The Case for Residential Investment by LA Forum

LA F OR U M

Investment Choices

The case for Residential Investment

Market Overview

The potential for developers Investment structures are becoming increasingly sophisticated, such as liability driven investment, buy-ins, buy-outs, derivatives

Yields that meet investorsâ&#x20AC;&#x2122; requirements The opportunities for investors Strong long term housing supply and demandtrading.

Issue November 2015

An in-depth review of the state of the market, including the latest forecasts across the UK

The Knowledge Framework

Contents Page 1. LA Forum: The case for residential investment 2. Local Government Association: Supporting housing investment 3. GMPF: Approach to housing investment 4. M&G Real Estate: UK residential â&#x20AC;&#x201C; Europeâ&#x20AC;&#x2122;s rising star 5. BLP: Bringing home residential investment 6. Heitman: Performance characteristics of the Dutch and German residential sector 7. Nabarro: Riding the wave 8. Castlefund 9. LA Forum: Contact details

The Case for Residential Investment THE EMERGENCE OF THE RESIDENTIAL SECTOR Despite rented residential being the fastest growing tenure and highest performing real estate asset class in the UK, today under 5% of rented housing, commonly referred to as the Private Rented Sector or ‘PRS’ is owned by institutions. Industry experts believe this provides potentially attractive opportunities for institutional investors because of the:

• • • • •

Long-term return profile Stability of income and capital values Development potential Low correlation with other asset classes within a typical LGPS portfolio Benefits it adds as part of a mixed-use portfolio

The increasing under supply of housing in the UK is expected to be c.1 million homes by 2020 and with the UK population growth being one of the highest in the EU2, we believe this demand and supply imbalance has the potential to create investment opportunities for institutional investors into the PRS. Last year the IPF published its 2014 Survey on institutional investors’ attitudes regarding UK residential real estate investment. Results show that only 4.3% of institutional investors’ assets under management are allocated to real estate, of which a mere 6.3% are residential. Residential has the potential to become a key element of an institutional investor’s portfolios, however, it does require, in our view, specialist expertise to access and assess the right opportunities to deliver potentially attractive returns. This Publication will cover:

• • • • •

The history of residential investment in the UK Current UK residential market fundamentals and composition Residential investment in international markets Creating an institutional investment strategy: where, what, how? A residential investment strategy in practice

_________________________________________

Supporting housing investment A Case Study Guide

This document provides examples of entrepreneurial activity lead by councils to provide new homes in response to the demands of their local housing market and housing pressures and shares some of the learning from those councils. It also highlights the options available to develop an investment offer that meets your local needs.

_________________________________________ Introduction This document provides examples of entrepreneurial activity lead by councils to provide new homes in response to the demands of their local housing market and housing pressures and shares some of the learning from those councils. It also highlights the options available to develop an investment offer that meets your local needs. Collectively, we simply arenâ&#x20AC;&#x2122;t building enough homes to meet the demands of a growing and ageing population. Demand for housing across all tenures is high and the housing waiting list in councils has increased by 70% in the last decade 1. Private renters make up an increasingly large part of the overall housing population, and 45% of them think it will be 5 years or more before they can buy their own home 2. After a period of uncertainty over house prices, the Royal Institution of Chartered Surveyors (RICS) report that house prices rose in every part of the country by the end of 2013 3. The challenges vary of course; for example areas experiencing high demand for housing face the challenges of affordability, leaving many households priced out of the market for home ownership and directing a significant proportion of the household income on housing costs. Conversely, areas where property is considerably lower in value can make it difficult to attract investment to support wider regeneration. Both of these issues will hold back the local economy, where housing and jobs are intrinsically linked. Taking a long term view on the housing needs and aspirations of your area and the investment needed to meet these needs can support wider plans to stimulate economic growth locally, and help to manage pressures on public services and affordable housing. As the councils in this document demonstrate there are opportunities for both stock and non- stock holding authorities to deliver, support, attract and underpin housing investment. For stock owning councils, self-financing provides an opportunity to run the housing stock in a more business like way to ensure value for money for tenants. For all councils there are opportunities to build on previous commercial and entrepreneurial experience to start new house building projects which provide private rented, affordable and market housing. A recent LGA survey 4 showed that 90% of councils intended to make land available for housing over the next five years and a number of City Deals and other asset development partnerships have opened up opportunities to pool and release assets across the public sector. Land values vary considerably across the country and this will have bearing on the development options for councils and the margins for potential investors. A complex housing market needs the creativity and entrepreneurial skills of councils to bring land and money to the table and get new homes built.

Councillor Mike Jones Chair, Environment and Housing Board - LGA 1

CLG live tables, Table 600 Rents, lettings and tenancies: numbers of households on local authorities' housing waiting lists1, by district: England 1997-2012 2 English Housing Survey 2011-12 https://www.gov.uk/government/publications/english-housing-survey-2011-to-2012-headline-report 3 RICS Housing Market Survey, 16 January 2014 4 http://www.local.gov.uk/c/document_library/get_file?uuid=7a1e4ffa-173a-438c-9252-bd46cf687725&groupId=10180

_________________________________________ 1. Housing delivery options There is no one model of partnership and each council will have a different set of requirements and opportunities. The table below sets out some of the different options. Examples highlighted in bold can be found in this guide. Vehicle

Form

Investment and return

Issues to consider

Example

Direct

Council or ALMO building financed through

Investment through the HRA or via

Undertake a risk and options appraisal: the

Stroud 5

development

the Housing Revenue Account (HRA) or

borrowing up to centrally prescribed

investment risk may be offset by the

borrowing.

cap.

development of a potentially valuable asset.

Financial investment by the council outside

Direct return to council through

of the HRA.

rental income and capital

Borrowing through the HRA is limited by a

appreciation.

centrally set cap. What impact will additional borrowing have on your long term HRA business plan?

Council

Power to set up trading activity established

owned

by the well-being power of the Local

housing

Government Act 2000 and the Localism Act.

Council investment

Investment is offset by the development of

Ashford

a potentially valuable asset. Direct return to council through rental income and capital

company

appreciation. Local

A form of joint venture between a council

Typically the Council invests land;

housing

and private sector partner originally piloted

partner provides funding and house

company

by the Homes and Communities Agency

building expertise.

(HCA).

Newcastle

This is a longer term partnership

Sheffield

arrangement and therefore councils will Shared reward.

Jointly owned, both partners share risks and

Shared risk.

wish to consider the choice of partner carefully.

benefits.

See “Let’s Get Building” (NFA, ARCH, CIH, LGA and CWAG 2012) for more examples of building through the HRA

_________________________________________ Vehicle

Form

Investment and return

Issues to consider

Example

Typically a medium to long term partnership arrangement. Special

Land is committed to a special purpose

Council provides land, partner

Investor may require guarantee from

Barking

purpose

vehicle and homes are built with private

provides funding

council or arrangement to underwrite

and

vehicle (see

finance

potential losses.

Dagenha

note below)

Returns go to investor for duration of lease. Asset may then return to council if a leaseback arrangement is in place.

Local Asset

Various models but typically involves the

Council provides land, partner

Backed

council transferring land to a separate entity

provides skills and funding

Vehicle

and financial investment from a partner

(LABV) (see

organisation alongside skills and capacity to

Different models of return,

note below)

deliver.

depending on the contract

Shared risk

Gateshea d

arrangements The vehicle is a distinct legal entity and shares and governance arrangements are typically shared across the partnership. Joint venture

Council and private commercial venture.

Council provides land, partner

(see note

Risk and rewards are split between the

provides funding

below)

partners

Shared risk

Oxford Barton LLP

Rewards are split between the Can take different forms, either a limited

partners, depending on the contract

Wakefield

partnership or a company.

arrangements

MDC and W&DH

Council will have high visibility and involvement in programme delivery. Private

Long term contracts between councils and

Agreed returns to private partner

Risk formalised in contracting process.

Kirklees

_________________________________________ Vehicle

Form

Investment and return

Finance

private sector firms.

during contract period. Asset then

Initiative (closed to

Management of the housing becomes the

new

responsibility of the private sector contractor;

applicants)

the local authority continues to own the

Issues to consider

reverts to council

Some risks transferred to private sector

Example

housing and retains its tenants. Development

Council investment of land, use of right to

Direct loan or bond provided by

What is the appropriate governance and

Hastings

through

buy receipts or financial investment to fund

council to housing association. Land

investment vehicle for this partnership

Council

registered

new building.

assets may also be used in a

locally? For example joint venture, special

loan to

partnership with the housing

purpose vehicle.

Amicus

provider

association providing the finance

Horizon Warringto n Council loan to Muir Housing Group

Pension

Pension fund acts as investor to housing

Fund investment

Long term partnership arrangement.

Consideration of the management of the

Housing

development. Council can provide land to

asset over the partnership period and the

Investmen

increase the viability of the model.

ownership of the asset at the end of the

t Fund

period â&#x20AC;&#x201C; for example would this remain in

supported

local authority ownership.

by Manchest er Pension fund and Manchest

_________________________________________ Vehicle

Form

Investment and return

Issues to consider

Example er City Council

obligations 6,

Planning

obligation

section106 agreements, are a mechanism which

(Section 106

make a development proposal acceptable in

agreements)

planning terms, that would not otherwise be

commonly known as

The wider viability of the development in question will be a key consideration.

acceptable. This can include obligations for affordable housing.

The Growth and Infrastructure Act introduces a new application and appeal procedure for the review of planning obligations on planning permissions which relate to the provision of affordable housing. The changes require a council to assess the viability arguments, to renegotiate previously agreed affordable housing levels in a S106, and change the affordable housing requirement or face an appeal.

A note on special purpose vehicles, local asset backed vehicles and joint ventures Each of these vehicles can be used as a framework for a council to enter into a partnership with a private sector partner. They offer different approaches to tax, to on or off balance sheet borrowing, protecting public interests and visibility of council involvement. This is a complex area that requires legal and financial expertise.

Land assets The availability and value of land for development will be a key factor in housing development. Councils will be identifying sites for development including public land through their strategic housing and planning function. Council owned land can be a valuable asset and considerations will include the councilâ&#x20AC;&#x2122;s overall asset management strategy as well the long term vision for the area including jobs and growth. In developing land assets for housing there are a range of issues to consider including capital receipts, achieving best value, de-risking sites and increasing the viability of development. The Homes and Communities Agency are working with partners on a programme to release HCA land and unlock development on publicly owned sites.

Section 106 of the Town and Country Planning Act 1990 (as amended)

_________________________________________ 2. Case studies A) Private investment London Borough of Barking and Dagenham – building homes for affordable rent Barking and Dagenham have developed 477 new homes for affordable rent using private investment. The investment was secured through a special purpose vehicle and the homes are managed through the council by an independent company. Tenants have moved into the first properties to be completed and marketing is well underway for the remaining homes. The homes are built on two sites across the borough, both owned by the Council. Other options for developing the sites had been explored but proved difficult to deliver. The Council’s partnership with Laing O’Rourke (the Local Education Partnership) started with schools projects and pre-dated the housing project. Drawing on their experience of building projects, the Local Education Partnership set up a special purpose vehicle (SPV) to act as a developer of the two housing schemes and secure private finance. Institutional investor Long Harbour funded the scheme with the council providing the land. The council guarantees the rents and after 60 years the homes will be owned outright by the Council. All the new homes are offered at affordable rents, with a mix of rent levels including 20% at social rent. The target group for the new homes includes local people in work who do not qualify for social housing, but struggle to afford options in the private housing market. The Council markets, manages and maintains the homes through an independent company called Barking and Dagenham Reside. Reaching out to a new group of renters has required a commercial and cost-conscious approach from the council to marketing and managing the properties. Barking and Dagenham are working on options for a second phase of housing development. The Council ran a funding competition last year to test the cost of private investment and are currently putting options to councillors on sources of finance and the mix of homes, which is likely to include some houses for sale.

Learning for other partnerships •

The complex nature of the project meant that it needed the agreement of key experts inside the council. Any project of this type will need agreement from the council’s finance, property and legal teams.

•

Setting up a partnership with an institutional investor takes time and money. It takes longer and is more complicated than using more traditional forms of borrowing such as the Public Works Loan Board.

•

With the benefit of hindsight the council would have simplified the contract arrangements. The number of organisations involved in the Barking and Dagenham project led to a complex arrangement that created a large volume of contract documents.

_________________________________________ Kirklees Council – Excellent Homes for Life The Excellent Homes for Life project will build 466 new one and two bedroom flats for council tenants in Kirklees. The new homes are tailored to local housing need and the project includes 35 flats designed for wheelchair use and 140 extra care flats, 10 of which cater for people with dementia. Kirklees Council have specified high sustainability and design standards and the homes are adaptable to meet tenants’ needs throughout their lifetime. The scheme has been delivered through private finance initiative (PFI) and delivered in partnership with the Regenter Excellent Homes for Life consortium. Building work started early in 2012. Kirklees Council developed the “Excellent Homes for Life” project to replace a core of high cost, poor quality homes with purpose built new affordable homes. The new building project was an opportunity to address shortages in the current housing stock, and deliver wider economic benefits to the area. The process began around 10 years ago and with limited options for the council to build new affordable homes in volume, PFI provided an achievable route for delivery. The PFI deal covers the construction of the homes and a 20 year service contract to manage and maintain them. The project went through a competitive procurement process and Regenter was appointed as the preferred bidder in 2010. The Regenter consortium includes Regenter Limited and Wates Construction Limited. Excellent Homes for Life is separate from Kirklees Neighbourhood Housing, (the arm’s length management organisation (ALMO) for council housing) and has its own maintenance and management contracts. In practice, there is no obvious difference to tenants. The flats are built in small developments on 27 sites across Kirklees. Managing the planning process threw up some challenges, including some public opposition and the complexity of managing 27 sites in one project. The council has sought economic benefit to the local economy from construction work, and from delivering the services by working with Regenter to use and develop local skills. Construction work has been completed ahead of programme. Properties are let quickly after completion thanks to good communication between the partners. Relations between local communities and the construction company are good, and the contractor worked hard to address any problems caused by the disruption of the building work. There is a stringent certification process from the council to ensure that properties are handed over to the specified standard. Tenants are pleased with their new homes, with very high levels of satisfaction recorded in a recent survey. The extra housing units have opened up new housing options for Kirklees residents and some of the tenants have moved in to the extra care flats from residential care.

Learning points for future partnerships The council set out a robust specification and this contributed to the success of the project. This was required as

_________________________________________ part of the PFI process but applies to other housing partnerships. The council has reduced risk as much as possible through tight specifications and contracts, but some risks such as the impact of welfare reform or future legislative change cannot be easily quantified. Understanding whether risks are acceptable to the private sector or should be kept in house is a subtle, but important skill for councils. Protocols between partners and expectations of service delivery have all helped the partners to understand each other and set out what is expected. The extra care element is treated separately to the housing management contract and is not part of the PFI deal. It was a deliberate decision to split the two contracts and avoid a conflict of interest. Councillors played an important role in developing the strategy and vision for building the new homes, and engaging local communities in the planning process.

Oxford City Council â&#x20AC;&#x201C; bringing forward new housing at Barton Oxford City Council owns a 36 hectare (90 acre) site at Barton, which was allocated as a strategic site for the provision of housing in the city. The site needed significant investment in infrastructure, making traditional development routes difficult. In order to bring forward housing growth the Council entered into a joint venture with an investment partner leading to the creation of Barton Oxford LLP. Outline planning consent has been granted for 885 new homes and work has begun on detailed building plans. In a challenging economic climate and against a background of severe housing shortage, the Council wanted to ensure early delivery of new market and affordable homes. Demand for affordable housing in Oxford far outstrips supply. The Council had very little development land available to develop social housing apart from the Barton site, and buying others was not an option due to lack of other land in the city. There were significant financial constraints associated with bringing forward the Barton site with infrastructure costs estimated at ÂŁ25m-ÂŁ30m relating to issues such as contamination, and access onto a major trunk road. In addition, there were significant viability issues relating to the provision of a new primary school and additional S106 contributions. The site needed substantial upfront funding before returns could be made from the sale of land and property could be made. Selling the site to developers was unlikely to lead to a quick route to building, with the likelihood of with protracted negotiation over section 106 requirement and viability of affordable homes. The Council could have funded the project through borrowing, but would have been exposed to the full development risk. After carrying out an options appraisal the Council agreed on a joint venture vehicle with a private sector partner to provide investment. The infrastructure provider will secure investment against the value of the land Oxford did not have significant prior experience of joint ventures and had to draw on external advice on tax and the accounting treatment. There were also costs for professional services including architects, surveyors and lawyers and further due diligence, met by HCA. The council started the procurement process to find a partner in 2010. As the developers are providing infrastructure funding alone, the procurement of the Joint Venture partner was not

_________________________________________ subject to the EU public procurement rules, avoiding a time consuming OJEU exercise. The procurement process was still a vital stage of the process as it brought out the economic, social and environmental benefits in the Councilâ&#x20AC;&#x2122;s vision for Barton, including the opportunity for training, apprenticeships and job creation. Following the procurement process Grosvenor Developments Ltd was selected as the preferred private sector coinvestment partner. The Council entered into a 50:50 limited liability joint venture partnership (LLP) with Grosvenor in October 2011. The scheme is expected to deliver 885 residential units of which at least 40% will be for social rent. The early stages are well advanced with outline consent granted and a detailed design code has been part of the planning process. The Council has been careful to keep a strict separation between its role as landowner and as Local Planning Authority. The joint venture has enabled development on a difficult site, and will enable the building of new affordable homes without additional public funding. It also allows the council to retain a degree of control over how the site is delivered. Running a joint venture takes time and effort from the council and initial investment to cover the cost of external expertise and the procurement process. Oxford has learnt that operating the joint venture takes more time than they originally expected.

Learning for other partnerships Oxford had clear objectives for the project and threaded these through the process and the procurement stage. For Oxford, the project was not just about getting housing built and the aim, clearly set out by elected members, was to support local economic growth and increase the range of housing options for local people. Choosing the right partner has been crucial to the success of the project. Oxford had clear aims and set them out in the procurement process, and this has been helpful to both partners. A joint venture requires resourcing by the council. Oxford have committed a lot of time to the partnership and other councils considering this approach will need to think about the demands on officer and member time. The skills and commercial experience needed to set up a successful joint venture will also be critical to success.

Gateshead Council â&#x20AC;&#x201C; Regeneration partnership The Gateshead Regeneration Partnership between Gateshead Council and Evolution Gateshead will deliver 2,400 homes over the next 15 years. The Council is using its land assets to secure private finance through this Local Asset Based Vehicle which also allows the Council to achieve wider economic, design and sustainability outcomes. Gateshead has partnered with Evolution Gateshead (itself a partnership between Home Housing and Galliford Try) to develop an innovative solution to delivering both private and affordable housing. This scheme is also being

_________________________________________ supported by the Homes and Communities Agency. The approach developed by the Council has been to secure a long-term public private partnership with access to private financing and commercial expertise. Sites are being ‘bundled’ together in groups of three or so where the sites with a positive value will cross-subsidise those with a negative value and thereby ensure development across the bundle. This public private joint venture will also support wider housing and regeneration objectives of the council and its communities including promoting economic development, increasing local employment opportunities, raising sustainability standards in residential dwellings and improving design standards. The project will deliver: •

the regeneration of 19 key development sites

•

around 600 affordable and 1,800 private homes

•

local employment and economic opportunities: 25% of employees working on the project will be from Gateshead and 25% of the value of supply chain opportunities will go to Gateshead businesses

•

homes will be built to Code for Sustainable Homes level 4

•

all homes will be built to Homes and Communities Agency space standards.

Learning for other partnerships •

This type of project requires a corporate approach with input from a dedicated range of professions across the Council.

•

An engagement plan is a useful tool to keep stakeholders informed of progress with the project.

•

A governance structure is needed that effectively represents the interests of all partners.

B) Council investment Ashford Borough Council – building on a track record of housing growth Ashford Borough Council is setting up a council owned housing company to build new homes for rent. Ashford has a thriving housing market but there is a gap in the provision of rented accommodation, and this is an area that the Council will target through the new housing company. Experience of building council homes, PFI projects and a proactive approach to housing development has given the council a base of commercial and entrepreneurial experience to build on. Ashford has a track record of housing growth, including the expansion of Chilmington Green with 6,000 new homes. Councillors and communities have supported the growth of the area and there is support for further building. The Council has built new affordable homes on Council owned land through Housing Revenue Account (HRA) borrowing and through the HCA funded local authority new build programme. New council homes have been well

_________________________________________ received, and have improved small and difficult sites such as garage areas. There is a strong housing market in Ashford for owner occupiers but the market is not keeping pace with demand for privately rented accommodation or providing alternatives for people without sufficient income to buy their own homes. The Council is seeking to target this gap in the housing market through a new venture. Building through the HRA is no longer an option as the council has reached the borrowing cap. A new trading company is the solution for providing additional housing capacity. The new property company will be Council owned and funded initially by council borrowing. The company will offer homes to rent and sale, with a mix of rent levels. Providing some properties for sale and market rent will make the company sustainable and enable the company to provide the properties at lower rent, creating a housing offer for local people that meets the gap in the commercial market. Setting up a council owned company has not been straightforward and the question of state aid has been particularly complex. This model was preferred by Ashford due to the ability for the Council to maintain control and ensure that the company has appropriate governance. It will also provide an income stream for the Council through the borrowings. Ashfordâ&#x20AC;&#x2122;s track record in building new houses will underpin the new company. Their experience of building through the HRA has built up their skills in design and consultation. Becoming a self-financing housing authority gave them confidence in their accounting ability, as they gained valuable experience from the process of negotiating the selffinancing agreement with the Treasury.

Learning for other councils Taking a more entrepreneurial role in housing has enabled council staff to develop new skills and services in house. The Council now has its own architect, for example. The expansion of the housing stock has had a positive effect on the housing service and opened up new areas of opportunity. The trading company allows the Council to manage the investment and keep a close control over governance. It has taken time to set up and other councils thinking of a similar approach will need to think about the time and skills needed to support this level of commercial activity. Ashford Borough Council prepared a detailed business case as part of their preparation, and had existing experience of trading companies to draw on.

South Cambridgeshire District Council â&#x20AC;&#x201C; Arms Length Housing Company South Cambridgeshire District Council have registered South Cambs Limited, a specialist armsâ&#x20AC;&#x2122; length housing company. Long term options for the housing company are under review, with the potential for commercial activity. Affordable housing is a significant economic issue in the local area. The shortage of rented accommodation is a concern for employers, with a real risk that essential workers will be priced out of the local jobs market by high housing costs.

_________________________________________ The council is considering leasing arrangements through the Housing Company to address the shortage of affordable rented property. Options under consideration include leasing empty publicly owned empty homes, and redevelopment of council owned bedsits. Leasing has the advantage of speed, as no building is required. It is also a low risk activity to the council in terms of risk and investment. The council is exploring different types of tenancy through Housing Company including longer tenancies. There is demand from professionals for rented accommodation with security of tenure, for example during a placement with the University.

