sector Initiative (PRSI) and is courting fund managers for help.

HCA hopes that a successful scheme can be used to fund the building of new homes specifically for private rent, to help relieve pressure on the housing market by kick-starting stalled developments, as well as make private rental an option of choice for consumers in the future.

The HCA, and its adviser DTZ, are now evaluating the submissions with a view to encouraging organisations to come together to create investment propositions with scale.

“The growing interest in the residential property sector shouldn’t come as a surprise,” says Phil Clark, European head of property investment at Aegon. “It offers a number of advantages, not least of which is the sector’s performance versus commercial property and all other asset classes. On a total return basis the residential property sector stands out above all the rest.”

How does the performance of residential property stack up?

Given the boom bust cycles of residential property and tales of negative equity and repossessions it might appear at first glance that its place in a pension fund is misguided. Yet figures suggest otherwise.

According to the IPD Residential Property Index, the residential total return index experienced growth of 135 per cent to December 2009 (10 per cent annualised), double the 68 per cent returned to investors in commercial property (5.9 per cent annualised).

Over fifty years, real house prices have risen by 274 per cent compared to a 55 per cent fall in real commercial property value. This represents long run annual residential value increase of inflation plus 3.3 per cent compared to inflation minus 1.2 per cent per year for commercial property.

Residential property also comes top when it comes to rental growth. The annualised rental growth over the nine-year period was 2.23 per cent for residential compared to just 0.45 per cent for commercial.

Clark adds: “Residential property offers lower volatility than other assets classes. This is not to say that it doesn’t have its peaks and troughs, but it tends to be less volatile than commercial property and significantly less than equities. It also offers a potential hedge against inflation, as traditionally as inflation rises, wage inflation, house inflation and rental income all tend to follow.”

Standard Life is another major pension player that is attracted to what residential property can offer added: “Residential property is capable of delivering stable income (rental returns) over the longer-term, but it has to be properly managed,” says Lawson.

What is holding pension funds back from investing in residential property?

Rules and regulations in the UK are barriers to entry, say property advocates. The Treasury consultation paper notes that investment by pension has been virtually absent from the PRS. It says the reasons include reputational and financial risks, the lack of suitable portfolios to invest in, high management costs compared to commercial real estate, and yields.

A pension scheme can invest in residential property if it invests through a ’genuinely diverse commercial vehicle’ such as a Real Estate Investment Trust (Reit).

However, Lawson points out that the diverse vehicle needs to meet a number of conditions. The fund value must be in excess of £1m and hold at least three properties, while no single property can make up more than 40 per cent of the fund. Finally the pension scheme cannot own more than 10 per cent of the vehicle.

He reckons that the 10 per cent ownership condition is one sticking point for residential property and pension funds.

“The ownership condition is a bit of a limiting factor for occupational schemes (some schemes are large enough to do their own developments but need to find at least nine other investors) where the limit applies at scheme level, whereas in a personal pension, the 10 per cent applies at ’arrangement’ or member level,” says Lawson.

Residential property offers a number of advantages, not least of which is the sector’s performance versus commercial property and all other asset classes. On a total return basis the residential property sector stands out above all the rest

Close Investments, which has launched several property funds over the past decade, believes that structural and tax issues get in the way of taking the market forward.

Steve Oliver, director at Close Investments says: “With residential property being an owner occupied market it can distort the whole market. VAT is a consideration which it isn’t with commercial property – building-to-let attracts VAT, building-to-sell does not.”

He adds that stamp duty is a big problem because it is charged as an aggregation for bulk buyers. Buy a single flat at £125,000 and there is no stamp duty, but buy 100 units in one go and your tax bill will be half a million pounds.

Oliver adds: “I believe that the Government are terrified that they would make the wrong decision (by relaxing the rules) and that some people will get stinking rich – housing is a very emotive issue. Also, it is all very well a landlord evicting a family because the bread winner has lost their job and cannot pay the rent, but an investment manager taking similar action might not be seen in the same light.”

Meanwhile, FPD Savills puts down the lack of residential offerings to institutional investors to four main reasons.

Firstly, it is the relatively low level of income return generated by residential investments in comparison with the disproportionately high amount of income lost due to management costs.

Secondly, it says, is the uncertainty of the income stream given short lease terms and a higher perceived exposure to voids. Thirdly, small lot sizes and fragmentation of the market which have made it hard for institutions to achieve economies of scale.

And finally, the role of owner occupiers – who set prices by reference to the short term affordability in a market with an inherent lack of stock – rather than investors in setting prices.

What type of funds will be developed for pension funds?
Scale is going to be crucial. According to a collective response to the Treasury consultation into the PRS, to invest in a new sector requires institutional investors to be able to show that this can make a material benefit to their overall returns, particularly as there will be entry costs.
For many of the largest institutional investors, this suggests a minimum investment of £200m. For smaller institutional investors commitments of £5m to £50m are required for sector returns to make a significant contribution to their overall investment portfolio returns.

But where a fund is aimed at the public, the likes of the CML, BPF and RIC reckon that the options are closed-ended vehicles, like ordinary listed companies (which are, however, not tax efficient) or REITs (their tax efficient equivalent), or open-ended vehicles such as a property authorised investment fund (“PAIF”).

The few residential funds that are available to private investors include offshore ground rent funds, which are offered by Close Asset Management, UBS, Braemar and Brandeaux. The Close Freehold Income Trust, for example, is to provide a secure, stable investment through acquiring freehold ground rents – the target yield is 4.25pc a year.

Meanwhile, the likes of Brandeaux and Unite offer student accommodation funds that offer a diversified spread of properties.

The student housing sector has offered opportunities to this type of investor as it offers a model where capital values are a function of rental income streams.

“In the current market, net income yields of 6.25 per cent for leased student stock or, as an alternative, leased housing association stock have provided both a stand-alone investment opportunity and one that can enhance the income return of a larger portfolio of residential investments,” says Yolande Barnes, director, Savills. “However, these investments are not easy to secure and new players in the market may find them difficult to access.”

Barnes and her colleagues are exploring models on how best to serve institutional investors, but it is not straightforward. She points out that the HCA has suggested that they may encourage investment in the sector by initially guaranteeing rents in order to achieve a minimum/competitive income yield of as much as 8 per cent for as long as five years.

“The ability to replicate such a return in absence of government intervention will be crucial as ultimately the property industry needs to take the central role in building the professionally managed investment vehicles in which the institutions can invest. Assuming that rental guarantees do not have widespread application, carefully designed tax incentives may be appropriate.”

Yolande reckons that unless a real rental premium becomes established for residential rental property, it remains difficult to see how the yield advantage can be maintained over time before owner-occupied values start to distort the figures again.

“This has led to the suggestion that a separate planning use class should be created to divorce the capital value of investment property from owner-occupied assets. The option has the disadvantage though of blocking the potential exit route to an investor of open-market, individual, property disposal,” she says.

How big will take-up be?

Residential property has all the hallmarks of a decent asset class, the numbers stack up and employees will have a close association with investing in bricks and mortar. For better or for worse they see it as a real asset worth holding.

But the barriers to entry remain – residential property experts and fund managers will no doubt discover novel ways for institutions to invest but it would appear that, to start with at least, these will be niche rather than mainstream vehicles.