Build-to-Rent or Buy-to-Let: Shiny New Things vs. Tried and Tested Assets?
By Russell Gould, CEO of Vesta Property. In this article, he debates which is the most profitable and suited for you: build-to-rent or buy-to-let.
It has been nearly a decade since the advent of Build-to-Rent (BTR) in the UK. The British Federation of Property estimates that around 47,800 BTR homes have been built since 2011, and a further 34,100 homes are currently under construction. CBRE estimates that more than £11 billion have been invested in BTR over the past five years. However, this represents a small fraction of the demand from institutional capital aimed at investing in the UK residential property.
The reasons for this high investment demand are well known: capital values are underpinned by an undersupply of houses, planning constraints and continued loose monetary policy; rental value growth is driven by affordability issues and changes in lifestyle preferences; unparalleled political support has made housing “too big to fail” (the recent stamp duty holiday is a case in point); residential property exhibits low historical volatility in capital values (relative to commercial real estate) and negligible volatility in rents; and housing is a strong match for pension funds’ long-term liabilities.
The coronavirus pandemic has amplified the relative structural strengths of the UK housing market as a robust means to preserve wealth and has further justified it becoming a larger part of institutional investor’s portfolios. What’s caused this and where does this leave BTR?
Firstly, the obvious – the demise of traditional offices and the systemic shift to spending more time working from home (WFH), which has made homes more valuable to their occupiers.
Almost every individual, small business and large organisation have had to adapt their working arrangements during the pandemic. The flexible WFH approach – first initiated by the dress-down tech brigade – has fast become the new normal, and traditional business leaders who stood steadfast against remote working have woken-up to the fact that they and their employees can be just as effective, and often more productive, by occasionally WFH. The result is greater productivity, more leisure time, more family time and happier employees.
According to the Office of National Statistics, around half of employees in the UK now spend some time each week WFH, and the expectation is that many businesses will permanently move to a more flexible model incorporating some level of WFH post-pandemic. The result is that employees are taking a new perspective on what they require from their homes. According to Rightmove, houses with gardens and additional space for a home office are the characteristics that are most in-demand.
However, that is not great news for BTR, which to date has principally comprised multi-family apartment blocks in city centres with no, or limited, greenspace and no co-living workspace. This is already starting to be felt in London, where 60% of existing BTR schemes are based (according to the British Federation of Property), with Zoopla reporting that rental values in London have dropped by 1.4% in the first half of 2020 due to waning demand from new tenants, resulting in longer void periods, a growing number of vacant units and a high likelihood that rents will reduce further. All ultimately pointing to lower overall yields.
Secondly, the accepted consensus that real assets (i.e. property, infrastructure and precious metals) will be amongst the long-term winners to come out of the pandemic (along with tech and consumer staple stocks and Bitcoin) as these assets benefit from cheap money, quantitative easing and inflation.
Tied to this is the growing scepticism amongst fund managers of the long-held “60:40 investment rule”, i.e. that portfolios should be constructed as a mix of 60% equities and 40% bonds. Institutional investors globally are increasingly questioning bonds, suitability to provide strong risk-adjusted returns that are non-correlated to equities, especially in an inflationary environment with persistently low-interest rates. Of course, the 60:40 investment rule is overly simplistic as most balanced portfolios will have some level of alternative assets; however, even a few percentage points reductions in the weightings of bonds in global portfolios implies hundreds of billions, even trillions, of dollars of capital looking for a new home, with real estate being a major contender.
However, BTR is clearly too small a market in the UK to accommodate such investment demand, and institutional investors remain deeply cautious of investing in commercial real estate until the dust settles (with logistics being the exception to the rule). The subscale nature of BTR in the UK also means that there is a risk of miss-pricing. BTR also presents a number of other challenges to institutional investors, including:
development risks and build overspend;
high ongoing operating cost leakage;
high concentration risk and difficulty to achieve diversification;
saturation of 1- and 2-bed prime apartments in London and other major regional city centres;
estimation risks in terms of rental values and tenancy demand (including downward pressure on achievable rents due to a high supply of homogenous stock in a small area); and
a lack of strategic flexibility at exit.