C) Housing as part of a wider growth and investment agenda Preston, South Ribble and Lancashire City Deal - Land assets and infrastructure The Preston, South Ribble and Lancashire City Deal is one of the second wave of City Deals. It focuses on the areaâ&#x20AC;&#x2122;s economic assets and opportunities to drive forward local growth, and over a ten year period the City Deal will generate 17,420 new homes and secure ÂŁ2.3 billion in leveraged commercial interest. New homes will be needed to support the planned increase in jobs and economic activity. The City Deal area already has many attractive sites allocated for housing development in its Core Strategy. Investing in infrastructure is critical to delivering large scale housing development on these dormant sites. The area has the potential for housing growth and the location and geography of Preston makes it a well suited for development as a regional hub. Several attractive sites have already been earmarked for housing development through the core strategy. The challenges have been to secure the infrastructure and speed up delivery on sites that have so far been dormant, and where planning permission has not been given due to capacity problems. The City Deal has enabled the partners to set up an Infrastructure Delivery Fund and Investment Fund to get schemes moving and provide the catalyst for jobs and housing. Infrastructure projects include four major new roads, a motorway junction and local community infrastructure. Infrastructure developments will be funded by bringing together existing funding streams, along with investment from the Lancashire Pension Fund, land receipts, New Homes Bonus and the community infrastructure levy (CIL) from developers. HCA assets, a legacy of the new town development in the 1970â&#x20AC;&#x2122;s, are being brought into the City Deal. The Partners will keep the receipts for 10 years and a Stewardship Board will guide the disposal process. By bringing certainty over long term investment, housing development can start quickly. Preston Council is working on a masterplan with developers and encouraging them to collaborate. The aim is to produce a single planning application.

Learning for other partnerships

_________________________________________ â&#x20AC;˘

Joint working between the local authority partners began long before the City Deal. The councils involved had a clear, simple vision for economic growth and this has been key to agreeing the City Deal.

â&#x20AC;˘

There will be complexity in the delivery of the City Deal projects, for example on the planning masterplan, but underpinning the agreement is a simple vision for developing the area and using existing assets.

_________________________________________ D) A quick look at other investment and delivery models in development Plymouth City Council Plymouth City Council is establishing a £50 million fund to build 1,000 new houses a year. The Council will borrow the money and lend it to housing associations and housing cooperatives at an interest rate of 3 per cent. The council also plans to release 100 acres for development for a mixture of affordable homes, family homes, executive properties, student accommodation and extra care housing. http://www.plymouth.gov.uk/rds

Kent County Council and Kier Kier’s property arm and Kent County Council have struck a deal to build 150 homes for private rent across the county. The council will provide the land, Kier and an international pension fund the finance for a mix of market sale, new, rental and affordable housing.

Cornwall Council In February 2013 Cornwall Council established a new £62 million fund which will deliver more than 4,000 new affordable homes over the next 4 years. A central proposition is for the Council to develop new innovative ways of investing which create value which can be recycled into future schemes. This includes commissioning new affordable housing from registered providers and appointing a development partner through the HCA to develop council owned sites where receipts are recycled.

Eastleigh Borough Council Eastleigh Borough Council offered a “guaranteed purchase” model for developers who had sites with existing planning permission but were unsure if they could sell the houses, leading to stalled development. Eastleigh provided a letter of guarantee that the Council would buy the property if it failed to sell on the open market. Under this arrangement the developer had an agreed period to sell, and the flats were in fact all sold to private buyers. Eastleigh is exploring options for developing a set of sites that are too small to attract commercial interest. Partnership with neighbouring authorities and local housing associations would allow the council to link up sites and share resources and expertise. A Special Purpose Vehicle is being established and options for housing delivery are being considered by councillors. It is likely that any new housing would include affordable housing as well as homes for market rent, to ensure viability.

Mansfield District Council Mansfield District Council is looking at a number of options to promote house building and a mixed approach to investment. Different options are proposed for different sites, allowing the council to support a range of different housing products and help local people access affordable homes and move up to home ownership. Proposals include new build “rent to buy” homes on land owned by the council, financed by private investors. Alongside the lease back scheme the Council is also looking at an arms length Housing Company as vehicle for direct investment. http://www.local.gov.uk/web/guest/housing/-/journal_content/56/10180/3891735/ARTICLE

_________________________________________ Thurrock Council, Essex Gloriana Thurrock will be a housing company wholly owned by the council and able to build new homes on councilowned on a site-by-site basis. The financial model assumes that most of the new homes will be let at 80 per cent of market rent, with the balance sold outright or through shared equity or similar schemes. The business case for Gloriana Thurrock can be found on the Councilâ&#x20AC;&#x2122;s website: http://democracy.thurrock.gov.uk/thurrock/MeetingsCalendar/tabid/70/ctl/ViewMeetingPublic/mid/397/Meeting/2261 /Committee/402/Default.aspx

Sheffield Housing Company The Sheffield Housing Company was formally established in 2011. It is a partnership organisation with 50 per cent of its shares owned by Sheffield City Council and 50 per cent owned by a consortium of Keepmoat Ltd and Great Places Housing Group. The Council invests land in the Company and Keepmoat Great Places invests money to match the value of the land asset. Profits and risks are shared equally between the partners. Sheffield Housing Company plans to build 2,300 new homes over a 15 year period. https://www.sheffield.gov.uk/in-your-area/regeneration/sheffield-housing-company.html

Wakefield Metropolitan District Council and Wakefield & District Housing Joint Venture Partnership Wakefield MDC and Wakefield & District Housing (a Registered Provider set up following transfer of the housing stock in 2005) have agreed to establish a Housing Joint Venture Limited Liability Partnership to develop private market homes with the purpose of increasing the supply of new high quality market sale homes and affordable homes. This innovative new partnership will operate on a commercial basis with a view to profit realisation, in order that the profit generated from market sales can be re-invested in further improving the local housing supply or investing in priority regeneration opportunities in the Wakefield district. The parties have agreed to invest equal sums into the Partnership that will enable it to acquire sites from the Council, with an initial programme of 200 new homes over the next 5-7 years. It is currently anticipated that the Partnership will be launched in April 2014.

_________________________________________ Brighton and Hove City Council Brighton and Hove City Council has identified a range of options for delivering affordable housing. The Council is engaging with institutional investors in order to utilise potential private sector funding opportunities to contribute to the delivery of new affordable homes. The HRA capital programme includes funding to support building new Council homes on vacant garage sites and £1 million for the procurement of initial feasibility, design and stakeholder engagement, on potential case studies for additional housing opportunities on HRA land. The Estate Regeneration Team is carrying out detailed work on an initial pipeline of 40 sites which have the potential to deliver up to 150 homes.

Westminster City Council Westminster City Council has developed an integrated model which incorporates direct development with a council owned housing company, leverage of value through planning obligations and funding through local authority borrowing. Together these initiatives have helped to speed up the delivery of housing regeneration across the Council’s area and add to housing supply. In 2010 the Council formed a wholly owned charity, Westminster Community Homes (WCH) to compliment the Council’s activities in delivering new and better affordable housing in the Borough. Westminster has a planning policy that allows a payment into the Council’s Affordable Housing Fund (AHF) if it is impossible or unviable to deliver affordable housing on site. The Council uses the AHF to grant aid charities and registered providers to provide affordable housing with this fund. Some donations have been provided from the AHF to WCH. In addition the Council transferred land at nil value to the charity plus loaned money at market rates to help WCH grow its portfolio. Over four years WCH’s portfolio will have grown to 400 homes with a mix of new build homes and acquisitions. WCH provides housing for those in priority need in Westminster. More recently WCH has worked in partnership, acquiring homes in and around the Council’s Housing Renewal Areas. With the benefit of these homes, WCH provides decant opportunities for households affected by the Housing Renewal Programme. The availability of these decant homes helps to speed up the process of regeneration by providing local residents with decant opportunities. The phase 1 Housing Renewal sites will deliver over 500 new and larger affordable homes alongside a programme of 600 private homes in the City. As the new homes are much larger than the old homes which are being demolished, the phase 1 programme will help up to half of the overcrowded households in the City.

_________________________________________ Building through the New Homes Bonus The New Homes Bonus is an un-ring fenced grant from central government. Councils use the New Homes Bonus for a variety of purposes and these examples show it in use as a funding option for new housing development.

Leicestershire County Council Leicestershire County Council committed all New Homes Bonus received in 2011/12 to support the building of rural affordable homes, available to rent or for shared ownership schemes in villages. This is bringing forward stalled housing developments by plugging funding gaps.

South Norfolk Council South Norfolk Council is using money from the New Homes Bonus to encourage Housing Associations to build affordable housing in the district. The first development funded under the scheme is for 8 new homes in Diss built on the site of derelict garages. The initial investment by the Council is expected to attract a further ÂŁ1 million from other sources.

Islington Council In 2011, Keniston Housing Association planned to develop a site on Junction Road in Archway, but did not have enough funding to provide all the homes for social rent. Islington Council stepped to meet the funding gap by adding ÂŁ820,000 of its New Homes Bonus money to unlock the scheme and guarantee that all 14 homes would be for social rent. Itâ&#x20AC;&#x2122;s one of the first deals of its kind between a local council and a housing association. The development of one, two, three and four-bedroom properties, including one which has been especially adapted for a wheelchair user, will help house more than 50 people, including Islington families currently living in overcrowded conditions. The properties will also have lower energy bills thanks to solar panels, green roof and argon-filled double glazing.

_________________________________________ 3. Issues to consider in selecting an investment and delivery model Vision and leadership Key questions to ask: •

What type of housing is needed now and in the future? Sources of information could include the Strategic Housing Market Assessment and Joint Strategic Needs Assessment.

•

How does the scheme link with your wider objectives? For example town centre regeneration, skills development and apprenticeship schemes, supporting an ageing population.

•

What is the business case for increasing housing supply? Could increasing housing supply reduce the pressure on council housing and homelessness services, for example?

•

What is the right balance for your authority between refurbishment of existing stock, stock replacement and new build?

•

What are the ambitions and priorities of your residents?

Learning from councils: Ensuring strong leadership and a clear and effective vision. The crucial role of councillors in setting a clear vision for investment was highlighted by many of the councils we spoke to. Housing as part of a wider agenda. The councils in our case studies linked housing to their wider vision for growth, local employment and sustainable communities. Getting the language right. A number of councils highlighted their role as mediator or ‘ring master’ of partnerships including a number of public and private interests. Ensuring effective communication channels and demystifying the public sector for private investors was identified as an important role for the local authority.

Level of involvement: risk and return Key questions to ask: •

What level of involvement does control does the council want to have in house building projects? This could range from being a strategic partner or funder, to taking a direct role in building and managing new homes.

•

What is the council’s approach to risk? This will underpin the right delivery vehicle and determine the degree of direct involvement in implementation and investment.

•

House building can offer a financial return through sales and rental income. Could increasing housing supply reduce the pressure on council services, for example in homelessness and temporary accommodation?

•

What skills and expertise will be needed? A role in delivery and commercial activity will need sound financial management as well as the ability to deliver new houses.

Learning from councils: Greater involvement will give the council more of an opportunity to share the rewards and influence the way that projects are run and delivered. To support this, councillors and officers may be required to invest significant amounts of time in housing projects.

_________________________________________ The traditional housing management function is moving into a new entrepreneurial and enabling role. Officers and councillors may need to learn new skills and adopt different ways of working as part of this process. This can be motivating and open up new opportunities, but it may also represent an increased workload and demand on limited capacity. Partnership working does not necessarily equate to the transfer of risk. Retaining some of the risk with the public sector may be necessary to make projects attractive to private sector partners and to reduce costs. Investment in housing can be part of a longer term strategy to create income for councils to invest in further housing activity, and become more resilient to reductions in grants and central government funding. Considering best fit for on-going and planned projects as well as new and unexpected initiatives is crucial when selecting a partner for a long term venture.

What source of finance? Key questions to ask Some form of financial investment will be required, either by the council or a private partner. Credit markets are fluid and borrowing rates have changed over time. Which option will be cheapest in the long run? Will the borrowing be on or off the councilâ&#x20AC;&#x2122;s balance sheet?

Learning from councils Each option will require different amounts of preparation and research. Entering into a partnership with an external partner will take time and involve complexity through legal, procurement and finance issues.

How can the planning system support you to attract investment in housing? Key questions to ask â&#x20AC;˘

Have you got your local plan in place? Providing certainty to potential investors and the community through a local plan and land allocations can attract investment locally.

â&#x20AC;˘

How can your pre application service support early engagement with potential partners? Could this take place across areas to attract investment on a larger scale?

Learning from Councils Using planning tools to package up land and reduce risk up front for potential investors was highlighted by councils we spoke to as a key tool to attract investment. An effective pre application service which develops and nurtures long term and mature relationships with potential investors can help deliver long term investment locally.

_________________________________________

Useful resources and further reading Online library of housing case studies on the LGA website: http://www.local.gov.uk/web/guest/housing/-/journal_content/56/10180/3845114/ARTICLE Meeting Local Housing Demand - A Guide for Elected Members http://www.local.gov.uk/web/guest/housing/-/journal_content/56/10180/3373353/PUBLICATION Supporting Housing and Growth: Case Study Guide http://www.local.gov.uk/web/guest/housing/-/journal_content/56/10180/5544777/ARTICLE “Let’s get building” The case for local authority investment in rented homes to help drive economic growth Published by the National Federation of ALMOs and ARCH, with CWAG, CiH and the LGA http://www.arch-housing.org.uk/policy-and-practice/arch-publications/lets-get-building.aspx Homes and Communities Agency Funding for national housing programmes and information on investment models http://www.homesandcommunities.co.uk/ourwork/investment-models LGA Productivity and Commissioning resources including asset management and economic growth http://www.local.gov.uk/productivity;jsessionid=26A1BDC51C449B7CE7414AA4FEECDFFE

Acknowledgements The LGA would like to thank the case study councils for their time and contribution to this report. Further thanks go to the Homes and Communities Agency for suggesting case studies and innovative examples of partnership working.

For more information please contact Local Government Association Local Government House Smith Square London SW1P 3HZ Email: hilary.tanner@local.gov.uk Telephone: 0207 664 3000

GMPF Approach to Housing Investment Greater Manchester Pension Fund has been investing locally for over 25 years. It currently has an allocation to local investments of up to 5% of Fund value. Such investments must satisfy the twin aims of delivering commercial returns and supporting the area. A diversified portfolio of local assets is being built, a significant proportion of which is property assets. The investment in housing for sale and rent in our local area is consistent with the local investment aims and in particular it is expected to deliver good solid long term returns at relatively low risk. Such returns are expected to exceed the assumed return built into the actuarial valuation. Greater Manchester Pension Fund has had a consistent and very successful approach to investment for over 25 years that is set out in its core belief statement and demonstrated by investment returns that are the highest for LGPS funds over 25 years. The key aspects of this include a long term approach and in having appropriate governance arrangements which allow the internal management of some assets with proper accountability to the Management Panel of the Fund. We also believe that diversification is important to reduce volatility of the overall Fund return, and that local investments provide such benefits together with assets such as corporate bonds, private equity and property. The Fundâ&#x20AC;&#x2122;s investment strategy and individual decisions are made with reference to these core beliefs. When considering the opportunity of investing in housing the Fund first had to assess whether there was a need for such investment. It then had to assess whether the prospective returns met its criteria and finally was there a means by which the Fund could invest. These are key questions for any investment. If there was a need, investment would have a positive impact on the local economy. A key decision in determining viability was which sector(s) to target. Nationally, the scale of house building is well below Government targets. Even looking beyond the impact of the 2008 financial crisis, the nature of the UK housing market is being altered by a combination of longer term trends. Issues preventing homes being built are well documented, e.g. the uncertain economic climate, the ability of house builders to fund developments, affordability from the home owner or tenantâ&#x20AC;&#x2122;s perspective, availability of mortgages to first time buyers and those with inadequate equity. Greater Manchester has seen a dramatic decrease in housing completions since the peak of the market in 2007/08. New supply is running at around 3,000 â&#x20AC;&#x201C; 4,000 per annum rather than the estimated 9,000 - 10,000 per annum needed to meet demand. Census 2011 figures show the private rented sector has grown by almost 70,000 properties since 2001 in Greater Manchester, from 10.7% to 17.4% of the total stock. Having established that investment in homes was needed in the area and that viability was best achieved by homes for sale and market rent, the final stage was to establish an appropriate investment vehicle. The Fund has always worked closely with its local authority employers and the first opportunity arose with Manchester City Council (MCC).

Two years ago MCC approached the Fund to ascertain whether the Fund would be interested in investing in the development of new build residential accommodation which would be homes for sale and let at market rent. In working up the model MCC agreed to identify sites within their ownership and control which are capable of supporting residential development and may also deliver regeneration benefits. The collaborative approach and the transfer of MCC owned sites were key to underpinning the returns to the Pension Fund and delivering the regeneration and financial benefits to the local area. GMPF agreed to work collaboratively with MCC in order to explore the opportunity to design a new residential development model which can initially be applied to MCC owned sites and provide the framework for further developments in Greater Manchester. The objective was to deliver a mix of homes available to let at market rent and for sale at market value. A new joint venture company â&#x20AC;&#x201C; Matrix Homes â&#x20AC;&#x201C;was established between GMPF and Manchester City Council. This pioneering approach was a first-of-its-kind partnership. GMPF agreed to invest over ÂŁ25m to enable 240 homes to be built on 4 sites owned by Manchester City Council and also a site owned by the Homes and Community Agency. There was a collaborative approach to ensure that the business and financial model met the needs of both parties. The key elements of the pension fund investment were that it is predominantly of a fixed income nature albeit a significant proportion of the drawn down investment is re-paid early, this necessitates a mix of sale of properties and rented properties, approximately 50% of each. The building contractor appointed after a procurement process was Wates Living Space. The tenure mix across the five Manchester sites was developed to ensure each location fits in to the property requirement for the local area. Thus some sites are just for rent or sale with others mixed. To help manage risk, there is a long term lease on the rented homes to a head tenant who manages the properties. This also means that the Fund is not exposed to voids and bad debts or other operational risks. The head tenant was procured through a competitive process. This head tenant is Places for People and Plumlife, also separately procured, are responsible for sale and marketing of the properties for sale. There is also scope for a sale at the end of the lease that provides the final returns on equity to MCC and the Fund. The financial model has been robustly tested and there is a high level of confidence in the probability of meeting the required investment return. The initial sale of homes is an important risk that needs to be managed. It is proposed to roll out the model to other local authority owned sites within Greater Manchester. We are actively promoting the opportunity to other authorities and the start of the building phase and sales programme has heightened interest. Paddy Dowdall Assistant Executive Director, Greater Manchester Pension Fund

Excellence. Responsibility. Innovation.

Hermes Real Estate

UK residential property: Accessing the opportunity

Key points The UK private rented sector has made consistently strong returns since 2001 while demonstrating low correlations with other property sectors and equities, and a negative correlation with Gilts.

To gain a first-mover advantage in this market, execution is key. Investors must be able to access institutional-quality stock and achieve scale through efficient property management to preserve yields.

Strong demand for rental properties, driven by higher costs of housing and demographic trends, combined with limited supply and cross-party political support underpin the investment case.

A strong history of returns, solid fundamentals and vehicles that offer both investment and property management lead us to believe that UK residential property is poised to become a viable allocation.

For professional investors only

www.hermes-investment.com

Seeking strong long-term returns, many UK institutional investors have entered private markets – acquiring assets like commercial real estate, private equity and, more recently, infrastructure equity and debt – in order to exploit strong yields, capital growth and the embedded illiquidity premium that can reward a long time horizon. Many of these investors have benefited, and as more pension funds mature, sources of enduring return will continue to be in demand. Key peers of UK institutional investors – like those in the United States, the Netherlands, Germany and Switzerland – have gained from investing in residential real estate, which has delivered stronger risk-adjusted returns than commercial real estate; is driven by powerful demographic trends; and enjoys cross-party political support. Currently, 1% of residential real estate in the UK is owned by institutional investors, compared with about 10-15% in continental Europe.1 One of the main roadblocks to greater institutional participation has been the absence of suitable investment vehicles. Pooled funds specialising in residential real estate are relatively new, but a number of joint ventures between fund and property management experts now enable access to a growing part of the market: the UK private rented sector (PRS). Here we examine the case for investing in UK PRS: historical and projected returns, correlations with other property sectors and asset classes, supporting fundamentals and key risks, and ways of accessing this opportunity.

Strong, uncorrelated returns

Residential properties also provide a moderate inflation hedge, and this correlation increases with time, which should suit pension funds with long-term liabilities. The table below shows that this link with inflation increased over a three-year period in the six markets where investing in residential property is well established, particularly France and the US. Figure 1. Correlation between local inflation and annual house price growth, 1970-2013 1-year period

2-year period

3-year period

Australia

0.23

0.44

0.55

Germany

0.39

0.42

0.49

France

0.52

0.56

0.59

Netherlands

0.30

0.35

0.41

United Kingdom

0.11

0.17

0.26

United States

0.29

0.36

0.44

In a low interest-rate environment, investors need to look at a wider spectrum of investments whose returns can help match their long-term liabilities. Real estate is a popular asset class, but institutions have focused on office, industrial and retail assets and currently allocate just £12.7bn to residential property from an aggregate allocation of £204bn2. But a strong case can be made for UK PRS: attractive riskadjusted returns; stable cash flows; real capital growth; low correlations with other property sectors; and inflation-hedging characteristics. With increased demand for rental homes across UK cities, greater construction of purpose-built PRS stock, and the emergence of investment vehicles enabling access to this market, the opportunity becomes more attractive. Investors who act quickly also stand to benefit from first-mover advantage.

Note: Correlations based on BIS (2014) data. For Australia, the data is from 1987-2013 Source: IPD UK Residential Property Index, IPD U.K. Annual Property Index. Inflationadjusted total returns, 1981-2013

From 2000-13, capital growth for residential real estate in the UK was 6.7% compared to 0.9% for all commercial real estate.3 This was mainly due to the nature of commercial stock, which is characterised by aging buildings and changing occupier preferences. By contrast, residential assets rarely depreciate and prices can rise depending on location. In addition, residential assets are not always a pure capitalappreciation play: the rental market can strengthen even in an economic downturn as mortgages become less affordable and home buyers delay purchases.4

Source: IPD UK Residential Property Index, IPD U.K. Annual Property Index. Inflationadjusted total returns, 1981-2013

Figure 2. Correlations between property sectors, 1981-2013 Intra-property correlations Residential

Retail

Office

Industrial

Residential

1.0

0.6

0.7

0.5

Retail

0.6

1.0

0.8

Office

0.7

0.8

1.0

0.9

Industrial

0.5

0.8

0.9

1.0

“Laying the Foundations: A Housing Strategy for England,” published by HM Government in November 2011 “Residential Investment in International Markets,” published by the IPF Research Programme, 2011-2015 3 IPD All Property Index 4 “Residential Investment in International Markets,” published by the IPF Research Programme, 2011-2015 1

Hermes Real Estate

Figure 3. The performance of UK PRS v other property sectors, 2000-13

Figure 4. Risk and return profile

12 Residential index

10 Residential index excl Central London

Other property

8 Return (%)

On a total-return basis, UK PRS has consistently generated better riskadjusted returns with lower volatility than all other real estate sectors over most time frames in the past 30 years.5 It has been the best longterm performer among major real-estate sectors from 2000-13, returning 10.5% against the 6.9% of the IPD All Property Index and outperforming retail, office and industrial property (see figure 2). This outperformance extended over a much longer period, from 1971 to 2009, as residential assets delivered a 13.4% average annual return to surpass the 12.6% gain by equities, the 10.8% posted by commercial property and the 10.1% return of Gilts.6

All property Retail Office Industrial

Gilts

Equities

4 10.5 6.7

9.3

9.5 5.0

8 %

7.0

6.6 0.4 6.1

1.2

5.7

6.9

7.0

0.9

2.6

Risk (standard deviations) Source: MSCI, JP Morgan 7-10yr

2.4 1.4

1.1

0.5

Income return

Capital growth

Total return

RPI inflation

Other property

Industrial

Office

Retail

Residential index excl CL

Residential index

0.3

Rental value growth

Source: IPD All Property Index

While capital values in commercial property have declined by less than 40% in real terms since 1980, those for residential property have increased significantly, which likely reflects the combination of restricted supply and strong demand – a supportive fundamental for the sector. In addition, residential real estate is a strong portfolio diversifier with a low correlation not only to other real estate sectors but also to equities and bonds. This is due to its different performance and risk characteristics. Returns are driven by fundamentals: strong demographics, supply-and-demand imbalances and UK government reforms that support investment in the sector, such as increased funding and reduced stamp duty for PRS properties.

4.3 3.6

0 4

6.0 5.0

4.1

All property

Residential real estate has also proven to be a diversified source of return. In the UK, it exhibits a limited correlation with commercial property, a low correlation with equities and negative correlation with Gilts, aiding diversified investors (see figure 5). But international PRS investors could also benefit as the UK market has a low correlation with those in Europe (see figure 6). Figure 5. Correlation of PRS returns with UK commercial property, equities and bonds, 2001-13 Total return by asset type

Correlation (%)

UK residential property

–

UK commercial property

65.7

UK property equities

34.8

UK equities

31.6

UK gilts

-47.9

Source: IPD UK Residential Index, IPD UK Annual Property Index

“Investing in residential property: A British Property Federation guide for asset allocation”, published by the British Property Federation Nationwide, IPD, DataStream and LaSalle Investment Management

www.hermes-investment.com

Figure 6. Correlation of European PRS markets by total return, 1999-2013 UK

DEN

FIN

FRA

GER

SWE

1.0

0.42

0.06

0.47

0.11

0.47

0.82

0.60

0.27

0.47

-0.19

0.67

1.00

Sweden Netherlands

0.53

0.17

0.42

-0.35

-0.42

0.22

-0.06

1.00

France

0.64

0.17

1.00

Finland

-0.23

1.00

Germany

-6%

Glasgow

1.00

+28%

Manchester

The average total return on residential property varies between countries, ranging from 5.2% for Germany to 11.8% for the UK over the last 15 years. This divergence is due to the higher volatility in the UK market compared to Germany, which has the best risk-return ratio. The rising demand for private rentals in the UK contrasts with the situation in Europe, where PRS is fully mature in many countries and has stopped growing, or is even shrinking. Figure 7. Annual residential property performance, 1999-2013

+13%

Bristol 0 2011

2001

3 4 5 6 Population (millions)

8.0%

11.2%

Return-risk ratio

1.00

1.68

2.88

1.16

1.46

0.73

UK PRS fundamentals A classic story of increased demand and limited supply underpins the UK PRS market. Strong urban population growth in UK cities, where much of the new PRS stock exists, and the high cost of home ownership are key drivers of demand. The populations of London, Leeds and Bristol rose by 14%, 5% and 13% respectively from 2001-11, and should continue to be supported by an overall UK population forecast to swell to 73.2m by 2035 (see figure 8). Amid this surge in population, the average household size is shrinking from 2.42 people in 1996 to 2.37 in 2013, and is forecast to continue to decline (see figure 9). To match the current rate of household creation, the amount of new dwellings completed per year must rise by 64%. In a further boon to the PRS market, 77% of all new households sought rental accommodation.7

2.45 2.42 2.39 2.36 2.33 2.30

2020

6.1%

2018

1.8%

2016

5.2%

2014

7.6%

2012

Risk

Figure 9. Average UK household size

2010

8.2%

2008

11.8%

2006

7.1%

2004

5.2%

2002

8.7%

1998

7.6%

Average number of people

AUS Total return

epartment for Communities and Local Government D Nationwide House Price Index, November 2014 9 Money Supermarket, 29 May 2014

+11%

Edinburgh

Source: Office for National Statistics, General Register Office for Scotland

Sources: IPD Multinational Index Spreadsheet – Update 3, 2013; BIS data as at 2014 for Australia’s house price performance

+5%

Leeds

Source: IPD, Catella

+10%

Birmingham

2000

Denmark

+14%

London

1996

United Kingdom

Figure 8. Urban population growth in some of the UK’s cities

Source: 2011 Census. Estimates calculated by Hermes using 2011 Census data

We see three broad categories of renters in the UK PRS market: —— Unable to buy: people who are permanently locked out of the

home-buyer market as house prices have accelerated faster than median annual incomes. Across the UK, the average house price for first-time buyers was 4.4 times average earnings in November 2014. In London, this increased to 6.8 times and in northern England declined to 3.2 times.8 One researcher has found that 37% of people in the UK do not intend to buy a home.9

Hermes Real Estate

A persistent shortage of housing supply intensifies this demand for rental properties. House building starts and completions have been at historically low levels for several quarters. This means that even as the UK economy continues to recover, there will not be enough new homes to meet increasing demand and prices will climb further. From 1973 to 2014, as the population grew, the number of UK dwellings completed per year has more than halved to less than 150,000 in 2014 (see figure 10). The National Housing and Planning Advice Unit estimates that 291,000 additional homes are needed each year to 2031 in order to keep pace with growing demand.14 Private builders have seen a 45% drop in completions due to lack of financing, onerous and local planning regimes, as well as government bureaucracy targeted towards developers. This combination of factors has pushed the housing stock replacement cycle to a new record of more than 175 years compared to the-long term average of 125 years.15

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Source: Department for Communities and Local Government

Household creation

2012

2010

2008

2006

2004

2002

2000

250 225 200 175 150 125 100 75

1998

Figure 11. More households are being created than dwellings

1996

transport connections, amenities and desirable nightlife options, an increasing number of people choose to rent instead of buy in places without the same concentration of lifestyle factors. Also, more people are prioritising flexibility in accommodation and employment and are reluctant to commit to a place of work or residence for long periods. Much of the UK’s population of international workers, which has increased as cumulative net migration has more than doubled to beyond 6m in 2013, also requires rental accommodation.13

United Kingdom

1994

—— Lifestyle choice: preferring to live in locations with more convenient

400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0

1992

Simultaneously, mortgage regulation has become more stringent and lenders are imposing tougher standards. Notwithstanding the UK Government’s Help to Buy scheme, deposit requirements remain high and mortgage approvals have slid 49% from the 1.4m peak reached in 2006 to 735,000 in 2013.11 Prospective new powers for the Bank of England’s Financial Policy Committee, which could force lenders to restrict mortgages to no more than 15% of new loans where borrowers are taking out more than 4.5 times their income, could extend this decline. Under the proposals, banks would stress-test borrowers’ ability to repay loans if their mortgage rate is 3% higher than the base interest rate at the time the loan was approved, and could further the time spent by aspiring home buyers in rented accommodation.12 The latest UK census, in 2011, shows that private renters under the age of 35 accounted for 46% of all households across England and Wales. This figure rose to 54% in London. Among 35-49 year olds, the level of private renting almost doubled between 2001 and 2011, to account for one in five households nationally.

Figure 10. Supply constraint: the decline in completed UK dwellings, 1973-2014

Completed dwellings

aspire to own property to wait – and save – for longer in order to accumulate a mortgage deposit. That 10% of people aged 16-24 years currently own homes, compared to 36% in 1991, reflects this. In a time when 34% of the UK population has savings of £250 or less and many young people have substantial university debts, the average UK deposit of £29,000 required by a first home buyer is increasingly difficult to achieve. In London, the average deposit for a first home buyer is £79,000.10

Household creation (’000)

—— Saving to buy: the growth in house prices is forcing many who

New dwellings

Source: Department for Communities and Local Government

Cross-party support for UK PRS The UK government is encouraging large institutional investors including asset managers, pension funds and insurers to invest in PRS properties given the country’s housing shortage. There have been several initiatives and reforms over the past few years, the most recent being the increase in the size of the Build to Rent Fund from £200m to £1bn in the April 2013 Budget. The fund provides equity or loan finance to developers building homes to privately rent, creating opportunities for investors, and was launched in response to 2012’s Montague Report of PRS. Aside from the fund, a further £10bn of debt guarantees are being made available to provide cheap debt financing for long-term investment of both social and market rental homes. The guarantees are available through two programmes: the Affordable Housing Guarantee Scheme and Private Rented Sector Guaranteed Scheme. Each provides £3.5bn in debt guarantees while an additional £450m in government grants is available. There is also £3bn being held in reserve to support the schemes in the future.

Source: ONS, Halifax, Council of Mortgage Lenders, HSBC “ Project Castle: An Investment opportunity in the UK private rented sector”, published by Countrywide 12 “Residential and Risk Monitor Q4 2014”, published by Knight Frank 13 Labour Force Survey, The Migration Observatory at the University of Oxford 14 “Project Castle: An Investment opportunity in the UK private rented sector”, published by Countrywide 15 “Project Castle: An Investment opportunity in the UK private rented sector”, published by Countrywide 10 11

www.hermes-investment.com

Other key developments include the National Planning Policy Framework (NPPF), which was launched in 2012 to slice red tape in the planning process, thereby expediting the construction of new homes and the regeneration of disused land and buildings (some of the regulations dated back to 1948). To date, the NPPF has been successful: the number of permissions granted for housing projects of 10 or more dwellings increased by 24% to 4,900 from the average seen in 2010-12, while refusals rose only 3% despite a sharp increase in applications. The number of permissions for small residential schemes of three to nine units also rose sharply with almost 10,500 applications being approved, a 29% increase on the annual averages in 2010-11 and 2011-12.16 Also, the reduction in the rate of stamp duty for purchases of multidwelling residential properties introduced in the 2011 Budget is supporting development. Stamp duty is now based on the average cost of the individual units rather than the aggregate value of a multipledwelling property.

The outlook for PRS Rental growth will continue to rise amid supply and demand imbalances, tougher mortgage requirements as well as an eventual rise in interest rates. The number of private rented households in England and Wales is forecast to increase by 1.2m over the next five years while levels of owner occupation will fall by 202,000 households. This would mean that by the end of 2019, over 24% of all households across the UK would be in the private rented sector. Most renters will continue to be in the under-35 age band. The proportion of households in PRS is expected to jump to 66%, with home ownership falling to just 16% by 2019. However, even those in the next age band – 35-49 – will see percentages climb with home ownership dropping to just 55% of all households, with private renting accounting for 28% of households. The hike will be 38% in London.17

Cities that offer the most opportunities are either home to a university, technology hub or have a connection to London and the financial sector. For example, Reading and Slough, which generated respective 5.9% and 6.3% gross yields in the first quarter of 2014, have benefitted from people seeking more reasonably priced accommodation than what is available in London. Oxford and Cambridge, which both produced gross yields slightly higher than 5% in the first three months of 2014, are part of the so-called ‘Golden Triangle’ with London. Both not only have consistently large student populations needing rental homes but also benefit from technological innovation and have experienced significant growth in financial and business services employment. These two cities are forecast to experience above-average growth in household disposable incomes, boosting the likelihood of higher rents. Northern cities, particularly Leeds and Manchester, with respective gross yields of 6.6% and 6.7% in the same period, are also poised for rental growth on the back of relatively strong increases in incomes. In the Midlands, the fundamentals are looking robust. Birmingham, which generated a gross yield of 6.3%, is forecast to experience a surge in its population by more than 85,000 in the next decade as it undergoes further gentrification. It should also benefit as its financial and business services sectors grow.

Figure 12. Knight Frank’s five-year residential market forecast, Q4 2014 Residential rental markets 2014 (%)

2015 (%)

2016 (%)

2017 (%)

2018 (%)

2019 (%)

20152019 (%)

UK Overall

2.0

2.2

2.3

2.4

12.1

Prime Central London

4.0

3.5

3.3

3.0

17.1

Prime Outer London

0.5

4.0

3.3

3.0

2.8

16.8

Rental growth: London and the regions London tends to capture the most property-related headlines but investors should not ignore regional UK cities. Rents may not increase as much as those in the capital, but higher growth in rents is forecast in cities such as Manchester, Birmingham, Leeds and Liverpool due to improving economic conditions, rising populations, fewer house completions, affordability and other mortgage constraints. Rising employment, earnings and lifestyle preferences are also contributing factors. In addition, the number of private rented homes in these cities has increased by at least a quarter since 2001.18 Glenigan, Construction Project Leads and Industry Analysis, March 2014 “ Staring into the crystal ball: What next for house price growth?”, published by Savills in Q4 2014 18 “Where are the next Rental Hotspots?” A Residential Rental Market report published by CBRE 19 “Dutch residential investments: a European perspective”, published by IPD 20 “Dutch residential investments: a European perspective”, published by IPD 16 17

The Dutch experience There are five European countries – the Netherlands, Switzerland, France, Germany and Sweden –where residential property has played a significant part in institutional investors’ portfolios. Although house prices fell during the financial crisis in most of these countries, total returns for residential property have remained positive due to the steady income streams they generate. However, the markets differ in terms of regulations, culture, investment opportunities and offerings from product providers. For example, the Netherlands has a long-established tradition of institutional investment in housing that manifests as a 49% weight in the Dutch IPD index, which has been tracked since 1995.19 Compared to other asset classes and real estate sectors, it has produced good risk-adjusted returns, a moderate inflation hedge and provides diversification. One of the contributing factors to the success of the Dutch residential real estate market is the experience and diversity of asset management firms focused on this sector. Institutional investors can choose from a wide range of investment approaches, size and specialisation. There were 30 unlisted residential funds with a combined market value in 2013 of €18.2bn.20 The sector is undergoing a period of change due to regulatory reforms. Currently, the number of Dutch households living in nonregulated rental housing is a minute 5% but this is expected to grow substantially over the next 20 years due to new social housing policies as well as less favourable tax treatment for mortgages. Institutional investors plan to capitalise on the shift and increase their real estate allocations to this category from the current 55% as new housing is built and released. The legislation limits social housing providers to the regulated rental market, often forcing them to sell part of their housing stock to other investors.

Hermes Real Estate

Challenges and solutions Key external risks include changes in the political agenda or economic conditions. On the micro level, a lack of available institutional-grade investment stock, small deal sizes that increase transaction as well as holding costs across a portfolio, historically low yields compared to commercial real estate and gross-to-net yield erosion are some of the major problems. Institutions also prefer investing in proven assets that are in full income-production mode. In addition, there is a dearth of quality data and metrics compared with commercial property, in no small part due to the lack of institutional investor involvement. Another challenge is finding investment managers who have the right skills to manage the acquisition and management of properties from beginning to end. This was not always a problem in the UK. Pension funds and insurers had been active landlords until the 1970s when rent controls had become widespread. Although they were scrapped under then Prime Minister Margaret Thatcher in the 1980s, her government promoted home ownership. This gave rise to individual buy-to-let investors who still dominate the market, with institutional investors accounting for only £1.3bn traded out of the £865bn PRS market as of the third quarter of 2014.21 The experience in overseas markets shows the importance of established fund managers with in-depth local knowledge and strong operational platforms capable of managing PRS stock and delivering professional services to tenants. In the UK, the PRS market is changing as investment firms build dedicated teams or form partnerships with property managers to source tenants, minimise vacancies and maintain assets. Experienced fund managers can help investors overcome the main obstacles that have barred access to the PRS market. For example, take the problem of perceived low yields. Working with local property management specialists, managers are better placed to source the appropriate assets as well as identify new and emerging markets that are ready to be gentrified. They can also help to increase the size of investments by targeting well-managed multiple-dwelling properties, generating scale in a market where asset sizes are small in comparison to commercial real estate. This local presence enables strong relationships with landowners and developers, who can provide information and access to suitable stock, to be forged.

retain tenants by delivering professional property management. Such collaborations help to identify and prudently invest in assets, and deliver services to multiple properties and tenants in an efficient way.

Opportunity knocks The UK PRS investment opportunity has been compelling for some years, and we believe that it is poised to become a viable allocation for institutional investors. The PRS market’s track record of strong performance with low correlations to other real estate sectors and asset classes make it a potentially attractive, diversified source of return within a real estate portfolio. The market is underpinned by solid fundamentals: the high cost of home ownership, increasing number of households and declining rate of dwelling completion create a long-term supply and demand imbalance. Cross-party support and incentives provide opportunities for investors to become involved in delivering purpose-built PRS properties, earn appealing long-term returns and support the social benefits of increased high-quality PRS stock. However, obtaining these benefits requires accurate execution. The UK PRS sector has been difficult to allocate to, but an increasing volume of institutional-quality properties and a new breed of investment vehicles that recognise the necessity of professional property management is changing this situation. Given the specific characteristics of the market, it is important that investors select experienced real estate fund managers with access to in-depth local knowledge, strong property management capabilities and prudent investment methods.

The PRS sector is fragmented, and inefficient management or lack of scale can drive property management costs higher, which negatively impacts yields. Firms with an integrated property and asset management platform can reduce vacancy periods, increase economies of scale and

“Investing in Rental Britain”, published by Savills in 2013

This document is for Institutional Investors only. The views and opinions contained herein are those of the Hermes Real Estate team and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes Fund Managers does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Hermes. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions. Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Lloyds Chambers, 1 Portsoken Street, London E1 8HZ. In Singapore, this document is distributed by Hermes Fund Managers (Singapore) Pte. Limited (“HFM Singapore”), which is a capital markets services holder for fund management under the Securities and Futures Act, Cap 289 (“SFA”), and an exempt financial adviser under Section 23(1)(d) of the Financial Advisers Act, Cap 110 (“FAA”). Accordingly, HFM Singapore is subject to the applicable rules under the SFA and the FAA, unless it is able to avail itself of any prescribed exemptions. HFM Singapore is regulated by the Monetary Authority of Singapore. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”). CM153086 UK/EU/AU/SG 02/15 T1737

www.hermes-investment.com

Excellence. Responsibility. Innovation.

Hermes Investment Management Hermes Investment Management is focused on delivering superior, sustainable, risk-adjusted returns â&#x20AC;&#x201C; responsibly. Hermes aims to deliver long-term outperformance through active management. Our investment professionals manage equity, fixed income, real estate and alternative portfolios on behalf of a global clientele of institutions and wholesale investors. We are also one of theÂ market leaders in responsible investment advisory services.

Our investment solutions include: Private markets International Real Estate, Pooled funds, Segregated mandates, UK Real Estate, UK Real Estate Debt, Infrastructure, Private Equity. High active share equities Asia, Global Emerging Markets, Greater China, Europe, Global and Small & Mid Cap. Specialist fixed income Global High Yield Bonds, Illiquid Credit, Multi Strategy Credit, UK Government Bonds and UK & Global Inflation-Linked Bonds. Multi asset Multi Asset Inflation. Responsible Investment Services Corporate Engagement, Intelligent Voting, Public Policy Engagement and PRI.

Offices London | Singapore

Contact information Business Development United Kingdom

+44 (0)20 7680 2121

Africa

+44 (0)20 7680 2205

Asia Pacific

+65 6808 5858

Australia

+61 2 9924 6402

Canada

+44 (0)20 7680 2136

Europe

+44 (0)20 7680 2121

Middle East

+44 (0)20 7680 2205

United States

+44 (0)20 7680 2136

Enquiries marketing@hermes-investment.com

Certified ISO 14001

Environmental Management

www.hermes-investment.com

Investment case: The UK private rented sector (PRS)

The UK private rented sector (PRS) has doubled in size in the past decade and is now starting to increasingly attract the attention of institutional investors. To institutional investors PRS offers diversification both from other asset classes and from other types of real estate investments, alongside the potential for a strong, stable income stream. Our research suggests that the investment case for UK PRS is backed by:

• A long-standing supply/demand imbalance in the UK housing market;

• One of the highest population growth rates in Western Europe;

• Low correlations with equities and UK government bonds (gilts);

• Potential to outperform commercial property during economic downturns;

• Scope for professional investors to add value through active management and economies of scale;

• Support from the three major political parties for the sector.

Demographics and demand size of the social rented sector. At the same time, only around two-thirds of households are now owner-occupied.

The UK population is expected to expand by around 0.8% per annum in the medium-term (2012-2021). That is one of the fastest growth rates across Western Europe. The London population, meanwhile, is forecast to rise at an even faster 1.3% per annum1.

English private rentals are now at their highest level since the 1960s, at four million households and overtaking the

50 40 30 20 10

Private renting

Owner occupied

13 20

03 20

19 93

3 19 8

19 73

19 63

19 53

19 4

Tenure as a percentage of all households (%)

19 33

This demand/supply imbalance is expected to place upwards pressure on house prices over the long run. Coupled with the fact that there are still significant affordability constraints, particularly in London. This means that barriers to home ownership remain high. This in turn is likely to fuel demand for rented accommodation – a sector which is increasingly dominated by private rather than social landlords. The PRS has been on the rise over the past decade, and now represents 18% of the English market, up from 10% in 2001, according to Department for Communities and Local Government (DCLG) data.

19 23

Household size is expected to continue to fall, with more people living in single-person households. Thus, demographic trends clearly point to a continued rise in demand for housing in the UK. Already, supply has not kept pace with existing increases in demand and this trend is expected to continue. Indeed, housing construction has been on a downwards trend since the 1970s. Only 143,630 homes were built in 2012 – well below the level consistent with new demand2.

Tenure over time (England) 80

Social renting

Source: English Housing Survey.

The rising demand for private rentals in the UK contrasts with the situation in Continental Europe, where in many countries the PRS is now fully mature and has stopped growing or is even shrinking. Indeed, the UK was the only European country out of 11 studied where the general trend was one of on-going PRS growth, according to a report by the London School of Economics and the University of Cambridge3. 1

Office for National Statistics, 2012. 2 Department for Communities and Local Government (DCLG). 3 "The private rented sector in the new century – a comparative approach", September 2012.

Strong risk-adjusted returns

Diversification benefits

According to IPD, UK residential property has outperformed commercial property over each decade since the 1980s and has also performed well against other asset classes.

Property has different market drivers to those of more traditional investments such as equities and bonds, and consequently shows very low correlation with those asset classes. Multi-asset correlations (Inflation-adjusted total returns, 1981-2013)

Total returns by asset class 20 18

Residential Commercial real estate real estate

16 14 12 10 8 6

Equities

Gilts

Residential real estate

1.0

0.7

0.3

-0.2

Commercial real estate

0.7

1.0

0.4

-0.1

Equities

0.3

0.4

1.0

0.2

Gilts

-0.2

-0.1

0.2

1.0

4 2 0

Source: IPD UK Residential Property Index, IPD Annual Property Index, Bloomberg. 1982-1993 Residential

1992-2003 All Property

2002-2013 Equities

30 years to 2013 Gilts

Source: IPD, Bloomberg.

While capital values in commercial property have declined by just over 40% in real terms since 1980, those for residential property have increased significantly, likely reflecting a combination of restricted supply and strong demand fundamentals. However, the sector can also be a source of longterm income, with returns for large investors (such as institutional ones) boosted by greater efficiencies in property management. One issue for investors has been that management costs tend to eat up around one-third of the income from privately rented residential. Such costs, though can potentially be reduced through the economies of scale available to large investors, compared to what can be achieved through management on a "flat by flat" basis. The sector benefits from lower voids than commercial property. In 2013, voids for All Market Let residential property were just over 7%, below the level for All (commercial) Property at 8.9%. The length of residential leases is shorter than in commercial, but the gap is getting smaller. Almost twothirds of private renters stay beyond the standard one year lease and the mean tenancy length is in fact three years, according to the IPD.

Analysis also suggests that residential could prove to be a suitable portfolio diversifier for commercial property investors, given that it has much lower correlations with most traditional property segments than those segments show with each other. Intra-property correlations (Inflation-adjusted total returns, 1981-2013) Residential

Retail

Office

Industrial

Residential

1.0

0.6

0.7

0.5

Retail

0.6

1.0

0.8

Office

0.7

0.8

1.0

0.9

Industrial

0.5

0.8

0.9

1.0

Source: IPD UK Residential Property Index, IPD UK Annual Property Index.

As such, adding residential property into a multi-asset or commercial property portfolio would be expected to improve risk-adjusted returns.