But are institutional investors missing a trick?
The UK Private Rented Sector (PRS) represents 5.7 million homes, or 1 in every 5 households in the UK, and is valued at over £1.6 trillion (Savills), more than twice the size of the investable commercial real estate market (IPF). This makes BTR’s contribution to the PRS a rounding error. Almost all rental properties are owned by private BTL landlords, comprising apartments, single-family homes and houses in multiple occupation. Historically, the fragmented nature of this market (there are around 2.2 million landlords in the UK according to Hamptons International) has acted as the main barrier to institutional investment. But things are changing.
Government policy to discourage amateur landlords (in the form of punitive tax changes for non-incorporated landlords, increasing regulation and higher compliance requirements) plus an ageing demographic of landlords looking to realise a key pension asset have resulted in a flood of landlords looking to exit the market. We conservatively estimate that a minimum of 850,000 BTL properties have been sold since 2016, worth over £180 billion.
Whilst the market is highly fragmented, there is also a significant skew in the distribution of ownership of BTL property. A joint study by the Council of Mortgage Lenders and the London School of Economics in 2016 found that 38% of all BTL properties are owned by 7% of landlords whilst a survey conducted by Vesta Property in 2020 found that 8% of landlords own more than 20 properties.
Building a fund for institutional investors may not be as difficult as previously thought, as there is both the liquidity and concentration of assets available from professional landlords.
For institutional investors, BTL has a number of other benefits versus BTR:
absence of development risk (i.e. assets are already operating and income-generating);
lower operating cost leakage, especially for portfolios of freehold single-family homes;
greater diversification (both by type and geography);
proven tenancy demand and heterogeneity in stock (which mitigates the risk of an oversupply of rental properties in a given area which could dampen rental value growth); and
superior strategic flexibility at exit.
An increasing number of institutional investors are grasping the importance of this last point and are seeking to buy portfolios of single-family homes. Whilst a BTR apartment block can either be sold to another institutional investor at a yield-based valuation (sometimes, but not always, at a discount to the vacant possession value) or else broken-up, the latter approach puts downward pressure on pricing as the market is flooded with a large volume of homogenous stock (or otherwise it takes a long time to avoid this outcome by drip-feeding sales). However, granular BTL portfolios provide the flexibility to maximise returns based on whether a yield-based valuation or an open market value represents the most profitable exit.
The BTL market has performed exceptionally strongly during the crisis, and we estimate more strongly than BTR given it is focused on 1- and 2-bed prime city centre apartment blocks. House prices have increased since the start of 2020, and Zoopla estimates that rental values have increased by 1.1% in the first half of 2020, increasing to 2.2% if you exclude London. Rental collection rates have also been strong, with Vesta Property estimating that 76% of BTL landlords collecting more than 90% of rent and only 3% of landlords collecting less than 50% of rents due. Other studies have found that rental collection rates have been in the region of 86% to 96%. All in all, we estimate that BTL returns are expected to be 16% greater than BTR returns over the next five years due to the opportunity for higher rental value growth, lower operating costs, and superior achievable capital values at exit.
Private investors, family offices and private equity have long been involved in investing in BTL portfolios in the UK, and many are refocusing on this asset class again for long-term strategic investments. Now though, larger institutional investors, who have cut their teeth in BTR, purpose-built student accommodation or social housing portfolios, are developing an appetite to focus on the bigger opportunity of consolidating the PRS.
Vesta has created a dedicated marketplace, Vesta Property for buying and selling PRS property thus allowing landlords to sell with tenants in place, preserving rental income and providing investors with access at scale. We are seeing growing demand from funds, family offices and institutions seeking BTL opportunities.
———