Political support Over the last few years there has been a sea-change in the UK government's attitude towards the private rented sector, welcoming professionalism from landlords and looking to large-scale investors to plug the housing supply gap through the build-to-let market. They have started offering incentives to encourage investors into the PRS. This is key, as government support for other tenure types over private renting was one of the most significant reasons for the withdrawal of institutions from the PRS in the first half of the 20th century. Political backing for the sector is expected to continue, with all three major political parties in the UK having voiced support for the PRS.

Advantages of institutional investment Obtaining the level of scale required to make institutional investment viable has been one of the prevailing barriers to entry for the PRS. Whereas the US multifamily sector is mature, this took time to develop. After many years, opportunities are now gradually beginning to emerge in the UK PRS. These are focused around London the South East and other areas of strong economic activity around the UK. By focusing on blocks and units designed specifically for rent and taking an active interest in the development of these products, investors can ensure greater efficiencies for operation, energy and maintenance. Similarly, by ensuring consistency across developments, experienced professional investors can maximise economies of scale to reduce costs of repairs and enhance overall returns through greater customer satisfaction.

Defensive characteristics Unlike commercial property, residential real estate is not purely an investment play. People always need somewhere to live. Therefore, if there is a downturn in the economy, the rental market will generally strengthen as the economic environment encourages, or even obliges, people to rent. This potentially lessens capital decline for rented accommodation investments. As such, in our view the residential sector has also proved a less risky investment than mainstream commercial property. Although the statistical volatility of the two property types has been similar over the past 30 years, this mainly reflects the upside volatility of residential property. When looking just at downside volatility (in this case, the risk of negative total returns), residential has actually shown a much lower level of risk than commercial. During the steep market downturns in both the 1990s and 2000s, residential property recorded a smaller capital decline than commercial and also recovered its initial value faster.

Conclusion Overall, our research suggests that the investment case for UK residential is supported by the fundamentals of the favourable demographic trends and the supply/ demand imbalance in the housing market. To this, the sector adds the benefits of diversification from other asset classes and other real estate sectors, defensive characteristics and a strong returns history. Professional investors have the scope to further optimise returns through economies of scale and greater efficiency. Taken together this makes a compelling case for investing in the UK PRS.

Kidbrooke Village

Our team M&G Real Estate is an income-driven, long-term specialist investor with 150 years’ experience. As one of the world's largest property investors, we have £20.4 billion (at 30 September 2014) of assets in the UK, Europe, North America and Asia. Over 200 people work in our real estate business, including a development team that operates across all key sectors. We pride ourselves on active management and on building long-term and effective relationships with agents, consultants and occupiers. Alex Greaves – Fund Manager Alex is a residential property specialist with over 15 years' experience. Alex is a member of the British Property Federation (BPF) Residential Committee, the Investment Property Forum (IPF) and the Royal Institution of Chartered Surveyors (RICS). He started his career as a letting agent and understands all aspects of residential, having worked his way up through to fund management.

Steve Hollands – Investment and Asset Manager, Residential Steve is responsible for seeking out investment opportunities in the residential sector, as well as for the active management of assets in order to maximise returns. Prior to joining M&G Real Estate in August 2014, he was Assistant Director at Deloitte, where he advised public sector organisations, major corporates and pension funds on high profile regeneration projects. Steve has over a decade’s experience in real estate, spanning commercial and residential development agency and consultancy works across the UK. He is a member of RICS.

Emma Grew – Research Manager Emma has been working in real estate research since 2003 and joined M&G Real Estate in 2011. She is involved in the view formation and analysis of the UK and European markets. In addition to this, she also works with the residential real estate team and has developed PRISM, a quantitatively-driven metric enabling the assessment of markets at local authority level, that aids the investment manager when considering potential acquisitions.

Alan Collett – Sector Consultant Alan acts as a consultant to M&G Real Estate advising on the private rented sector. He is a chartered surveyor and former senior partner of Allsop LLP, who has worked in all aspects of residential property in the UK since 1972. On retiring from Allsop, Alan joined the leadership team of the Royal Institution of Chartered Surveyors and was global president 2012/2013. He is a member of the Investment Property Forum and is also vice chairman of the British Property Federation Residential Committee and a trustee of the College of Estate Management.

For more information Lucy Williams Director, Institutional Business UK and Europe, Real Estate

Christopher Andrews, CFA Head of Client Relationships and Marketing, Real Estate

Stefan Cornelissen Director of Institutional Business Benelux and Nordics

+44 (0)20 7548 6585

+65 6436 5331

+31 (0)20 799 7680

lucy.williams@mandg.com

chris.j.andrews@mandg.com

stefan.cornelissen@mandg.co.uk

www.mandg.com/realestate

IMPORTANT INFORMATION: For Addressee only. The value of investments can fall as well as rise. This article reflects M&G Real Estate’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. The distribution of this article does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of Professional Client as defined in the Handbook published by the UK Financial Conduct Authority. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G Real Estate does not accept liability for the accuracy of the contents. Notice to recipients in Australia: M&G Investment Management Limited does not hold an Australian financial services licence and is exempt from the requirement to hold one for the financial services it provides. M&G Investment Management Limited is regulated by the Financial Conduct Authority under the laws of the UK which differ from Australian laws. Notice to recipients in Hong Kong: The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Notice to recipients in Singapore: This document has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, this document and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of shares may not be circulated or distributed, nor may shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor pursuant to Section 304 of the Securities and Futures Act, Chapter 289 of Singapore (the “SFA”) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. M&G Investments and M&G Real Estate are business names of M&G Investment Management Limited and are used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under numbers 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. M&G Real Estate Limited is registered in England and Wales under number 3852763 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Real Estate Limited forms part of the M&G Group of companies. M&G Investment Management Limited and M&G Real Estate Limited are indirect subsidiaries of Prudential plc of the United Kingdom. Prudential plc and its affiliated companies constitute one of the world’s leading financial services groups and is not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America. DEC 14 / W52988

Bringing home residential investment Understanding investor appetite and opportunities

Berwin Leighton Paisner LLP

Foreword

Contents Foreword At a glance Setting the scene The residential real estate landscape Institutional preferences The challenges that remain Explaining the tax issues The future of the sector Recommendations Our conclusion Methodology

Increasingly, we are seeing our clients turn to new opportunities in this sector, driven by a perfect storm of economic and social factors. Andrew Yates Partner, Real Estate

The residential sector is currently attracting huge interest from those involved in UK real estate. Increasingly, we are seeing our clients turn to new opportunities in this sector, driven by a perfect storm of economic and social factors. Evidence suggests that the UK is experiencing a housing crisis, fuelled by demographic shifts, the widening supply/demand gap and a decrease in the availability of mortgages. In response, the governmentâ&#x20AC;&#x2122;s greater focus on housing has stimulated debate as to whether building our way out of recession may be the way forward. This Augustâ&#x20AC;&#x2122;s Montague Review, which further highlighted interest, was rapidly followed by more positive announcements from government on housing in September. Although this is a sector with great potential and increasingly recognised as such by incoming overseas investors, questions continue to be raised regarding yields, adequacy of stock and, whether from a long term investment perspective, commercial and residential property have true equivalence. In relation to the opportunities in affordable housing and despite the recent consultation on social housing REITs, there still seems to be a perceived lack of clarity from government on how it sees the private sector investing into the affordable sector and what it could do to support new investment opportunities. Although the Montague Review highlighted the role of local authorities, there is scope to achieve more. It would be hard to claim a uniform level of understanding among local authorities as to the viability of private rental schemes and how the planning system could support these. We believe, too, that there is room for improvement in terms of facilitating a more innovative approach to legal issues within local government, in order to get the best from the private sector. Housing investment has been the subject of various reports and initiatives over recent years but has not always attracted the focus it deserves. Some would say its moment has finally arrived.

Andrew Yates Partner, Real Estate andrew.yates@blplaw.com

Bringing home residential investment

Berwin Leighton Paisner LLP

Foreword

Increasingly, we are seeing our clients turn to new opportunities in this sector, driven by a perfect storm of economic and social factors. Andrew Yates Partner, Real Estate

Andrew Yates Partner, Real Estate andrew.yates@blplaw.com

Bringing home residential investment

At a glance

Setting the scene

Housing At a glance Key statistics to set the scene

4.5bn

will be invested by Homes and Communities Agency during 2011-15 through the Affordable Homes Programme

3.6m

households in England rent their homes from private landlords

estimated number of registered providers in England

39 170,000 the target for new affordable homes in England by 2015

Bringing home residential investment

the number of affordable houses built in England during 2010-11

Institutional investment could help stimulate the sector, with the strong opportunities, particularly in London and the South East, highlighted in February 2012, when residential property was first recognised by the Investment Property Databank (IPD). Their Index showed the overall UK residential sector to have outperformed all commercial sectors in 2011. The growing attraction of residential property has more recently been underlined by overseas investors entering the prime London market in high volumes, building momentum in residential real estate as an emerging asset class.

Government initiatives to stimulate the residential sector have also accelerated interest including reforms to stamp duty land tax (SDLT), planning law and Real Estate Investment Trusts (REITs). Yet, barriers to investment within the residential sector remain. As one of our interviewees succinctly put it, ‘If it is such a good investment opportunity, why hasn’t everybody invested yet’? It is precisely this question which this report will try to answer.

UK institutions need a first mover. Foreign money is coming into the UK residential sector and investors in this country risk being left behind. Nick Salisbury, Consultant and Independent Board Member, Home Group and Homes for London

90%

of the PRS is dominated by individual buy-to-let landlords, with fewer than 10 properties in their portfolios.

Size of the housing market

average age of a first-time buyer

57, 940

The UK is ill-equipped to offer meaningful alternatives to home ownership. Many people are turning to the private rented sector (PRS), which today accounts for 3.6m UK households, compared to some 2m in the early 1980s. However, 90 per cent of the PRS is dominated by individual buy-tolet landlords, with fewer than 10 properties in their portfolios.

22.8m 3.6m

60%

decrease in government investment in capital grant in the 2010 spending review

Homes in England

Private Rented Sector (PRS)

2.2m Registered Provider (RP) Sector

1m PRS homes are owned by corporates and institutions

Bringing home residential investment

At a glance

Setting the scene

Housing At a glance Key statistics to set the scene

4.5bn

will be invested by Homes and Communities Agency during 2011-15 through the Affordable Homes Programme

3.6m

households in England rent their homes from private landlords

estimated number of registered providers in England

39 170,000 the target for new affordable homes in England by 2015

Bringing home residential investment

the number of affordable houses built in England during 2010-11

90%

of the PRS is dominated by individual buy-to-let landlords, with fewer than 10 properties in their portfolios.

Size of the housing market

average age of a first-time buyer

57, 940

22.8m 3.6m

60%

decrease in government investment in capital grant in the 2010 spending review

Homes in England

Private Rented Sector (PRS)

2.2m Registered Provider (RP) Sector

1m PRS homes are owned by corporates and institutions

Bringing home residential investment

Setting the scene

Political snapshot

One of the greatest challenges facing the government is to encourage and restore the depressed construction industry in the UK. The faltering construction industry has recently been described in the media as a ‘symbol of Britain’s double dip recession’ – and addressing this will be a top priority for the government. The government believes house building will both solve the housing shortage and help lift Britain out of recession. This has led to a range of measures being introduced – which so far have not been successful in sustaining a recovery in the construction sector.

The residential real estate landscape

The government has reintroduced the policy of Right to Buy and instigated the acceleration of the release of public land – which includes a deferred receipts model, which they have termed ‘Build Now, Pay Later’. They place huge emphasis on building new homes to boost the economy and this is reflected throughout the Housing Strategy published in November 2011.

1.84m

households on local authority housing waiting lists at April 2011

Mark Prisk, the newly installed housing minister, will be instrumental in any potential recovery of the construction industry and will be interested in exploring all options to make this happen. Through his experience as construction minister at the Department for Business, Innovation and Skills and his previous professional role as a chartered surveyor he clearly understands the industry.

SEEKING INVESTOR Registered provider, solvent, own house(s) and good prospects looking for openminded investor for meaningful (and mutually beneficial) LTR

INVESTOR

Many investors currently feel London residential yields are not competitive with commercial in providing the returns professional investors require. Steve Sprigens, Relationship Director, Barclays

Bringing home residential investment

Setting the scene

Political snapshot

The residential real estate landscape

1.84m

households on local authority housing waiting lists at April 2011

SEEKING INVESTOR Registered provider, solvent, own house(s) and good prospects looking for openminded investor for meaningful (and mutually beneficial) LTR

INVESTOR

Many investors currently feel London residential yields are not competitive with commercial in providing the returns professional investors require. Steve Sprigens, Relationship Director, Barclays

Bringing home residential investment

The residential real estate landscape

A lack of knowledge Institutional investment in real estate has historically been focused primarily on commercial property. Explaining this, many industry stakeholders cited a lack of knowledge about the residential sector, particularly surrounding the products available and the different gross-to-net returns. While IPD Index integration has gone some way towards breaking down knowledge barriers, many commentators also argued that while this is useful, IPD currently lacks enough members to paint a true picture of the sector and that more granular detail on the different measures of calculating, for example, gross-to-net return, is required in the industry.

Developers and institutions need to focus more on income through rent rather than capital values. Ralph Luck, Director of Property, Olympic Delivery Authority

Bringing home residential investment

Structural differences

There are some fundamental differences in structure between commercial and residential property which stifle institutional investment. The commercial model is focused on high yielding large schemes with a small number of tenants in one location. By contrast, apart from the East Village (formerly the Olympic Village), there are very few residential developments of scale. The sector is generally perceived by investors to be low yielding and the large number of tenants relative to commercial property is thought to create a greater risk of void periods. Moreover, the imposition of thresholds to the churn rate of private rented property under proposals around Section 106 (s106) agreements restricts the flexibility of residential investors to realise the capital value of their assets. Investors also consider residential property to be a different risk proposition to commercial property. Returns in the residential sector have been primarily driven by capital growth rather than income, meaning institutions have tended to see investment as a bet on future house price movements. In assessing property investment opportunities, institutional investors generally seek a strong income stream before considering capital appreciation. As a result, commercial property has historically been considered a more attractive asset class.

Our contributors felt that to convince institutions to back residential, the sector would require a fundamental restructuring in which value is determined according to rental income rather than sale price on the open market. Though not insurmountable, these differences contribute to investor reticence about the residential sector. UK institutions can be traditional in their choice of assets and are also frequently short-termist in the way they are measured. As a result, the long term, unfamiliar opportunity presented by residential can be neglected by institutions. Colin Humphreys, Business Development Director of Canada Life, explained: “much of the institutional property expertise comes from people who have grown up with commercial real estate. The scope for residential investment would therefore mainly come as part of the overall asset mix”.

Reduced development finance Another reason for the lack of investment into the residential sector is that banks have in recent years been unwilling to provide housebuilders with the finance required to kick-start developments. Commentators believed that this is because the risk of lending a high ratio of a scheme’s value is too great when economic instability means the value of the end product could be less than anticipated. The interest rates on those schemes where development finance has been secured have also been so high that they have pushed the price of the property beyond levels of affordability for buyers.

Government initiatives

Faced with a chronic housing shortage and institutional uncertainty about investment in the residential sector, the government has introduced a number of initiatives to stimulate growth. In 2009, the Homes and Communities Agency (HCA) launched the Housing Finance Group and the Private Rental Sector Initiative, intended to identify and deliver institutional investment opportunities in the residential sector. Both met with limited success. The reform to SDLT, announced in the 2011 budget, has been a welcome stimulus to the residential sector. It saw the rate of SDLT calculated according to the average price per individual property rather than the total price paid, helping to improve yield. The move has helped put bulk purchasers on an equal footing with individual investors and has removed a significant barrier to large scale investment.

The Build Now, Pay Later model, introduced in 2011 by the then Housing Minister Grant Shapps, was also welcomed and is still well-regarded by the industry stakeholders we spoke to. But it has not yet delivered the quantities of housing required to address the shortage. More recently, reforms to planning laws have presented opportunities to remove obstacles in residential development. However, commentators remarked that the potential of the National Planning Policy Framework (NPPF) is still to be realised. They said many developers are yet to see the principle in favour of sustainable development – in the NPPF - being used and that local authorities should be bold enough to grant consent for large scale developments.

Affordable Rent should have been set as a maximum of 55% of market rent, making the proposition more affordable for tenants and providing headroom for incremental increases in future.

Bringing home residential investment

The residential real estate landscape

Developers and institutions need to focus more on income through rent rather than capital values. Ralph Luck, Director of Property, Olympic Delivery Authority

Bringing home residential investment

Structural differences

Government initiatives

Affordable Rent should have been set as a maximum of 55% of market rent, making the proposition more affordable for tenants and providing headroom for incremental increases in future.

Bringing home residential investment

The residential real estate landscape

While UK residential REITs have not yet gained any traction, this year’s changes to the regime will help. The abolition of the conversion charge, the more flexible rules for ‘institutional shareholders’, allowing funds to list on alternative exchanges and rules to help start up will be particularly useful. Contributors were optimistic that with these barriers removed the growth of residential REITs could emulate the proliferation seen in the US. Nonetheless, they warned that many investors are unlikely to risk being the first mover in developing a residential REIT and some expressed uncertainty that yields would be high enough to attract investment, given the potential volatility in the listed environment.

The residential real estate landscape

Constraints on capital grant

In the affordable housing sector, the last Comprehensive Spending Review (CSR) led to a 60 per cent reduction in capital grant, the funding allocated to registered providers (RPs) by the HCA to support social housing supply. This resulted in a dramatic fall in social housing provision by RPs, compounded by the obligation to complete all building by 2015 in order to receive this grant. As one commentator said: “The 2015 completion deadline set out in the CSR for new RP developments has created a burning platform. Nobody is going to put a spade in the ground before 2015 with this sword of Damocles hanging over them”.

Many RPs have responded by diversifying their portfolios to generate income through market rent and private sale, while a number have also turned to the bond market to raise the finance required to support social housing provision. Though these may first have been regarded as temporary solutions to the reduction in grant, there has been no clear signposting as to future CSR funding and this uncertainty has prevented RPs from delivering the volumes of housing desired.

Affordable Rent

In 2010, the government introduced Affordable Rent, a concept presented as an intermediary between full market and socially rented property. Homes under the scheme are made available to tenants at up to a maximum of 80 per cent of market rent and allocated in the same way as social housing. Nick Salisbury, board member for Home Group and contributor to the Montague Review told us: “government has good reason to want to move some affordable housing toward market rents, following the recent negative press on cases of expensive housing being offered as ‘social’. But in many areas this means people will not be able to afford accommodation, particularly when benefit caps are brought in”. Other commentators reiterated this point, suggesting that Affordable Rent blurs the distinction between what is affordable and what is private, particularly when in some cases social rent is set as low as 27 per cent of market rent.

When discussing Affordable Rent with RPs, they stated that the requirement for local authority approval of rent levels effectively neutered the scheme and created potentially dangerous liabilities. One RP indicated that having applied for grants on the basis that it could charge 80 per cent of market rent, it had been unable to obtain consent from the local authority to increase rents to this level. The result was that the RP had to make up the shortfall, creating ‘worrying’ losses on the development in question. Another RP suggested that Affordable Rent should have been set as a maximum of 55 per cent of market rent, making the proposition more affordable for tenants and providing headroom for incremental increases in future.

2009

the HCA launched the Housing Finance Group and the Private Rental Sector Initiative, intended to identify and deliver institutional investment opportunities in the residential sector.

Many investors are unlikely to risk being the first mover in developing a residential REIT.

Many RPs have responded by diversifying their portfolios to generate income through market rent and private sale.

Bringing home residential investment

The residential real estate landscape

Constraints on capital grant

Affordable Rent

2009

the HCA launched the Housing Finance Group and the Private Rental Sector Initiative, intended to identify and deliver institutional investment opportunities in the residential sector.

Many investors are unlikely to risk being the first mover in developing a residential REIT.

Many RPs have responded by diversifying their portfolios to generate income through market rent and private sale.

Bringing home residential investment

The residential real estate landscape

The Montague Review

As part of its housing strategy entitled, ‘Laying the Foundations: a Housing Strategy for England’, the government commissioned Sir Adrian Montague to research the obstacles preventing institutional investment within the housing sector. His August 2012 report made further recommendations to the government, including a relaxation of Section 106 agreements to reduce affordable housing obligations for PRS schemes and make investor returns more attractive. Additionally, he recommended continuing the impetus to release public sector land which could be sold on with an agreed PRS component.

Institutional preferences

The recommendations, which the government appears keen to act on, also seek to create a new asset class of residential investment for large scale developments where values are driven by rental income. Montague relies on local authorities to prioritise PRS development and to use covenants and planning restrictions to set minimum periods during which new assets must remain in the PRS. With the cooperation of local authorities, our contributors were confident these recommendations could support new and attractive investment opportunities. However, they also indicated local authority support cannot be guaranteed and expressed concern that excessively long covenants restricting usage could hinder the investment case.

The government’s housing stimulus package

The release of the government’s housing stimulus package indicates the recommendations of the Montague Review are being taken seriously. The intention is for the package to unlock the stalled development of 75,000 new homes by allowing developers to renegotiate existing S106 agreements with local authorities. The government has also announced £300m in capital funding for 15,000 affordable homes, £200m investment in the private rented sector and passed the Infrastructure (Financial Assistance) Act, providing up to £50bn of guarantees for infrastructure (including housing), potentially for long term debt. These measures are to be supported – as Montague recommended – by a task-force which will assist local authorities in appraising build-to-let proposals.

The BLP perspective Figures of £300million and £200million may be seen as a drop in the ocean. However, they provide a positive message from government that house building is a route out of recession. The proposed government taskforce could particularly help local authorities to see what they could do to encourage and also benefit from investment in the private rental and intermediate rental sectors.

Bringing home residential investment

With its much publicised affordable rent deal, Barking and Dagenham demonstrated that local authorities can successfully invest in new models themselves. Investing land in a way in which means that they can participate in a finance lease structure and retain a valuable reversionary interest, the land and housing then being returned to them after a period of years.

There are issues to navigate around best consideration and the procurement rules. However, these are far from insurmountable as the Homes and Communities Agency has demonstrated with its Build Now, Pay Later models. Pragmatic local authorities can also get the best from private sector innovation without necessarily stifling this with a full scale “OJEU” public procurement process.

75,000

government estimate of new homes to be built as a result of negotiating Section 106 agreements

There are issues to navigate around best consideration and the procurement rules. However, these are far from insurmountable.

The residential real estate landscape

The Montague Review

Institutional preferences

The government’s housing stimulus package

Bringing home residential investment

75,000

government estimate of new homes to be built as a result of negotiating Section 106 agreements

There are issues to navigate around best consideration and the procurement rules. However, these are far from insurmountable.

Institutional preferences

Key themes When asked to consider the most attractive opportunities in the residential sector, there are two clear themes: • investment in the affordable housing sector with RPs •

the potential for RPs to kick-start the build-to-let model by using their ability to raise finance to develop more homes that could be sold on to large private rent investors.

Affordable housing

While welfare reform has placed a strain on social housing, commentators acknowledged RPs still represent a secure investment. RPs can be both for profit and not-for-profit, presenting opportunities for joint ventures with institutions. Consequently, a number of RPs have been developing their market sale and rental offerings, which co-exist with their affordable, shared ownership and social housing provision. This diversification has gone some way towards allaying investor concerns that RPs lack experience in management and development beyond social housing. It also provides an opportunity for RPs to generate funds that can be reinvested in the not-for-profit side of their businesses and to use their skills to help institutional funds plug the perceived skills gap for certain portfolios.

According to commentators, the RP sector is worth £65-75bn, £32bn of which comprises existing grant. Commentators suggested that funding quasigovernment backed RPs is an attractive proposition for investors, particularly when they yield 100250 basis points over gilts, are highly rated by Moody’s and operate in a well regulated sector. However, contributors conceded that large RPs are the most attractive prospect available as they are already credit rated. Few institutional investors have the capacity to do credit rating work on smaller RPs, which may lead to smaller RPs struggling to obtain finance due to there being a smaller universe of players able to invest in them.

£65-75bn

Commentators noted that many ‘expensive’ RP properties could achieve double their tenanted value if sold with vacant possession on the open market. Some stakeholders suggested that a portion of these properties could, when empty, be sold in the short-term, releasing that increased equity value to stimulate construction of additional affordable homes. Others believed this could also present a longerterm opportunity for RPs to maximise the value of sales in better market conditions. While bonds were acknowledged by RPs to be a useful source of finance, others argued that bonds alone are unable to sustain the degree of housing provision required to address the current UK shortage. Commentators anticipate RPs embarking upon joint ventures with institutions, at least in the medium term. Investors would benefit from the secure income flow and low index yields coupled

with guaranteed tenants, indirect support through housing benefit and a professional landlord managing a granular portfolio. RPs would benefit from access to finance, enhanced by additional income generation from managing the units. In working with known investors with private sector experience, the commercial reputations of RPs are strengthened. While joint ventures are likely to be attractive to many RPs, some commentators suggested RPs are unlikely to look to these alone for future finance. Instead, direct equity investments and REITs were cited as the RPs’ next step from the bond market, providing a long term opportunity for RPs to de-risk their portfolios and provide a platform for private investors to choose to invest in the sector.

Investment into social housing is attractive to us. If the same returns continue to be offered and rents are set at the right rate, big social rewards are possible. Pete Gladwell, Business Development Manager, Legal & General Property

size of the RP sector, according to commentators

To attract institutional investors a 4% net yield is key and the current VAT regime makes this much harder to achieve. John German, Residential Fund Manager, Grosvenor Fund Management

Bringing home residential investment

The BLP perspective The government’s recent consultation paper on the possible role of REITs in social housing was welcomed. The question is whether the debate around the private sector role in social housing provision should be widened. Our research confirmed the growing interest from the private sector in the area of affordable housing.

However, it also reinforced the view that there is not yet sufficient clarity on the role that the government has in mind for private sector investors in this area. While low margin long term bank finance has become difficult for RPs to secure, the relative stability and index linked returns that they offer are still attractive

to institutional investors through the debt capital markets. We have seen some institutional investment through sale and leasebacks but the bond market is still proving attractive for some large RPs. However, a pure equity investment is still to be seen.

Bringing home residential investment

Institutional preferences

Key themes When asked to consider the most attractive opportunities in the residential sector, there are two clear themes: • investment in the affordable housing sector with RPs •

the potential for RPs to kick-start the build-to-let model by using their ability to raise finance to develop more homes that could be sold on to large private rent investors.

Affordable housing

£65-75bn

size of the RP sector, according to commentators

To attract institutional investors a 4% net yield is key and the current VAT regime makes this much harder to achieve. John German, Residential Fund Manager, Grosvenor Fund Management

Bringing home residential investment

Institutional preferences

Key themes When asked to consider the most attractive opportunities in the residential sector, there are two clear themes: • investment in the affordable housing sector with RPs •

the potential for RPs to kick-start the build-to-let model by using their ability to raise finance to develop more homes that could be sold on to large private rent investors.

Affordable housing

£65-75bn

size of the RP sector, according to commentators

To attract institutional investors a 4% net yield is key and the current VAT regime makes this much harder to achieve. John German, Residential Fund Manager, Grosvenor Fund Management

Bringing home residential investment

Institutional preferences

PRS

One of the fundamental challenges in the residential sector is the welldocumented issue of yields. While headline gross yields for residential are comparable to commercial property, on a net basis residential yields are significantly lower. A driver for this is that in the UK buy-to-let market, only 1 per cent of PRS landlords hold more than 10 properties. As a result, rental stock is often geographically dispersed and incurs high running costs, which in turn impacts the net yields available. So, while institutions are looking for a minimum net yield of 4 per cent, after private rental voids and maintenance costs, this becomes hard to achieve.

Institutional preferences

To meet the yields desired by institutions, a development model attracting long term tenants and cost-effective maintenance will need to be devised. However, the majority of opportunities available to date have worked in theory but lacked a tangible product, requiring investors ‘to plan too far ahead to put money in’. But as Steve Sprigens, Relationship Director at Barclays, commented: “If somebody came with the right product, namely a longer-term rental model, there is no reason to think that it wouldn’t be successful, but you just need to ensure the returns at each stage work.” If the right PRS product is built from the outset, potentially using the well-received Build Now, Pay Later model, this could deliver the investment vehicle that institutions are looking for.

If the right PRS product is built from the outset, potentially using the well-received Build Now, Pay Later model, this could deliver the investment vehicle that institutions are looking for.

The question remains as to who will manage the units. Institutions do not want to procure and manage properties, particularly when faced with the prospect of up to 1,000 individual tenants as opposed to a handful for commercial properties. However, the right management is important as it could strengthen the investment prospect of the PRS by tackling the void issues that impact yields and protecting investor reputations. It is for this reason that RPs are becoming central to the PRS proposition. Yet, institutions were unanimous in their desire to partner with commercially astute and highly efficient RPs with a positive reputation for their management expertise.

It’s impossible to have a properly managed private rental sector while the market is dominated by small-portfolio landlords. Andy Savege, Head of Regeneration, Morgan Sindall Group

Bringing home residential investment

Institutional preferences

PRS

Institutional preferences

If the right PRS product is built from the outset, potentially using the well-received Build Now, Pay Later model, this could deliver the investment vehicle that institutions are looking for.

It’s impossible to have a properly managed private rental sector while the market is dominated by small-portfolio landlords. Andy Savege, Head of Regeneration, Morgan Sindall Group

Bringing home residential investment

The challenges that remain

Despite the interest expressed in affordable housing and the PRS, why is investment not yet gathering pace?

Home ownership aspirations

Some stakeholders suggested that investor reticence in the rental market could reflect that the UK is at its core a nation of home owners. Yet, if people cannot afford to buy in a market where interest rates are at a 300 year low and mortgage affordability is at its long term average, then it is highly unlikely this will improve once interest rates eventually increase. At this critical time, some interviewees argued there must be a shift in mind-set towards renting.

The release of public land

The release of public land was also cited as a problem by industry stakeholders. While this is something addressed by the Montague Review, commentators emphasised that sites of a suitable scale, access to local amenities and in the right location are required for successful PRS developments. Some attributed this to central and local government pulling in different directions on the release of land. Others suggested government departments have an obligation to maximise the value achieved from the sale, something that the current economic climate is not conducive to.

Planning complexities

Planning applications were named by many as ‘the major challenge for all types of residential development’. There were calls from contributors to reduce the complexity and expense of planning applications. Many also said that the HCA could provide more support to local authorities to help them interpret their powers under Localism and the NPPF. Ultimately this could see local authorities build in favour of sustainable development rather than succumb to NIMBYism. However, where local authorities are controlled by one of the three major parties, political limitations on the power to refer applications to the planning inspectorate mean local concerns may continue to act as an obstacle to development.

Bringing home residential investment

S106 obligations were still thought to be too onerous compared to the value of land and significantly impacting the desired yields required to make residential a viable asset class. However, while both the Montague Review and the government’s housing stimulus package indicate these should be reduced and in some instances waived, many commentators remarked that S106 obligations to deliver developer subsidised affordable housing had already been eroded from 30-40 per cent of a development to 10-20 per cent. They therefore questioned whether a further reduction of this aspect of S106 would have any significant impact.

Beyond London

A lack of institutional interest beyond London was acknowledged by commentators. Many investors see London as where the jobs, higher yields and capital values are. Moreover, London is still viewed as an international safe haven and therefore comparably low risk, so it is to be expected that this is where investment will be triggered. As the shortage of housing stock is a national problem, it is likely market forces will create attractive investment opportunities beyond London thereafter.

Tax burdens

The tax treatment of investors was one of the most commonly cited barriers to investment. There has been on-going uncertainty about how to structure investments to minimise capital gains particularly as residential property attracts 20 per cent VAT when commercial investments are zero-rated.

The majority of industry stakeholders agreed that in order to become a genuinely attractive asset class, the tax levied on residential investments needs to be reconsidered.

To make more money, RPs must have greater efficiency and professionalism to enter into commercial developments and the removal of S106 obligations is prompting this. Nick Salisbury, Consultant and Independent Board Member, Home Group and Homes for London

The BLP perspective

The BLP perspective Despite rumours to the contrary, there is no moratorium on affordable housing. But the scene is changing. Increasingly affordable housing will be rented housing rather than the array of tenures encountered over recent years. Affordable housing is still required for new housing and mixed use developments but greater emphasis is to be placed on this being subject to a viability test.

Section 106 agreements

For consented schemes with affordable housing requirements under extant Section 106s, where “developers who can prove that the Council’s costly affordable housing requirements make the project unviable”, there is to be a right to go straight to appeal under S106 for reduction in affordable housing to a viable figure for a 3 year period only. But use of this will come down to really convincing evidence on viability.

The same is true for pre-April 2010 Section 106s for which there is to be a general right to apply and appeal under S106 for modification of agreements. Viability is bound to come into play here also. These “relaxations” will not come into effect until early to mid-2013. Absent local authority support for Section 106 modifications, change could be a year or more away.

While the government has brought in positive changes to help the sector, through, for example, the SDLT multiple property relief on portfolio purchases and the new proposals for REITs, there have also been changes and proposals which have had a negative impact on certain parts of the sector.

These have, if nothing else, caused investors to think twice and caused uncertainty. At the more expensive end of the market they have actually caused transactions to be put on hold. These include the new proposals around SDLT at 15% and the potential annual charge and CGT for certain single residential properties over £2m.

While these may not have been directly targeted at that part of the sector that this report is focussing on as a whole, it has impacted on it and caused much uncertainty and cause for thought pending rule changes and clarification.

Bringing home residential investment

The challenges that remain

Despite the interest expressed in affordable housing and the PRS, why is investment not yet gathering pace?

Home ownership aspirations

The release of public land

Planning complexities

Bringing home residential investment

Beyond London

Tax burdens

The majority of industry stakeholders agreed that in order to become a genuinely attractive asset class, the tax levied on residential investments needs to be reconsidered.

The BLP perspective

Section 106 agreements

Bringing home residential investment

Tax issues explained

Explaining the tax issues

VAT costs can be a real issue for many investors in the sector. Potential leakage can be as much as 8% of gross income. So far, industry cries for a reduced rate of (say) 5% on repairs, refurbishment and capex have fallen on deaf ears. It is a call that should be taken up again. Other reforms (such as SDLT and REITs) have not yet proved to be sufficient to stimulate the widespread investment required, though multiple dwellings relief is widely viewed as very beneficial.

The focus on capital growth, rather than income, makes investors likely to want to reduce holdings flexibility in their residential investments. Restrictions on the churn rate are an unwelcome barrier to investment.

>2m

the value of residential property units which will be subject to a 15% SDLT charge

While the capital gains versus trading debate (i.e. tax leakage) is only an issue for some business models, it remains a deterrent to investment by many. The general industry uncertainty is not resolved by HMRC’s view that normal tax rules apply. If there is not to be any published safe harbour rule as the industry would like, HMRC should at least publish some examples where in their view trading would not be an issue to improve the position. In terms of structuring, there is no one clear model for the industry. As institutional investors do not want any tax leakage, the REIT has its attractions. However, the feeling is that appropriate scale is required for a residential REIT to be really successful. Other points that the industry would like to improve the viability of the REIT structure in a residential context - a lower distribution requirement or shadow capital allowances regime. Meanwhile investors continue to look at alternatives including land based models.

also affecting properties with a value well below £2m. Even if the position is resolved, uncertainty meanwhile is not good. Lobbying has been made for bona fide commercial businesses to be taken outside the rules and while there may still be issues for those at a more expensive end of the market we are confident that some positive change will come. Cathryn Vanderspar Partner cathryn.vanderspar@blplaw.com

As institutional investors do not want any tax leakage, the REIT has its attractions.

The most topical issue in the residential context has, however, been the new 15% SDLT rate and the potential annual and CGT charges on residential properties over £2m. While the changes are targeted at high value “enveloping schemes”, some properties in the rental sector will be caught. The position has had a hugely adverse impact, in particular, upon foreign investors, who may now look elsewhere. The proposals are

James Taylor, Head of Residential Investment & Asset Management, British Land

18/ Bringing home residential investment

Bringing home residential investment

Tax issues explained

Explaining the tax issues

>2m

the value of residential property units which will be subject to a 15% SDLT charge

As institutional investors do not want any tax leakage, the REIT has its attractions.

James Taylor, Head of Residential Investment & Asset Management, British Land

18/ Bringing home residential investment

Bringing home residential investment

The future of the sector

The recommendations of the Montague Review appear to have been taken seriously by government, with the housing stimulus package prompting one contributor to suggest the Montague Review was superseded by the government’s activities within weeks. Despite acknowledging that affordable housing obligations had already been reduced, commentators were upbeat about the potential impact of the reforms to S106 planning restrictions. Likewise, it was agreed that the government’s £300m contribution to affordable housing and £200m investment in the PRS could make a tangible difference to housing provision as seed funds. Nonetheless, uncertainty remains over the government’s proposed debt guarantees, not only in their extent but also in their purpose. As one commentator added: “I’m always nervous about government guarantees. What do they mask, what is the underlying need and what is it addressing?”

Cultural shift in attitudes toward renting

As highlighted earlier, the cultural resistance to long term rental accommodation will be broken when tenants receive a comparable quality of housing in the rented sector and secure tenures become widely available. There is an opportunity for government to spread a strong message that buying is not for everyone, especially younger generations. One contributor reiterated this, anticipating the UK will move towards a more European model where it is broadly accepted that in the first 10 years of peoples’ careers they will rent, allowing them to save for a deposit before a significant life change prompts a step onto the housing ladder. While it may be politically awkward for government to back rented housing development as opposed to supporting house purchases, some suggest that this will not only be the most responsible action but is likely to become inevitable.

Creation of a proven track record

A number of institutional investors have stated their interest in the residential property market would be greater if they did not have to accept the additional risk of being the first mover into the sector. Some of the experts we consulted felt the best solution to this would be for government to back a series of pilots to demonstrate the viability of residential investment in the private sector.

£300m

government contribution to affordable housing and £200m investment in the PRS could make a tangible difference to housing provision as seed funds

One model, suggested by the Resolution Foundation, avoids the requirement that institutional funds invest before an asset is built and let. In the model, a consortium of registered providers would build private rented units, funded by bond finance at a low rate, taking advantage of the sector’s quasigovernment backing. Large-scale units would then be built and let with a secure income stream and sold to institutional investors. At a later stage, the fund could be listed as a REIT, which would allow investors to move in and out of the fund in shorter periods of time. Vidhya Alakeson, Director of Research and Strategy of the Resolution Foundation said: “There is a big opportunity for registered providers to kick-start development as they can raise finance cheaply through banks and bond markets, and some have the capacity to build on balance sheets.”

In an alternative model, Thames Valley Housing Association (TVHA) has set up a commercial subsidiary called Fizzy Living, which lets homes to young professionals at market rents. Fizzy Living was set up with £30m of equity from TVHA and plans to attract a further £50m from institutional investors. The company purchases blocks of new build accommodation and uses TVHA’s management expertise to drive rental revenues which are returned to TVHA as interest payments. Fizzy Living only invests in blocks of 100 or more flats and has invested in its branding to make it attractive to young professionals. It has also installed on-site management and controls accommodation standards to encourage long term tenancies which, along with the scale of the blocks owned, allows Fizzy Living to minimise void risk.

Harry Downes, Managing Director of Fizzy Living said: “As long as properties in the PRS are owned in small portfolios, you cannot have a properly managed and planned sector. Fizzy Living is trying to address this by developing rental schemes in large buildings and only where we are the sole owner. This means there is no scatter effect of private tenants and high property standards can be maintained”. Seemingly, if the PRS can deliver proof of concept in some of the innovative ways both the Resolution Foundation and Fizzy Living are suggesting, we anticipate that so long as the yields are attractive and the RP behind the scheme has a reputation for good management, institutions will begin to invest.

As long as properties in the PRS are owned in small portfolios, you cannot have a properly managed and planned sector. Harry Downes, Managing Director, Fizzy Living

Bringing home residential investment

The future of the sector

Cultural shift in attitudes toward renting

Creation of a proven track record

£300m

government contribution to affordable housing and £200m investment in the PRS could make a tangible difference to housing provision as seed funds

As long as properties in the PRS are owned in small portfolios, you cannot have a properly managed and planned sector. Harry Downes, Managing Director, Fizzy Living

Bringing home residential investment

The future of the sector

Changing attitudes to investment

Commentators argued that while IPD Index integration is beginning to inform the market of the investment opportunities available in residential property, institutions still lack the depth of understanding to be convinced of the opportunities available. But this may not be the case for long. The Montague Review and proposed restructuring of residential property as a rental-income driven asset was well-publicised and the British Property Federation (BPF) is seeking to educate the market about the different types of residential investment and the scale of the opportunities available.

The future of the sector

One contributor indicated the purchase of the East Village by a Qatari pension fund is a strong signal that foreign investors are likely to be the first to make largescale UK residential investment work. On a global scale only Canada and Sweden have a lower proportion of institutionally funded PRS accommodation than the UK. Where others have seen it work in their markets, they can see the emerging opportunities in the UK. Furthermore, the other bidders in the East Village process are bound to materialise elsewhere. So, unless there is an attitudinal shift by UK investors, they could find they are cut out of the major investment opportunities that the residential sector will soon present as overseas investors take the lead.

INVESTOR SEEKS LT PARTNER Broad-minded and entrepreneurial investor with sense of adventure WLTM ambitious professional Housing Association with cracking assets for meaningful relationship. Willing to experiment.

RPs as an equity investment

Few RPs expect capital grant to return to levels formerly seen and many consider the bond market too small to sustain the level of development required to meet the demand for new housing. As a result, we foresee an increasing number of RPs embarking on joint ventures with private sector companies to off-set this shortfall. Some commentators suggested this could eventually evolve into direct equity investment into RPs, particularly via the REIT model. However, it will be essential RPs continue to demonstrate their professionalism and commercial prowess to shed reputations garnered in pockets of the market for poor management.

Registered Provider

East Village (formerly the Olympic Village)

As the Olympic Village it housed some 23,000 Olympic and Paralympic athletes. It will be converted to 2,818 new homes, including 1,379 affordable homes and 1,439 houses for sale and rent. It is made up of 11 residential plots each made up of 5-7 blocks around communal squares and courtyards, together with high quality education and healthcare facilities. The private housing within the Village, to be known post-Games as East Village, was sold to a joint venture between Delancey and Qatari Diar at the end of a highly competitive tender process, which saw submissions from many of the key players from the worldwide real estate market. The majority of the homes are to be let on a rental basis, rather than being sold, to create the first UK private sector residential fund of over 1,000 homes to be owned and directly managed as an investment.

The East Village was constructed over the period

East Village is a successful example where major funders looking to secure a long term income stream have bought into residential development as an asset class. The lessons are worth understanding to see if this is a one off or whether it could be replicated elsewhere to attract the conventional institutional investor. Clearly, the scale of the development is likely to have appealed, as did the location in an area where there is a long term regeneration strategy and the likelihood of capital values rising over the next decade. If this example is to be repeated elsewhere it is likely that initial public investment in the form of infrastructure and land assembly would be required in order to achieve the necessary quantum.

Models that could replicate these conditions need not apply to a single large site, as in East Village, but could cover a range of sites over a specific area, backed by public land put into a suitable joint venture vehicle. The degree and nature of public intervention would need to be tailored to each individual circumstance. The key in all cases is likely to be for the investment risk, especially at the planning and construction stage, to have been borne by the joint venture partners prior to disposal to a long term investor.

23,000 athletes housed during the games

Converted to 2,818 new homes, including 1,379 affordable homes and 1,439 houses for sale or rent

2008-12

Bringing home residential investment

The future of the sector

Changing attitudes to investment

The future of the sector

RPs as an equity investment

Registered Provider

East Village (formerly the Olympic Village)

The East Village was constructed over the period

23,000 athletes housed during the games

Converted to 2,818 new homes, including 1,379 affordable homes and 1,439 houses for sale or rent

2008-12

Bringing home residential investment

Recommendations

The case for investment in residential property as an asset class is compelling and we consider the sector to be close to a turning point. Foreign investors have already identified significant opportunities and some commentators indicated there is a risk UK investors could be left behind if they fail to act quickly. Most suggested that once one investor takes the plunge, this could open the floodgates to rapid development and transformation of funding structures within residential real estate. It is uncertain when this will be, but as barriers to investment fall, a rapid expansion in private sector residential investment may not be far away.

An active approach

The government has no choice but to encourage investment in the residential sector. Having commissioned the Montague Review, it is vital it maintains the impetus on housing seen since the ensuing report was published. Kicking wholesale reform into the long grass will inevitably increase the size of affordable housing waiting lists and condemn market renters to insecure tenure in properties with unpredictable standards of management and accommodation. Ultimately, this will do little to shift the public psyche towards renting and the new models required, if institutions are to invest.

Incentivising new entrants

People need to be thinking about what goes on outside our shores to make things happen and see what overseas pension funds/ investors are investing in within the UK. Ralph Luck, Director of Property, Olympic Delivery Authority

There must be more incentives for new entrants to emerge in the PRS. For instance, as schemes such as Fizzy Living boost confidence in the market, banks may be encouraged to relax their requirement for a certain portion of PRS developments to be sold off-plan.

15%

SDLT charge excluded for genuine property rental businesses

Bringing home residential investment

Removing grant restrictions

Tax changes

Clarifying the status of grant

So far as the tax recommendations are concerned at the top of the wish list would be: • VAT changes to reduce the leakage on residential funds – particularly on repairs, refurbishment and capex

Given the strong sense among our contributors that the withdrawal of grant for developments not finished in 2015 is already acting as a powerful brake on development, government should review this policy. This would not increase the government’s grant exposure beyond the commitments it has already made to RPs, but it would remove the current disincentive to beginning developments. Commentators expressed confusion about the status of grant funds, which are currently listed as liabilities on RP’s balance sheets. The status of these funds should be clarified. One option would be for the government to classify grant funds as an asset and to act to influence RPs to engage proactively with institutional investors. An alternative and potentially more effective method would be to remove grant funds listed as liabilities from RP’s balance sheets. This would increase institutional confidence in RPs as joint venture partners and candidates for equity investment.

Tax was outside the ambit of the Montague Review and so the report did not address tax in detail. It is time, however, for the cudgels to be taken up again of issues for government to consider in advance of the Autumn Statement, to ensure that there is some chance of getting changes reflected in next year’s Budget.

• Exclude the 15% SDLT charge for genuine property rental businesses, development and joint ventures • Exclude, similarly, from the impact of the new annual charge and CGT rules, genuine property rental businesses and otherwise defer the potential changes for at least a year, so that the policy can be properly thought through with regard to its impact on investment

Investment in pilot schemes To specifically stimulate PRS, the government should provide funding on a non-grant basis for pilot schemes in which RPs are given the opportunity to raise finance to develop and let homes to be sold to private investors. However, institutions in the UK currently lack the knowledge and experience of the residential sector to comfortably commit to investment. If the government is to pilot schemes to prove the commercial viability of residential models, it is essential UK and overseas investors are educated about and remain open to new models of investment.

As barriers to investment fall, a rapid expansion in private sector residential investment may not be far away.

Local authorities

Government could do more to support local authorities and to help them be aware of the opportunities arising from private rental and affordable rent. There are opportunities to encourage house building, but also to invest. We see it as a priority, perhaps through the new task-force, in helping local authorities to understand that some of the new housing investment models do not require them to give up their assets forever. Helping them recognise that by injecting land for “free” there are still finance opportunities available, which will enable them to satisfy their best consideration obligations. Increasing awareness of different and less heavily regulated procurement approaches as well as tested routes to deferred consideration and long term value would also help.

• Give clarity or introduce a safe harbour threshold on what types of transactions that could definitely be treated as capital, to avoid the deterrent effect this can cause for certain models and investors • If the government really does want to stimulate more institutional use of the REIT, to an unlisted variety should also be seriously considered.

Bringing home residential investment

Recommendations

An active approach

Incentivising new entrants

15%

SDLT charge excluded for genuine property rental businesses

Bringing home residential investment

Removing grant restrictions

Tax changes

Clarifying the status of grant

So far as the tax recommendations are concerned at the top of the wish list would be: • VAT changes to reduce the leakage on residential funds – particularly on repairs, refurbishment and capex

As barriers to investment fall, a rapid expansion in private sector residential investment may not be far away.

Local authorities

Bringing home residential investment

Our conclusion

A consensus is clearly building that the evolution of residential property as an investment asset class is going to require greater mutual understanding and closer co-operation between government, investors and RPs. We are already seeing these stakeholders explore new ways of working with each other, and fully expect these pilot schemes to be refined and adopted by the market generally. We perceive two broad trends. Firstly, increased investment into the private rented sector is going to happen. Investors’ long term commitments require them to closely consider a sector that, according to IPD, outperforms equities and commercial real estate. The East Village, Fizzy Living, and others have led the way and will be emulated. International investors are already active and may want to import established models from their home markets, which will be adopted by UK institutions. As Alex Jeffrey, CEO at PRUPIM concluded:

“The shortage of good quality, private rented housing in the UK is clear, with demand only set to increase as home ownership remains out of reach for many. Combine this with a continued squeeze on funding in the affordable housing sector and private rental seems not only an attractive, flexible housing option but also for many the only viable one. Long term investors such as pension funds and insurance companies can play a significant part in meeting this demand and in doing so gain access to an asset class providing a stable income which responds to real earnings growth, has strong diversification benefits for multi-asset portfolios and has typically outperformed commercial property in the long term. If the government wants to see an increase in institutional investment then some changes to public policy may be required; ensuring a viable, stable regulatory and tax regime to give investors the confidence to support the sector for the long term is vital in the success of this asset class.”

Secondly, investors are appreciating the potential offered by the third sector. RPs have been hiding their light under a bushel. The largest and most commercial RPs offer covenant strength, expertise and balance sheets that rival many REITs, but they are not yet household names. RPs perceive a pressing need to provide more affordable housing. To achieve this they are being led to market by government at the same time as institutions are looking for partners with stock and management expertise in the residential sector. If these trends continue to develop and converge and are supported by targeted government intervention and tax reform, in the next few years we may have a very different answer for the question raised in setting the scene for this report: “Why hasn’t everybody invested yet?”

The largest and most commercial RPs offer covenant strength, expertise and balance sheets that rival many REITs, but they are not yet household names.

Bringing home residential investment

Our conclusion

The largest and most commercial RPs offer covenant strength, expertise and balance sheets that rival many REITs, but they are not yet household names.

Bringing home residential investment

Methodology

Methodology This report convenes the views of a range of stakeholders from across the real estate community, intending to understand the obstacles to and appetite for investment within the residential real estate sector. The private rented sector, as defined in this report, is the market for privately owned property which is being rented out by a landlord for profit to tenants who occupy the property. The study relied upon one-to-one interviews with information gathered either in person or by telephone. Berwin Leighton Paisner employed the public relations consultancy Bell Pottinger Business & Brand to conduct these interviews as an objective third party.

Bringing home residential investment

About BLP Today’s world demands clear, pragmatic legal advice that is grounded in commercial objectives. Our clients benefit not just from our excellence in technical quality, but also from our close understanding of the business realities and imperatives that they face.

Interviews were conducted with 25 senior representatives from RPs, banks, property developers and consultancies, investment companies, funds and independent research and policy organisations. This allowed us to capture a wide breadth of views and opinions. Interviews were conducted in summer 2012. To guide these questions, Berwin Leighton Paisner prepared a structured question format along the themes of: • Residential real estate as an asset class • The private rental sector • Affordable housing • Obstacles to investment • The impact of government initiatives

The interviews were designed to be free flowing around these themes in order to explore key stakeholder priorities for the industry. While most interviewees exercised the right to anonymity on their opinions, others were happy for portions of their dialogue to be captured within the report.

Our achievements for clients are made possible by brilliant people. Prized for their legal talent and commercial focus, BLP lawyers are renowned for being personally committed to clients’ success. Our approach has seen us win five Law Firm of the Year awards and three FT Innovative Lawyer awards. With experience in over 70 legal disciplines and 130 countries, you will get the expertise, business insight and value-added thinking you need, wherever you need it. Expertise • Commercial • Competition, EU and Trade • Construction • Corporate Finance • Dispute Resolution • Employment, Pensions and Incentives • Finance • Funds and Financial Services • Intellectual Property • Private Client • Projects • Real Estate • Regulatory and Compliance • Restructuring and Insolvency • Tax

Methodology

Bringing home residential investment

Getting in touch When you need a practical legal solution for your next business opportunity or challenge, please get in touch. London Adelaide House, London Bridge London EC4R 9HA England Andrew Yates Tel: +44 (0)20 3400 4328 andrew.yates@blplaw.com

Clients and work in 130 countries, delivered via offices in: Abu Dhabi, Berlin, Brussels, Dubai, Frankfurt, Hong Kong, London, Moscow, Paris and Singapore www.blplaw.com

Amsterdam — the top end of the Randstad

From zero to hero Dutch residential has all the makings of a place to call home by Brian Klinksiek and Zubaer Mahboob

he Dutch residential sector is one of the most promising segments of the European property market. It is characterised by a unique blend of cyclical turnaround potential, constructive structural reform and favourable supply/demand fundamentals. The sector is quickly transitioning from being a niche market — the preserve of domestic investors and housing associations — into one of the most discussed “outside-the-box” targets in European real estate. This is reflected in investment activity; transaction volume in the sector for the year ending Q3 2014 exceeded €1.6 billion, up 128 percent over the prior 12-month period. Nevertheless, the sector remains at an early stage of its recovery compared with other property sectors and has considerable room left to run. In this article, we lay out the basic case for investment in Dutch residential. It rests

on four key factors: (1) a cyclical rebound in Dutch macroeconomics, home prices and apartment rents; (2) fundamental housing demand that outstrips supply; (3) government policy changes that cut regulatory red tape and drive more households into the private rented sector; and (4) a major ownership transition away from challenged legacy structures toward more-sophisticated, value-driven investors. Cyclical turnaround underway The Dutch residential sector is positioned to benefit from parallel rebounds in home prices, in apartment rents and in the broader national economy. All three are now building momentum and recovering from cyclical low points, suggesting that today offers an attractive entry point into the market.

Considerable supply/demand imbalance The Netherlands has a shortage of housing units; the number of households exceeds the number of housing units by around 3.5 percent. As a result, the vacancy rate in the rented housing sector is extremely low, at around 2 percent and falling. The shortage will be amplified by both strong

The Dutch residential sector is characterised by a unique blend of cyclical turnaround potential, constructive structural reform and favourable supply/demand fundamentals. demographic demand and low supply. Over the next 25 years, the number of households in the Netherlands is expected to rise from 7.6 million to around 8.5 million, an increase of 12 percent, with nearly all of the growth accounted for by single-person households. Supply, meanwhile, is very weak. In 2013, only 26,000 building permits were granted, down by a third from the year before. New permits reached their lowest level since 1953, which means that the number of completions will remain restricted, at least over the next couple of years. Supply should eventually pick up, although the country’s unique geotechnical conditions as well as planning controls in historic city centres will constrain supply in the most attractive urban locations. Indeed, the shortage of housing is particularly acute in the Randstad and especially in Amsterdam, where the frustration of trying to find an apartment rivals that experienced by households in Manhattan. Policy reforms drive demand Multiple changes to government policy toward the mortgage market and rental regulation are underway that should have a positive impact

Dutch nominal house price index, 1990–2020f 120

CAGR (2014f–2020f) 2.4% 100

CAGR (2009–2013) –4.2% (–20% cumulative)

House price index

CAGR (1996–2008) 8.3%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Starting in the mid-1990s, Dutch for-sale housing experienced a prolonged boom, with prices more than doubling in the decade preceding the global financial crisis. As in the United States, the housing market was boosted by aggressive mortgage lending; LTVs routinely exceeded 100 percent and interest-only loans were common. However, consistent with other debt-fuelled housing bubbles, Dutch home prices dropped sharply as credit became scarce. Between 2008 and 2013, nominal house prices fell by around 20 percent. At the national level, home prices finally reached an inflection point in Q2 2014, recording positive year-on-year growth for the first time since 2008. As of September 2014, prices were 3 percent higher than the cyclical trough reached in June 2013, and the number of home sales was up by 38 percent year-over-year. In Amsterdam, prices were up around 8 percent and home sales volumes increased by almost 50 percent. Several factors have contributed to this turnaround. Higher consumer confidence has boosted demand, especially from first-time buyers who had been putting off purchases. Affordability has improved thanks to lower valuations and historically low borrowing rates. The removal of longstanding uncertainty over the tax treatment of mortgage interest has also encouraged more buyers to commit to purchases, as its tax-deductibility will be scaled back more slowly than had been feared. The history of apartment rents in the Netherlands has been less tumultuous than that of prices, with no rent declines recorded even during the global financial crisis. National annual rental growth reached a low point of 1.9 percent in 2011, down from run rates of around 3 percent in the early 2000s and around 5 percent in the mid-1990s. Rental growth has since recovered to 4.5 percent per year in 2013–2014. Conditions are even stronger in the “liberalised” (non-regulated) segment of the market and in the Randstad (the conurbation encompassing the four cities of Amsterdam, Rotterdam, The Hague and Utrecht). Rental growth for liberalised units in Amsterdam was running at around 5.5 percent as of mid-2014. On the macroeconomic front, the Dutch economy is expanding again after years of stagnation, and is expected to be one of the euro zone’s outperformers. The Netherlands has long been among the world’s most open and innovative economies, boasting a highly-skilled workforce and deep-seated strengths in business services, transport, energy and industry. These are enduring advantages; the EIU expects average GDP growth of 1.7 percent per year over the next decade, faster than growth of around 1.4 percent for neighbours such as France and Germany.

Sources: Thomson Datastream; Heitman Research

Heitman, in a joint venture with Orange Capital Partners, recently acquired two separate residential portfolios in central Amsterdam for around €76 million. The portfolios comprise 400 rented residential units and 12 retail units across 24 buildings, with a total area of 28,400 square metres.

on investors in rented housing in the Netherlands. These reforms should shift demand from homeownership to the rental market, while moving supply from the regulated to the liberalised sector. First, the favourable tax treatment of owneroccupation is being scaled back, cutting the government’s implicit subsidy of homeownership and likely making renters out of more households. Historically, all interest paid on mortgages was fully tax-deductible, giving homeowners a generous tax shield. This boosted demand for interest-only loans, which became widespread, contributing to the boom-and-bust in house prices. From 2013, tax-deductibility of interest on new mortgages is available only to fully amortising loans. In addition, tax-deductibility on amortising mortgages will decrease gradually over time. As a related measure, the maximum permitted LTV will fall. Second, ending the abuse of regulated housing will lead to the dropping of rent controls on many qualifying flats. Estimates suggest that up to a quarter of the regulated market is occupied by households with incomes above the qualifying threshold of €34,000 per year. Although these tenants technically have security of tenure, landlords are now permitted to increase their rents at a fast pace (CPI plus 1.5–4 percent per year,

depending on income). This is expected to equalise the price differential between regulated and non-regulated housing for around 700,000 tenants, pushing them to seek flats in the non-regulated sector. Many of the units that they will free up are in urgent need of refurbishment and renovation. Once vacant, there is an opportunity to upgrade these units to the extent that they can be removed from the regulated sector and converted into non-regulated apartments. Transitioning ownership base Traditionally, the ownership of Dutch rental apartments was dominated by housing associations and domestic pension funds, which together held 2.39 million units in 2013, around 75 percent of the rental stock. Their presence has helped to create a degree of transparency in the sector. Indeed, IPD tracks €16.4 billion of for-rent residential assets in the Netherlands, more than for any other European country. However, it does not follow that the existing institutional ownership base has necessarily been sophisticated in the sense of actively seeking to add value to its holdings. Many owners have underinvested, missing opportunities to grow rents, including those created by ongoing changes to the regulatory environment. We expect many of the existing owners to sell to

value-driven investors over the next few years; this is already evident with the entry of international groups such as Patrizia Immobilien and Qatar Holdings into the market. Housing associations, in particular, are expected to be major sellers; they are under a mandate from the government to sell more than 1 million units. This directive is rooted in the peculiar history of these supposedly nonprofit associations. They began as government-funded entities, although when subsidies were cut off they were set free to make for-profit investments to subsidise their social mission. All too often, however, these took the form of risky ventures such as speculative development of for-sale housing. Moreover, excessive leverage was used to improve returns and dabbling in derivatives created risks. Now that housing associations are being forced to refocus on providing social housing, they are bringing large and small portfolios to the market. Vestia Group, for example, sold more than 17,000 units in eight separate transactions in 2014. A targeted approach We believe that now is an especially attractive moment for investment in the Dutch rented residential market. The economy is rebounding and investors have the chance to buy at the bottom

of the cycle. Deregulation and liberalisation will boost demand for deregulated rental apartments. The size and liquidity of the investment market is also expected to undergo a step change. Investor interest is increasing, but the opportunity to

Multiple changes to government policy toward the mortgage market and rental regulation are underway that should have a positive impact on investors in rented housing in the Netherlands.

buy and accumulate rented residential portfolios in the strongest regions of the Netherlands will exist for the foreseeable future. That said, it is wrong to assume that national trends will apply equally across geographies and assets. Experienced residential investors partnered with local experts will show their edge in asset selection and value creation. v Brian Klinksiek (Brian.Klinksiek@heitman.com) is senior vice president and director of European investment research at Heitman, and Zubaer Mahboob (Zubaer. Mahboob@heitman.com) is assistant vice president, investment research, both based in London.

Residential accommodation in the Netherlands can be almost as hard to come by as car parking spaces. It is no coincidence that public transport is so comprehensive or cycling so popular.

Project Radar – Germany

Market Overview

Market Overview German residential assets offer an attractive combination of risk and reward. Absolute return performance has been strong. Perhaps more importantly, the distribution of results is characterised by a “positive asymmetry”, whereby the upside end of the distribution of expected returns is substantially “thicker” than the downside tail. This owes to a number of intrinsic features of the market that make tenants and their rents relatively “sticky” on the downside. These include cultural aspects of rental housing and the regulatory framework. Downside is further limited by a lack of new supply and entry pricing that is at or below replacement cost. At the same time, growth is likely. At a minimum, rent escalation features built into the regulatory framework tend to track CPI, providing a measure of at least inflationary growth. Strong residential demand as well as opportunities for operational enhancement provide upside potential. The combination of all of these factors supports our view that the German residential sector represents an especially attractive risk-adjusted return proposition.

Performance Characteristics & Value-Creation Drivers of German Residential Investment returns data from IPD show that residential returns in Germany and other European countries have been strong. As the table below indicates, residential was the strongest performing sector in both the UK and Germany over the past 15 years. Results in other countries have also been solid. RENTED RESIDENTIAL HAS STRONG PERFORMANCE RECORD: Annual Average Returns by Sector & Country Residential

Office

Retail

Industrial

11.6%

8.1%

7.4%

8.4%

France

8.5%

8.8%

12.1%

8.4%

Germany

5.4%

2.9%

4.6%

5.2%

Netherlands

6.3%

5.3%

8.2%

7.2%

Source: IPD; Heitman Research

What about risk? This is where residential really shines. In order to focus exclusively on the occupier fundamentals of the sector, stripping out capital market effects, we calculate the downside volatility of each sector’s IPD rental value growth series. We calculate downside volatility, rather than general standard deviation, so as to not penalise assets that tend to deliver upside surprises. Downside volatility is defined as the standard deviation of all results that fail to meet some baseline hurdle return. For the hurdle rental value growth rate we used the actual rate of inflation in that period. In other words, we measure the risk that each sector will deliver substantially worse than 0% real growth. CLEAR TRACK RECORD OF POSITIVE RETURN ASSYMETRY: Downside Volatility¹ of Rents 6.1%

3.0% 2.5% 2.0% 1.5% 1.0%

0.5%

Germany

Netherlands

Residential

Retail

Offfice

Industrial

Residential

Retail

Offfice

Industrial

Residential

Retail

Offfice

Industrial

Residential

Retail

Offfice

Industrial

0.0%

France

Source: IPD; Heitman Research 1. Downside volatility is defined as the standard deviation of negative real rental growth results (rental grows minus inflation). Downside volatility is a component of the Sortino Ratio concept, which is concerned with downside volatility, ignoring upside surprises.

Confidential

Project Radar – Germany

Market Overview

As the chart above shows, downside volatility in the residential sector is less than for the commercial sectors in every country except for France, where it is similar to retail. German residential has the second lowest downside volatility of any country/sector combination. This highlights the attractive risk profile of German residential as an investment. Below we present a schematic comparison of this risk profile against that of a more conventional investment sector. Schematic of Expected Real Estate Return Distributions European Residential vs. Other Real Estate Sectors Expected return

INFLATION-PROTECTION CHARACTERISTICS Indicative German/ Dutch rented residential return distribution

CPI- or market index-linked rental increases

DOWNSIDE-LIMITING CHARACTERISTICS

DRIVERS OF UPSIDE VALUE CREATION

-- Tenant stickiness

-- Improve operations, service charge efficiency & marketing of undermanaged assets

-- Relative affordability of rents -- Supply constraints -- Favourable relationship between value & replacement cost

-- Realisation of rental mark-to-market upon vacant possession -- Unit renovation works & area additions -- Gains on portfolio rationalisation: Block sales of non-strategic assets & privatisation -- Deregulation (NL)

Inherent characteristics of sector limit downside risk

-- Increased investor acceptance of residential sector

Indicative typical real estate return distribution

Source: Heitman Research

As the diagram indicates, several factors limit the likelihood of downside outcomes in the sector: 

Tenant stickiness – Tenant turnover in German residential is relatively low, with the average duration of tenancies ranging from 5-10 years, depending on location. This owes to a number of factors. First, it is expected that tenants will invest in their apartment, providing their own kitchen cabinets and appliances, and in some cases, flooring (on average they make an only partially recoverable investment of at least €2,000). Tenants prefer to amortise the cost of these improvements over a greater number of years in occupancy. Second, rental regulation stipulates that the rents for in-place tenants increase at the average index rent for similar quality apartments in the same submarket (the follow the Meitspiegel or “rental mirror”). Because this index normally lags the market, it is generally a better “deal” for tenants to remain in their current flat than it is to move.



Relative housing affordability – As will be detailed in a later section, Germany scores extremely well on metrics comparing income levels to rents and home prices. As such, there is little risk that rents or prices are overvalued and therefore subject to declines.



Supply constraints – Many German cities, like all of Europe, have planning and land availability constraints that make it challenging to add additional supply to the market. A study by the OECD, for example, indicates that the price elasticity of housing supply (a measure of the responsiveness of development to price changes) in Germany is less than 25% that of the United States and 45% that of Japan.



Favourable entry point relative to replacement cost – According to our analysis, many residential assets in Germany are still available at per square meter prices at or below replacement cost. Moreover, they are low relative to such metrics in other countries. This provides an element of inherent protection.

Confidential

Project Radar – Germany

Market Overview

Meanwhile, there are numerous source of opportunity to potentially drive growth and generate an upside result: 

Operational improvement – Many portfolios of German residential assets have been relatively undermanaged. The German residential sector has not yet fully adopted systems and processes as multifamily owners have done in other markets, particularly the US. In most German residential portfolios there remain significant opportunities to improve operating efficiency, reduce rental delinquencies, enhance expense recovery, and boost collection rates. There is also scope to implement IT systems that monitor and assist with asset management and tenant accounting. Although the nature of the German housing market makes on-site marketing suites unnecessary, there is scope to improve marketing to new tenants through strategic branding, advertising, and the internet.



Rental mark-to-market gain – Upon receiving vacant possession of a unit, there is often the potential to realise a mark-to-market gain on the rent. This is because, as noted above, the index to which rents for in-place tenants is linked usually lags the market. Subject to some limitations in some markets, rents for new leases reflect open market pricing. (In other countries, such as the Netherlands, there is further mark-to-market gain to be realised by de-regulating a unit, although this is presently not possible in Germany.)



Unit renovation works & area additions – Often it is possible to renovate a unit upon vacant possession and achieve a higher rent upon re-leasing. If the renovations are substantial enough, the rent for the unit will not be subject to any limitations on rent even in markets where the “rental brake” is in place (see discussion below). There may also be opportunities to increase the leasable area of apartments, for example by expanding them into attic areas or adding balconies. Moreover, it is also possible to increase rents even for existing tenants if certain modernisation is undertaken, especially if they relate to energy efficiency. More detail on this is provided in a later section, but leveraged IRRs on incremental capital invested in modernisation can reach 15-26%, according to Morgan Stanley.



Gains on portfolio rationalisation – The history of many German residential portfolios is such that they typically include assets in disparate submarkets and of widely varying quality. This owes to the fact that many portfolios originated as part of municipal housing corporations or housing companies affiliated with a large employer, such as Deutsche Bahn, rather than through deliberate portfolio construction. As such, there are often opportunities to “rationalise” portfolios by selling non-core assets, normally those with weaker growth potential because they are toward the top or bottom of the quality spectrum. Exit options include privatisations (condo conversion) and partial sales to other investors. In terms of privatisation, investors should not blindly assume that an arbitrary percentage of units in a portfolio can be sold to tenants, but examine portfolios on a building-by-building and even unit-by-unit basis to identify specific apartments that are ripe for privatisation. Investors should also consider which assets it may make sense to dispose of in “block sales” to smaller investors, such the wealthy doctors and dentists who support liquidity in Germany for transactions with smaller lot sizes and in smaller cities.



Increased investor demand for German residential – Finally, investor demand for German residential has grown substantially in recent years, and we see scope for more improvement. As such there is room for some additional yield compression/multiple expansion.

In summary, the German residential sector has intrinsic characteristics that limit downside risk, and a number of features that facilitate additional value creation and growth. And as a baseline, income growth is supported by rent escalation terms that tend to be correlated with inflation. It is worth noting that not only does German residential represent an attractive risk-adjusted return on a freeand-clear basis, the characteristics described above are also conducive to the application of moderate amounts of leverage, given the limited downside. Indeed, German residential is easily financeable from a variety of sources, including banks, covered bonds, and even CMBS. It is telling that risk spreads for German

Confidential

Project Radar – Germany

Market Overview

residential are around half those for the commercial sectors. This suggests that debt markets are aware of the attractive prospective return distribution.

German Residential: Supply & Demand The German residential market can be characterised by strong demographic-driven demand, particularly in certain regions and cities, combined with very modest levels of new housing supply. Demographic-Driven Demand It is well established that German demographic growth has been hindered by an ageing population and a lower growth rate. Recently, however, a rebound in net migration has picked up the slack, pushing population growth into positive territory. As the chart below shows, net migration into Germany turned sharply positive starting in 2010, driving a rebound in the overall population. The rebound in German growth is driven by Germany’s robust economy and the relative employment prospects there versus other European countries. NET MIGRATION HAS DRIVEN REBOUND IN GERMAN POPULATION: German Population & Net Migration 82.8

millions

thousands

450 400

82.6

Total population (L axis)

82.4

350 300

250

82.2

200

82.0

150 Net migration (R axis)

81.8

100 50

81.6

0 81.4

-50

81.2

-100

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 Source: Oxford Economics; Heitman Research

Drilling into the demographic data further, it is evident that for two reasons, demographic-driven demand for housing is even stronger than suggested by the rental growth identified above. Both are highlighted in the chart and map below. VARIABLE DEMOGRAPHIC OUTLOOK – KEY REGIONS, HOUSEHOLD NUMBERS OUTPERFORMING: German Population and Household Count by City Type (2000-2020f) 1.15

FOCUS ON MARKET SELECTION: Heat map: Population forecast through 2025

Index (2000=1.00)

Households (key cities¹)

1.10

Households (rest of Germany)

1.05 Population (key cities¹) 1.00 Population (rest of Germany)

0.95

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15f 16f 17f 18f 19f 20f Source: Oxford Economics; Heitman Research 1. 15 largest metropolitan areas

Population declines

Population growth

Source: CBRE; Heitman Research

Confidential

Project Radar – Germany

Market Overview

First, the pace of growth in households is substantially stronger than growth in the population as a whole. This is driven by a trend toward smaller households due to ageing and latter marriage. Because single-person households normally require more than one-half the floor space as does a two-person household, this should result in a net increase in housing demand. Second, the internal migration within Germany is driving much stronger growth in certain regions than is evident at the national level. As the chart above indicates, the top 15 cities in Germany are seeing strong population gains, whereas the rest of the country is actually experiencing population declines. As the “heat map” above indicates, the strongest population gains are expected in the south of the country, with the greatest gains occurring around Munich and Berlin, and in Baden-Württemberg. There is also strong growth around major cities such as Frankfurt, Hamburg, Cologne, Dusseldorf, and Bremen. Meanwhile, declines are apparent in some of the ex-industrial areas in the West, and in large swathes of the former East Germany. Subdued Supply At the same time that demand is strong, the levels of new construction remain only slightly above their lowest levels in the post-war years. Although supply has rebounded somewhat since the nadir in 2010, a closer analysis of this recovery shows that the revival in new supply (and indeed almost all of the aggregate apartment completions) consists of high-end for-sale apartments in select top cities such as Munich. There continues to be minimal new supply of apartments targeting the rental and non-luxury segments of the market. SUPPLY REMAINS JUST ABOVE ALL-TIME LOWS: Apartment Completions Germany 1950-2013 900

thousands of units

800

700

Rebound limited to upscale forsale housing in top cities

600 500

POSTWAR RECONSTRUCTION

400 300

REUNIFICATION & SUBSIDY BOOM

200 100

2010

2005

2000

1995

1990

1985

1980

1975

1970

1965

1960

1955

1950

Source: Federal Statistics Bureau; Heitman Research

Value & Rent Growth: History & Outlook The result of this demographic-driven demand and minimal new supply has been a strong revival in growth of rents and home prices. Rents have been growing at 3-4.5% for the past few years, while prices have been growing by 3-5%. Note that the recovery in prices and rents really gathered momentum around 2010, just as net migration into Germany began to pick up again. SOLID, SUSTAINABLE RENTAL & PRICE GROWTH: Change in Residential Rents and Prices Germany 1997-2014 6%

Rental growth (existing units) Home price growth

5% 4%

2.6%

3% 2%

3.1% 3.0% 2.2%

1.9%

1.2%

4.6% 4.4%

0.5%

0.7%

2.4%

2.2%

1.4%

1.0%

0.2%

0% -0.2%

-1% -0.4%

-2%

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

-3%

Source: Datastream; Heitman Research

Confidential

Project Radar – Germany

Market Overview

Naturally, it is important to ask: Is this robust, consistent growth sustainable? Indeed, some commentators, albeit only domestic German ones, have publicly signalled the risk of a bubble. Our view, based on an examination of housing affordability as well as the catch-up potential in home prices and homeownership levels, suggests that current conditions look nothing at all like a bubble. In the global context, the recent growth in the German housing market is modest and steady. Affordability metrics suggest housing is still cheap compared to income levels, not overpriced as it is in some markets. We provide additional detail on the analyses that lead us to this conclusion in the sections that follow. Fundamentals Check: Affordability Housing in German cities is extremely affordably priced relative to other European markets. The chart below ranks European cities according to an affordability index that combines key indices of housing rent and price affordability: the price-to-income ratio, the price-to-rent ratio, and mortgage costs as a percentage of income. Note that the scale depicted by the chart is intended for comparison of magnitude only; it does not have a direct numerical interpretation. Shorter bars indicate more expensive housing relative to local income levels. DESPITE RENT/PRICE GROWTH, GERMAN RESI STILL AFFORDABLE: Affordability Index¹ Various European Cities 2015

LESS AFFORDABLE RELATIVE TO INCOMES

MORE AFFORDABLE RELATIVE TO INCOMES

Rome Milan London Paris Bristol Warsaw Budapest Munich Vienna Athens Bordeaux Prague Lisbon Nice Manchester Cambridge Helsinki Geneva Amsterdam Lyon Milton Keynes Reading Dresden Hamburg Utrecht Stuttgart Guildford Dublin Southampton Berlin Lille Zurich Marseille Copenhagen Nuremberg Edinburgh Cologne Frankfurt Rotterdam The Hague Glasgow Aachen Birmingham Dusseldorf Karlsruhe

1. Index of price-to-income ratio, price-to-rent ratio, and mortgage as percent of income

Source: Numbeo; Heitman Research

As the chart indicates, German cities are clustered toward the more affordable end of the spectrum. Scores such as these are inconsistent with any diagnosis of a housing bubble. Only Munich, which is highly supply constrained and ranked as one of the world’s most liveable cities, features anywhere close to the less affordable end of the spectrum. This analysis is consistent with a comparison by Morgan Stanely, below, which shows that over the long term, house price growth in Germany has been substantially outstripped by disposable income, even considering the recent price rebound. The trend suggests that since around 1980, housing in Germany has become progressively more affordable.

Confidential

Project Radar â&#x20AC;&#x201C; Germany

Market Overview CATCH-UP POTENTIAL VS. INCOME GROWTH: House Prices vs. Disposable Income (75=100) Germany 1975-2014

Disposable Income

House Prices

Source: Morgan Stanley; Heitman Research

Fundamentals Check: Catch-Up Potential It is also notable just how much house prices in Germany have lagged those in other countries. As the chart below shows, German prices were essentially flat in real terms for many years as the market adjusted to the effects of re-integration of East and West Germany. As net migration rebounded in 2010, German home prices started to drift upward. But the movement has not been extreme relative to those of other countries. None of these observations point to the likelihood of unsustainable price growth. CATCH-UP POTENTIAL VS. OTHER COUNTRIES: Nominal Home Price Index (92=100) Selected Countries 92-14 400

350 300

France Spain Netherlands US

250 200 150

Germany

100 50

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

Source: Datastream; Heitman Research

Fundamentals Check: Owner-Occupier Market As it currently stands, Germany has the lowest homeownership rate among major countries, as the chart below shows. This is a dual significance for investment in the German residential sector. First, it means that Germany has a strong culture of renting flats. There is no social stigma about being a renter, meaning that the credit quality of the renter pool does not suffer any major negative bias versus the rest of the population.

Confidential

Project Radar – Germany

Market Overview

GERMANY LAGS OTHER COUNTIRES IN HOMEOWNERSHIP: Homeownership Rates Selected Countries 2013 Germany

52.6

Austria

57.3

Denmark

63.0

63.7

France

64.3

64.6

Netherlands

67.4

Sweden

69.6

Italy

73.0

Finland

73.6

Cyprus

74.0

Portugal

74.2

Slovenia

76.6

Iceland

77.5

Spain

77.7

SUPPORTIVE MORTGAGE RATE ENVIRONMENT: Indicative German 10-Year Fixed-Rate Mortgage 94-14

Czech Republic

80.1

Malta

80.3

Estonia

81.1

Latvia

81.2

Norway

83.5

Poland

83.8

Bulgaria

85.7

Hungary

89.6

Slovakia

90.5

Lithuania

92.2

Romania

95.6

Source: European Mortgage Federation; Heitman Research

100

% Source: Morgan Stanley; Heitman Research

But it also means that there is potential for “catch up” as more households elect to move into homeownership. We are already seeing signs of an upward shift, albeit a modest one, of the homeownership rate in Germany. Near record-low mortgage rates (see above chart) are at least partly responsible for this change. But it also reflects expectations among households of continued priced growth. More demand from owner-occupiers will help to support investment strategies that include some element of privatisation (condo conversion). It also points to the likelihood of continued upward price pressure, especially given the highly affordable starting point.

Capital Markets Environment The German rented residential market has matured and is now one of the most institutional, liquid, and financeable segments of the European property market. Since the Global Financial Crisis (GFC), investment volumes in the sector have rebounded to strong but sustained levels, with around €11-13 billion transacted in each of 2012, 2013 and 2014. As of June 2015, the pace of investment in 2015 appears to be consistent with this level or somewhat stronger, as the chart below shows. CONSISTENTLY STRONG TRANSACTION VOLUMES: Residential Portfolio Transaction Volumes Germany: 1997-2015 YTD 20

EUR billions

18 16

14 12 10 8 6 4 2 0

97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15e Source: CBRE; RCA; Heitman Research

1. Full year estimate. Actuals (in blue) through 19 Jun.

Confidential

Project Radar – Germany

Market Overview

Residential portfolio transactions now make up around one-third of all property investment volume in Germany, up from around 15-20% in the pre-GFC years. Listed residential companies dominate the country’s publicly traded real estate markets, and the sector has attracted new CMBS issuance and IPO activity, both still relatively rare in post-GFC Europe. Not surprisingly, the profile of the typical transaction and investor in the market has changed considerably since before the GFC. The range of normal transaction sizes is broader and return expectations are lower. Meanwhile, the profile of the typical buyer has changed. The investment market for German residential portfolios was catalysed in the early- and mid-2000s by chunky bets made by big players such as Terra Firma, Fortress, Blackstone, Cerberus, Morgan Stanley, and Goldman Sachs. By contrast, listed companies and direct purchases by pension funds dominate today. The retreat of big private equity funds signals a stabilised phase in the evolution of the market and more realistic expectations on the part of investors. Pre-GFC strategies targeting high-octane returns driven by massscale privatisation (condo conversion) and financial engineering did not achieve the desired results. Today the investment opportunity set is drawing in longer term, strategic capital with return expectations that are appropriate given the market’s high level of transparency, awareness, and liquidity. Like any sector that has emerged, the cost of capital has fallen with increased maturity. The new environment is healthy for the German residential market; it implies increased stability because investment is being financed by longer-term sources of capital. Listed Sector The most important driver of the capital markets for German residential has become the listed sector. As the chart below shows, residential firms in Germany currently account for around €23 billion of market capitalization or more than €45 billion of implied gross asset value (GAV) at today’s loan-to-value (LTV) ratios. This represents the lion’s share of the listed real estate market in Germany.

RESI COMPANIES HAVE COME TO DOMINATE GERMAN REIT MARKET: German Listed Market Cap and Number of Resi Names: 01-15(Jun) CONSOLIDATION 30

EUR bn

Other sectors market cap (L axis)

Residential market cap (L axis)

Number of listed residential names (R axis)

20 15

RESURGENCE

EMERGENCE

4 3

GFC

2 1

Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15

Source: EPRA; Heitman Research

One key trend in the recent evolution of the listed German residential market has been M&A activity, bringing the listed sector into a consolidation phase. As the chart above shows, the number of listed firms tracked in the EPRA index has declined from a peak of six to four today. After Deutsche Annington’s IPO in July 2013, it has been especially acquisitive, buying large private portfolios as well as acquiring listed rival Gagfah in December 2014. This deal eclipsed the previous record holder for German residential M&A, the acquisition of GSW by Deutsche Wohnen at the end of 2013. As the table below shows, German residential companies are richly valued by the listed market. They trade at premium to NAV of, on average, around 17% and at an implied portfolio yield of 4.9%. We view this as confirmation from the marketplace as to the strength of the sector.

Confidential

Project Radar – Germany

Market Overview

GERMAN RESI REITS TRADING AT LARGE PREMIA, LOW YIELDS: Listed German Residential Companies Valuation Metrics: 15 Jun 15 Market cap (EUR bn)

Premium/ Market implied (discount) to NAV portfolio yield

LTV ratio

Deutsche Annington

10.0

13.5%

4.9%

Deutsche Wohnen

7.5

19.9%

4.8%

51.0%

LEG Immobilien

3.8

22.3%

4.6%

47.3%

TAG Immobilien

1.5

9.6%

5.9%

62.2%

22.8

16.8%

4.9%

50.6%

Total/wtd avg

49.7%

Source: HSBC; Heitman Research

Additional Detail on Regulatory Framework As noted earlier, rented housing in Germany is subject to regulation. German housing regulation reduces vacancy risk by encouraging tenant stickiness, but it also slows the pace at which landlords get access to vacant units. Subject to compliance with the terms of their lease, existing tenants have security of tenure. Their rents can only be increased in line with a government-published market index, the Mietspiegel (“rental mirror”), and no more than 20% every three years (15% in Berlin and parts of Bavaria). A Mietspiegel is a database of local rents agreed on new leases during the four years preceding its reference date. It is updated at least every two years and is recompiled every fourth year. To adjust for the type of apartment being benchmarked, the outputs of the Mietspiegel are normally segregated by apartment size, quality, and location. As a result of the Mietspiegel, in-place rents in a rising market will lag market levels. While this system limits the immediate upside of rising rents for owners of rented housing, it also has the effect of dampening volatility and increasing the stickiness of existing tenants, who are incentivised to stay if rents rise, and we expect they will continue to do so. As noted above, there are exceptions to this rule when renovations are made. According to German law, landlords can re-charge 11% of qualifying modernisation expenses to a sitting tenant in the form of higher rents if these expenses relate to improving energy efficiency or accessibility for the elderly. However, any modernisation project is usually a mix of qualifying and non-qualifying expenditures. According to a report by Morgan Stanley, around 65% of modernisation expenditures can be charged to tenants, resulting in a yield on investment of around 7% (i.e., roughly 65% of 11%). In addition, qualifying capex can be financed at an attractive rate through a government-owned development bank. As a result, leveraged IRRs on incremental capital invested in modernisation can reach 15-26%, according to Morgan Stanley. Generally speaking, regulation does not impede the free negotiation of rents for new leases. However, the government recently implemented a “rent brake” that allows German Federal states to implement a limitation such that rents in specified locations cannot be more than 10% above a “reasonable level”, usually defined as the Mietspiegel level. Although the Mietspiegel is meant to reflect market rates—and therefore the rule appears to say “market rents cannot be set above market”, a redundant concept—it does introduce a lag. It should also be noted that the rent brake rule is meant to be temporary, with restrictions expiring after five years. Not all states have enacted the rule and some may elect not to do so. Overall, the impact of this change is expected to be limited from a top line growth perspective. This is because it is incumbent on the new tenant to prove that they are paying too much rent after the lease is already agreed. Few are expected to bother. Moreover, most rental contracts can be easily structured so that costs are allocated differently between parking, the apartment, and other areas, avoiding the rental brake. This increases the importance of diligent management and monitoring, but allows for the same growth in aggregate rental income to be realised. Finally, the regulations do not apply in the case of substantial renovation. Many investors already find it profitable to conduct value-added capex every time they achieve vacant possession for an apartment; in these cases the apartment is considered “new” and the rent brake does not apply.

Confidential

Project Radar â&#x20AC;&#x201C; Germany

Market Overview

Conclusion In conclusion, despite recent improvement in the German residential occupier and capital market environment, the sector still has room to run. Growth in rents and prices is strong, steady, and sustainable. The sector is liquid, financeable, and offers a multiplicity of exit options. Absolute return expectations are lower than a few years ago, but risk-adjusted returns are strong due to an attractive â&#x20AC;&#x153;positive asymmetryâ&#x20AC;? of likely outcomes. We recommend and aggregation strategy focused on smaller portfolios rather than attempting to compete in the large portfolio space, which is dominated by the listed companies. Investments can take the form of a core/core+ strategy that emphasises the return drivers detailed above, or a more privatisation-rich approach, for the right portfolios, targeting value-add returns.

Confidential

UK Real Estate: Riding the Wave Report

UK real estate: opportunities, trends and politics Post-election, the UK now has the certainty of a majority government and it’s a buoyant time for the real estate market. This is opening up exciting opportunities in our industry, but we now face new questions about our future in Europe and further political change in Scotland. Which trends will shape UK real estate over the next five years and will the current optimism continue?

Portfolios worth more than £400bn Our 271 survey and interview respondents are together responsible for portfolios worth more than £400bn.

Levels of optimism 77%

Chances of a downturn 77% are more optimistic about the UK real estate market compared to last year.

High

74% feel the chance of a UK real estate downturn within two years is low or very low.

Medium

Low

2015

2017

Timeline

Red hot real estate

The European question

73% find residential property to be appealing/ very appealing for investment. Overtaking industrial and logistics, it is second only to offices.

64% of respondents believe a UK exit from the EU will have a negative effect on UK real estate.

73%

2020

64%

However, this changes in the longer term. 85% feel there is a medium to high risk of a downturn within five years.

Despite the uncertainty, 72% will not delay their investment decisions ahead of the referendum.

72%

The UK picture When it comes to London real estate, respondents are evenly split over whether it’s fairly valued or over-valued.

65% are less likely to invest in Scotland as a result of the rise of the SNP, making it a bigger negative factor than the EU referendum.

74% see the devolution of further powers to major UK cities as positive or very positive.

The real estate market is behind the Government’s Northern Powerhouse Initiative. 84% believe it will have a positive or very positive effect. THE NORTH

84% 65%

74%

Regional players Manchester’s popularity continues to soar with 79% singling it out as the most appealing regional city. Birmingham follows with 52%.

Birmingham

Glasgow (9%)

Manchester

79%

Edinburgh (15%)

Manchester is the most soughtafter regional centre with 79% preferring this location.

52%

Birmingham is the second most popular with 52% finding it an attractive investment prospect.

Leeds (17%)

The top 6 “cities or towns to watch”

Cambridge Reading 22%

Liverpool

Bristol

Newcastle

Bristol is the third most appealing with 22% choosing it as a favoured investment prospect.

Oxford Sheffield

Overseas investment

2015 - 2020

Of the major geo-political factors affecting UK real estate, terrorism and escalating conflict in the Middle East are the most pressing concerns (33% and 25% respectively).

2015 - 2017

80% 64%

80% predict that global investors will be more acquisitive than UK investors in the medium term, although this drops to 64% in the longer term.

How optimistic are you? To explore the opportunities in UK real estate, contact Nabarro’s expert legal team. www.nabarro.com

62% 62% of respondents see Asia as the top region for UK inward investment and it is expected to be one third more acquisitive than the Middle East.

UK Real Estate: Riding the Wave Contents Surfer’s paradise Interview Bill Hughes, Legal & General A swell of optimism London: surf’s up! Interview Hideto Yamada, Mitsui Fudosan (UK) Positioning, timing and balance Interview David Paine, Standard Life Inflows of capital Dangerous waters Interview David Partridge, Argent Interview Mark Titcomb, DekaBank The crest of the wave Rip currents Interview Amal del Monaco, AXA Real Estate Storms brewing over Europe Scottish drift Interview Ross Blair, Hines Local squalls Tidal pulls North Interview Stephen Down, Savills Surf lessons

About the research Nabarro, in conjunction with FTI Consulting, created and ran a poll of 263 property investors, developers and agents, and conducted eight interviews with leading market figures. Those surveyed and interviewed have combined assets worth more than £400bn. Of the survey respondents, 60% work in property investment companies, 22% for property development companies and 18% for property agents. Giles Barrie, Managing Director of strategic communications company, FTI Consulting and former Editor of Property Week, undertook the in-depth interviews during May 2015.

Surfer’s paradise

With the economic tide firmly in the UK’s favour, there are substantial waves of capital available in the market. Nabarro’s third thought leadership report “UK Real Estate: Riding the Wave” considers the current buoyant conditions and the undercurrents that may alter the balance. Our latest market analysis draws on a survey of 263 property professionals and interviews with eight key market players controlling real estate portfolios worth over £400bn. Our research shows a very positive outlook, with 77% of those polled more optimistic than last year and 74% expecting the strong market to continue for at least another two years. Overseas capital continues to flow into UK shores, but our research identifies a shift in focus to Asia with 64% predicting it to be the main source of future UK investment; this supersedes the Middle East which led two years ago in our first report “Global Investor Appetite: Who’s Hungry for UK Real Estate?” Falling oil prices are clearly affecting investors’ view of this region. Almost half those polled think London is fairly valued and see opportunities there, particularly in fringe areas. However, continuing the trend highlighted in our 2014 report “Growing Opportunities: A New Outlook for UK Real Estate”, investment is also flowing to dominant regional centres. Manchester and Birmingham continue to lead the pack and the tech boom means that Cambridge and Oxford have now joined as cities to watch outside of the “Big Six”. In 2013, our report reflected a mood of financial uncertainty as the UK emerged from recession. Two years on, we face a different uncertainty, this time largely political. The general election provided the conviction of a majority government. However, a Conservative term raises questions about Britain’s future in Europe and emphasises the political divergence between Scotland and the rest of the UK. 81% of investors told us in the run-up to the Scottish referendum that they would be less likely to invest in an independent Scotland. Despite the “no” vote, this year 65% still are less likely to invest because of the rise of the SNP. In contrast to what happened ahead of the Scottish independence vote, the majority of those polled would not delay investment decisions due to the forthcoming EU referendum, with most experts discounting the likelihood of a Brexit. Whether this changes as the poll nears remains to be seen. The market is decidedly against a break, with 64% saying it would be bad for UK real estate. Our survey provides a fascinating snapshot of a market awash with opportunities, rounding off a trilogy of vibrant reports over the past three years (details on page 30). We’d like to thank all those involved, in particular our interviewees whose views have added colour to our research. To take advantage of the current “surfer’s paradise” for UK real estate, please get in touch with our expert legal team.

Ciaran Carvalho Head of Real Estate T +44 (0)20 7524 6152 c.carvalho@nabarro.com uk.linkedin.com/in/CiaranPCarvalho #REwave

Interview

Bill Hughes, Head of Real Assets, Legal & General “ I’m optimistic because I sense the universe of opportunities for property investment is expanding in proportion to the amount of money available. Increased interest in investing in property related to social infrastructure is a trend that will manifest itself more.” When Bill Hughes’s role was expanded from Head of Property to Head of Real Assets at Legal & General last year the fund manager was at the forefront of the trend he pinpoints. With growing interest in long-term, stable income and an increasing desire to invest in improving national infrastructure, fund managers like Legal & General are growing into residential property through the Build To Rent sector and other fields like healthcare, as well as other forms of social and economic infrastructure such as renewables. For Hughes this trend will help to act as an escape valve, helping to ensure that property prices don’t rise to stratospheric levels. London, he believes, is fairly valued, but he continues: “It’s become very commonplace for people to generalise about London, and that’s dangerous. Very prime retail is stretching valuations, and it is clear that prime office investments are being over-bid. “However, for regeneration opportunities there is tremendous potential: we have recently let buildings in Shoreditch at £60 per sq ft which would have been leasing at £20 per sq ft five years ago.” As well as “alternative” property or infrastructure assets, Legal & General has also set the pace in diversifying out of London and, when asked which two core cities outside the capital he favours most he names Birmingham and Bristol. “Birmingham as an early High Speed 2 station is already shaping investment thinking, while Bristol has great regeneration potential with electrification of the rail connection and the arrival of its Arena alongside local infrastructure improvements.” Hughes also sees strong potential in Leeds and Newcastle. On asset classes to watch, he not surprisingly names healthcare as appealing as private capital becomes more involved with supporting the NHS, and says that we have UK Real Estate: Riding the Wave

reached a “tipping point” in terms of the Build To Rent sector becoming an established asset class. But Hughes also cites logistics as a sector to watch, due to the way that it cannibalises the role of traditional retail by offering retailers the opportunity to send goods direct to people’s homes. Hughes also sees some clouds on the horizon, and says the chances of a property market downturn within the next two to five years are at a “medium” probability, with the most likely disruption being caused by a shock rise in interest rates. While he finds it hard to see an immediate reason for interest rates to rise, Hughes does believe that the impact of a rise in base rates of up to five per cent would have a “material impact” on the economy. Likewise, he says a rise in interest rates would have a more significant impact on the UK’s prospects than a Greek exit from the European Union, a significant oil price rise or even a British exit from the EU. This scenario would be “slightly bad, but could be nearer neutral, depending on the terms of our exit”. For its part, Legal & General remains committed to the UK, and won’t imminently be investing in other markets abroad: it positions itself as an expert in local markets and, by diversifying its portfolio believes it can still find plenty of opportunities within the UK. Right now, Scotland is causing Hughes some concern, and on the prospect of growing devolution or even independence he says: “The Scottish National Party needs to understand that political reasons for creating change in Scotland will materially affect investors’ thinking. “Scotland must not make itself appear too different as an investment destination.” And on devolution to English cities? “Well-enacted localism is a positive, and good governance can make this work. But equally, with poor governance there is a danger of a policy vacuum.”

A swell of optimism

The UK real estate market in the summer of 2015 is divided between those who believe in a new economic paradigm leading to a long-term boom, and those who believe disaster still lurks around the corner.

When do you expect interest rates to rise?

Some consider that low interest rates create an unbeatable arbitrage between yields on property investment and rival investments like government bonds; there are others who stand by the inherent volatility of the property market. The participants in the 2015 Nabarro poll, however, are mainly in the optimistic camp, with more than three-quarters either optimistic or very optimistic about the marketâ&#x20AC;&#x2122;s prospects. This is a mood which appears to be in line with other sectors. For example, the construction industry has enjoyed a post-election bounce with confidence levels now at their highest since 2006. Even the UKâ&#x20AC;&#x2122;s slip into deflation, rather than concerning economists, has resulted in consumer confidence almost returning to where it was before the financial crisis. However, with interest rates certain to rise one day, and the European Single Currency as shaky as ever, could this prove to be the high water mark of the current boom?

5% 2% 25% 22%

46%

12 months 18 months 24 months 36 months Other

Compared with 1 year ago, how optimistic do you now feel about the UK real estate market? Very optimistic 13% Quite optimistic 63% Neutral 21% Quite pessimistic 3% Very pessimistic 0% 0

100

UK Real Estate: Riding the Wave

London: surf’s up!

London’s prospects inevitably dominate discussion, with half of respondents seeing the capital as over-valued as billions pour in from mainly overseas investors. According to PropertyData, £15.5bn of commercial real estate had been traded in London in 2015 by 5 June, at an average yield of 4.76%. This compares with £26bn in the whole of 2014, at an average yield of 4.87%. Given that the second half is traditionally stronger for the property investment market and that yields have edged in, this indicates that the market is continuing to strengthen. In 2015 rental records for both the City and the West End have been broken. At 8 St James’s Square, Green Property leased the 3,000 sq ft top floor of the new development to Helly Nahmad Gallery at £185 per sq ft, and British Land and Oxford Properties achieved a new City record at The Leadenhall Building (aka The Cheesegrater) by leasing 6,600 sq ft to Affinity Shipping at £90 per sq ft.

What is your current view of the London real estate market?

What would be the best option regarding airport expansion? 3% 16% 4%

18%

59%

Heathrow Gatwick Stansted

Undervalued

New Estuary Airport

No change

Over-valued 50% Fairly valued 49% 0

100

With the central London market hot, many believe that by turning to development and refurbishment opportunities in fringe areas there are still good returns to be made. The International Quarter, a £2.1bn development on the former Olympic site at Stratford, is a good example. Meanwhile, with inadequate airport capacity, London’s status as a global city may come under threat. The need for expansion is a pressing issue. Whilst the Davies Commission is due to report this summer there is concern over speculation that ministers will not respond to its recommendations until late in 2015 or early in 2016.

In one of the year’s biggest pre-lets

425,000 sq ft was recently secured by the Financial Conduct Authority for its new HQ in Stratford.

Interview

Hideto Yamada, Managing Director, Mitsui Fudosan (UK)

Mitsui Fudosan has built up a strong portfolio of London projects, ranging from the £800m Television Centre White City development, in partnership with Stanhope, to a number of City and West End office buildings. Whether it is providing new residential units, studios for the BBC at White City, or building in the heart of the City at Moorgate or Mark Lane, Mitsui has become an established part of the London development scene. Its current projects will cost £1.3bn and have an end value of £2bn. Its UK Managing Director Hideto Yamada is well-placed to discuss trends among UK and overseas investors. He is cautiously optimistic, but foresees a rise in interest rates in 18 months because “at some point we will have to tighten such an extremely liquid market.” Asked if he views the UK market positively or negatively, Yamada replies “neutral”. “The market has been hot since 2010, and since 2013 the occupational market has been strong as well. Rents have been moving up and we are now at a good level, but we can still see growth for a year or two. But we are coming to a high point in terms of values.” He believes London is “fairly valued”, but aside from a project in the capital’s satellite city, Reading, Mitsui doesn’t invest in other cities in the UK. As a global player it deploys the 30% of the capital it spends outside Japan in “gateway” cities like New York, San Francisco, Shanghai and Singapore. Asked what real estate sectors Mitsui favours, Yamada explains that its focus in developed countries like the UK is

“ London is strong and growing, Mitsui is a committed investor, but don’t tamper with the successful formula.”

on offices, where it foresees growth in creative industries, biotech and IT. Its White City project, for example, will play on links to Imperial College nearby. In the Asian market Mitsui invests more in shopping centres and residential, where rapid consumer spending and population growth is driving demand in both sectors. Yamada expects more investors to arrive from Asia for two reasons: Far Eastern investors have an affinity with the UK market due to historic links; they also relish the liquidity of London, which allows them to access prime property at transparent prices. He believes that to maintain Britain’s competitiveness, infrastructure investment is important, and favours an expansion of Heathrow above other options for increasing airport capacity. As a global investor, Yamada’s views are pertinent: “Everyone from a business point of view prefers an expansion of Heathrow. It has good connections with Europe, but also cross-continent, and airport connectivity to us is vitally important. “As a global player we look at ratings in different fields for all cities. London is well rated overall, but transport comes up as an issue. That’s why we are big fans of Crossrail, which the Government was right to press ahead with despite its austerity plans.” He is also cautious about Britain cutting itself off from the world by exiting the European Union, believing that following a “Brexit” not only might manufacturing businesses hold back, temporarily, from investing in London, but also London could suffer a fall in its status and levels of office occupation. Overall the message from Yamada is “London is strong and growing, Mitsui is a committed investor, but don’t tamper with the successful formula.”

UK Real Estate: Riding the Wave

Positioning, timing and balance

As in our 2013 report, when it comes to asset choices, offices remain in first place. Traditionally offices are appealing to the overseas investor and this is now also bolstered by increasing occupier demand. Retail has grown in appeal, but remains the least attractive of the asset classes. Whilst recent IPD research found that the retail vacancy rate is almost half that of the all commercial property average and tenant default is below average, this is clearly having little impact on investor sentiment. Our survey highlights the appetite for alternatives as part of a wider portfolio. However, how much longer before certain alternatives truly become mainstream? The drive towards alternative real estate really started to gather momentum last year. In our 2014 report, interviewee Alex Jeffrey (CEO of M&G Real Estate) predicted that 20% of M&Gâ&#x20AC;&#x2122;s portfolio would be invested in alternatives over the next five years. In line with this, it recently acquired six Priory Group hospitals as part of a sale and leaseback transaction.

Rate the following asset classes on their level of appeal Office 16%

18% 4%1%

61%

Retail 6%

34%

41%

18% 1%

Industrial 13%

46%

32%

8% 1%

Distribution/Logistics 23%

46%

25% 6%

Residential 25%

21% 4% 2%

48%

Hotels/Leisure 9%

48%

32%

9% 2%

Student 12%

41%

35%

10% 2%

Healthcare 13% 0

31% 20

Very appealing

38%

40 Appealing

60 Neutral

Unappealing

15% 3% 100

Very unappealing

77% 73% find offices and

find residential appealing or very appealing.

The residential sector continues to lead the alternative charge. Despite doubts over the prime residential market in London (with many believing that there is insufficient demand to take up the flood of £2m apartments planned), residential continues to appeal to investors due to the demographics in the sector’s favour. London’s outer boroughs and northern cities with a growing private rented sector market are also now catching the eye of investors. 2015 has so far been another strong year for the student accommodation sector. For example, in one of the largest student accommodation deals of recent years, Canada Pension Plan Investment Board acquired the Liberty Living UK student accommodation portfolio from the Brandeaux Student Accommodation Fund for £1.1bn.

“ For everyone logistics is proving difficult to buy. In the current retail revolution, moving goods around is a very good business to be in.” David Partridge, Argent

Where do you see occupier demand coming from? Technology 76% 65% Financial Services 29% 34% Professional Services 35% 31%

2 years

Retail

5 years

7% 12% Distribution/Logistics 38% 26% Healthcare 14% 27% 0

100

Future occupier demand is seen as coming most strongly from the technology sector (76%). Distribution and logistics come in second, which may account for the fact that 69% of respondents see investing in distribution and logistics as appealing or very appealing. Interestingly this is up from 35% in our 2013 survey, perhaps reflecting the growing impact of the internet revolution on this sector.

UK Real Estate: Riding the Wave

Interview

David Paine, Head of Real Estate Investment, Standard Life

Last year was a very good year for investment in real estate in the UK, so should investors have concerns about the prospects this year? It’s a resounding no from David Paine, who has over £17bn of real estate assets under his management.

“I remain optimistic about the market. This year will be a good year but it will not be as strong in terms of performance as 2014 - but that is a reflection of the fact that we are moving further through the market cycle.” He cites rental growth as the deciding factor. “The capital side of the equation is still playing out as we anticipated so there will not be the same extent of yield compression as we saw last year. What we are seeing is rental growth, emerging as expected with the recovery underway, in a number of markets.” Paine sees the geo-political situation as one of the reasons London attracts so much overseas capital. “London is a global city that will attract investor flows. When there are uncertainties around you see more elevated levels of demand for what is one of the most liquid, transparent and low risk global markets. That has got a lot of appeal and makes it one of the most straightforward markets to deal in around the world.” But Paine is always looking for the right opportunity: “Many of our funds have UK wide mandates and have been moving out of London to the rest of the South East as well as regional centres around the country. So moving out of ‘core London’ has been a theme as we look to find value.” Standard Life is actively developing new stock and improving assets in regional centres and looking at a wide variety of asset types. The appeal of regional markets can be enhanced where infrastructure improvements are being realised, and he sees Reading as a good example. “Once infrastructure commitments are made, there is a degree of certainty that things are starting to unfold and happen. Investors will respond fairly rapidly once the plans begin to crystallise in order to try to unlock opportunities.”

UK Real Estate: Riding the Wave

One of the trends that has been a growing feature for real estate investors in the UK is “alternative real estate”. This now represents 12% of the money that Paine manages. “This trend is underpinned by more of an outcome focus amongst investors in real estate with an allocation used for different things.” An example would be where real estate investors have sought out inflation protection and long-term high quality income streams. “You can get that in traditional UK real estate but you can also get that in student accommodation, in healthcare, in hotels and other segments. This outcome focus has broadened the appetite for a wide range of real assets. Other examples would be a desire to preserve capital or focus on growth.” Paine also wants the new Government to make a decision on the ongoing London airport debate: “As I’ve already mentioned, infrastructure improvements can be major drivers of economic growth and investment will be attracted where there is greatest clarity. The Government, having evaluated the arguments, needs to take a decision which permits others to act.”

“ London is a global city that will attract investor flows. When there are uncertainties around you see more elevated levels of demand for what is one of the most liquid, transparent and low risk global markets.”

Inflows of capital

Soaring investment from Asia has dramatically altered perceptions of who will have the greatest appetite for UK real estate from overseas, compared with the poll we carried out in 2013. China’s Dalian Wanda, Japan’s Mitsui Fudosan and a plethora of other Singaporean, Malaysian and Indonesian investors are leading the way. Two years ago, Middle Eastern investors were seen as the likeliest source for new overseas property investment in the UK with the impact of the Arab Spring increasing the attractiveness of the UK as a safe haven. Those polled in this report appear to have doubts about the continuation of high levels of investment from the Middle East. The region was ranked top by 75% of respondents in our 2013 report but has dropped to just 40% this year. This is hardly surprising with the price of oil, its main source of income, falling sharply causing fiscal pressure on governments and casting doubt on sovereign wealth fund investment. That said, Middle East investors are still active in the market with, for example, Qatari buyers teaming up with Canadian investor Brookfield to buy Canary Wharf in the first half of 2015.

80% of respondents say that global investors will be more acquisitive in the UK market than domestic investors in the next 2 years.

Which two regions will increase investment in UK real estate in the next 2 years? Middle East 40% Asia 62% North America 40% Western Europe 14% Australia-Pacific 13% Latin America 5% Eastern Europe 6% Africa 5% Don’t know 10%

UK Real Estate: Riding the Wave

Dangerous waters

Terrorism, and conflict in the Middle East have both had a major impact on the property industry for recent generations: the fallout from the September 11 terrorist attack affected the market badly in 2001, and the very severe mid-1970s crash was triggered by conflict in the Middle East. These remain our respondentsâ&#x20AC;&#x2122; biggest geo-political concerns today by a significant margin. Meanwhile, tension between Russia and the West is at its highest since the Cold War. If Russian aggression spreads to the Baltic States there could be severe repercussions for real estate. Germany, for example, is heavily dependent on Russia as an export market, and if this causes an impact on Europeâ&#x20AC;&#x2122;s biggest economy the chill could spread across the continent.

Which of the following geo-political factors is most likely to affect your UK investment decisions? Terrorism 33%

17%

22%

17%

11%

Natural disasters 6%

12%

13%

28%

41%

Russian foreign policy 8%

20%

31%

23%

18%

Immigration 13%

15%

20%

26%

Escalating conflict in the Middle East 25%

20 Most likely

UK Real Estate: Riding the Wave

29%

22%

13%

11%

100 Least likely

Whilst immigration remains a hot topic politically, 72% of investors do not consider it is likely to have a major impact on their investment decisions.

Interview

David Partridge, Managing Partner, Argent

“ For everyone logistics is proving difficult to buy. In the current retail revolution, moving goods around is a very good business to be in.” In predicting that Australian and American investors will step up their involvement in UK real estate, Argent’s boss David Partridge is speaking from first-hand experience. Fund manager Australian Super agreed in March to take a 25% stake in Argent’s King’s Cross scheme, in its first London investment and only its second investment in the United Kingdom.

While partners like Australian Super and Related Companies focus their partnership with Argent on large-scale regeneration, mixed-use and the Private Rented Sector, Partridge himself is impressed by the potential in logistics.

Australian Super has joined the King’s Cross Central Limited Partnership alongside Argent itself, Hermes Investment Management, DHL and London & Continental Railways.

Argent is unlikely to take on the likes of SEGRO, ProLogis or Gazeley, but, asked which sectors are most promising, Partridge says: “For everyone logistics is proving difficult to buy. In the current retail revolution, moving goods around is a very good business to be in.”

Also in March, Argent announced that it had teamed up with American developer Related Companies to undertake UK development projects, targeting mixed-use and residential schemes with a focus on homes that are built-to-rent. Both Australian Super and Related Companies are attracted to a partnership with Argent after its stellar performance at King’s Cross, with the promise that it will be a world-class partner in large-scale, mixed-use development projects. Partridge says American investors have a deep appetite for UK property because there is a global trend for diversification, and because they are having to travel to achieve value for money outside the red hot United States market.

Having built in Birmingham and Manchester with Argent, Partridge is highly enthusiastic about Chancellor George Osborne’s “Northern Powerhouse” stretching across the north of England. “It will reinforce connectivity across those northern cities, giving the UK a much more regionalised offer. All the UK’s major cities need to demonstrate they have got real strength, depth and resilience, and ideas like this can only reinforce that perception.” He is less enthusiastic about Scotland, however, describing it as a “whole different proposition” where Argent would be unlikely to break into the local development scene successfully.

The same need for diversification arises with Australian equity investors looking to hedge their bets – and where better to head than for the UK, where Partridge is now “very optimistic”.

With Argent and London in such good health – Partridge puts the chances of a slowdown over the next two to five years as “low to medium” – he is wary of anything that will rock the boat.

“Getting the election out of the way made a huge difference to the real estate market,” he says. “First we had the Scottish independence referendum, then we had the election, but in the last 12 months the attraction of London has just grown. The weight of capital has increased.”

Now with a strong exposure to international investors who have bought into the idea of Britain as part of the European Union, Partridge says: “A lot of people investing in the UK see it as a stepping stone into Europe. If we exited the European Union they might think twice about buying an office building with a bank tenant here – because the bank may then move abroad.” UK Real Estate: Riding the Wave

Interview

Mark Titcomb, Head of London Representative Office, DekaBank As one of property’s leading bankers, Mark Titcomb was one of the first to see an upswing in UK commercial property after the great crash of 2008-2009. As a result the team at DekaBank lent hundreds of millions of pounds at healthy lending margins just as the sector was recovering. Having called the upturn correctly, what does Titcomb think are the chances of another downturn in the near future? He is ever wary of people who predict the end of boom and bust and a “new paradigm”. “There’s a high chance of a downturn within five years because history tells you that property cycles don’t go away, but for now I find myself surprisingly optimistic. “Investment decisions are in part made on the basis of `how do returns on property compare with the return on government bonds?’, and I can’t see property’s advantage over bonds changing significantly soon.

In the longer run he is expecting London and other cities with critical mass to become “polycentric”, with occupational demand distributed more broadly particularly in response to new infrastructure investment. There is plenty to play for as the niche markets of Oxford and Cambridge demonstrate growth as biotech and hi-tech centres and others will similarly also play to their strengths. For Titcomb, though, Scotland is not of much interest with the Scottish National Party dominant. The SNP appears to be overly critical of business “especially given that business growth is the driver of employment and the capacity to fund its manifesto”.

“Combining stronger occupational demand across the board with a relatively weak development response, we should not be surprised with the lower levels of vacancy we are now seeing; even for shopping centres – the picture is obviously much healthier.”

Titcomb is also wary of a British withdrawal from the European Union, arguing that until now the business community has been distracted by the twin challenges of Scottish independence and the General Election. “I cannot see a majority of people voting for greater unemployment and a balance of payments crisis though.

One reason for Titcomb’s relative optimism is that property lending has not run out of control this cycle, with loan rating measures like “slotting” putting pressure on banks to set more capital aside to give themselves a cushion against unexpected falls in value. This is helping restrict late cycle increases in LTV ratios.

“Now the business community needs to stand up and let people know what the negative impact of a British withdrawal will be,” he says. “It would undoubtedly be negative for the global city of London and the financial services industry in particular.”

As an expert who in the late 1980s and early 1990s saw first Japanese, then Swedish, Middle Eastern and German investors arrive in the UK, Titcomb now sees overseas interest as more consistent and “deeper”, with Taiwanese buyers the latest to arrive. While London is red hot, Titcomb and DekaBank are also assessing Birmingham’s potential due to the growing investment being made in the city centre, with New Street station undergoing a £550m overhaul which is due to complete this year. Logistics and dominant shopping centres also appeal – but over 75% of DekaBank’s UK lending commitments are in the capital with a concentration inevitably in large lot size offices underpinned by heavy replacement cost.

UK Real Estate: Riding the Wave

Titcomb now wants the new Conservative Government to press on with expanding Heathrow, and, like many, is sceptical over plans for a new airport in the Thames Estuary due to potential cost overruns. On the core real estate market, however, Titcomb is bullish, with the huge volume of equity heading towards London showing no sign of abating in the face of a narrower range of globally acceptable investable locations. “Asian money is becoming more dominant but it has not yet got to the stage of being unhealthy in scale and is conservatively geared in general. With UK GDP growth of 2% - 3% looking well set for several years to come, allocations to the UK are unlikely to dry up soon.”

The crest of the wave

With the General Election result widely welcomed by the real estate sector, fears of a downturn in the next two years have receded sharply. In 2014, 17% of those polled thought there was a high or very high chance of a downturn in the next two years: now this figure is just 3%. However, the five-year picture is very different with 42% saying the chances of a downturn is high or very high, nearly double the figure of the previous year. This is not surprising given most experts believe we are midway through the current property cycle. If real estate’s historic track record is anything to go by, a downturn or major correction at some point is inevitable.

From your perspective what is the risk of a UK real estate downturn in the following time periods? In the next 2 years 14%

23% 2% 1%

60%

In the next 5 years 1%

13%

44%

20 Very low

Low

40 Medium

33%

60 High

Very high

100

“ There’s a high chance of a downturn within five years because history tells you that property cycles don’t go away, but for now I find myself surprisingly optimistic.” Mark Titcomb, DekaBank

Rip currents

Although most of those polled are optimistic about prospects for UK real estate, there are some undercurrents which could affect the market. With our survey taking place after the General Election, the prospect of a British exit from the European Union has risen to the top of the agenda, closely followed by interest rate rises with many property companies and developers still heavily in debt. Whilst it may dominate the news, the prospect of a Greek exit from the European Union now seems to be factored into the calculations of most of those polled. Surprisingly, only one per cent said this is the issue most likely to destabilise the UK market.

Please rank the below on their likelihood to destabilise the UK property market Interest rate rises 47%

40%

9% 4%

British exit from the EU 49%

32%

13% 6%

Greek exit from the EU 1%

14%

37%

48%

Oil and gas price rises 4%

14%

41% 20

Most likely

UK Real Estate: Riding the Wave

41% 60

80 Least likely

100

â&#x20AC;&#x153; I am concerned about how interest rates will evolve in the coming years, about how quickly they will rise and the impact that they will have in the property markets.â&#x20AC;? Amal del Monaco, AXA Real Estate

When we asked our respondents what they felt was the greatest challenge facing the UK real estate industry, 66% said housing supply first ahead of infrastructure investment (60%.) The general consensus is that 200,000 homes a year need to be built to keep pace with population growth, but over the last five years the UK has managed barely half this figure. With major house builders tasked with supplying this market there is little hope that the total figure can be reached without a large-scale publicly-funded house-building programme.

Please rank the following factors in terms of the amount of influence they will have on the future of UK real estate. Housing supply 43%

23%

18%

10% 6%

Tax on business 25%

29%

20% 4%

22%

Infrastructure investment 27%

33%

30%

66% of respondents think housing supply is the greatest challenge facing the UK real estate industry, followed by infrastructure investment with 60%.

9% 1%

Talent pool 11%

15%

23%

Immigration policy 2% 5% 12%

30%

21%

28%

53%

Government cutbacks 5% 0

14%

15% 20

Greatest influence

26% 40

40% 80

100 Least influence

UK Real Estate: Riding the Wave

Interview

Amal del Monaco, Senior Fund Manager, AXA Real Estate

Is the UK real estate market overheated? “To me everything looks expensive!” Having worked in the real estate industry for 18 years Amal del Monaco would know, “especially when compared to what we know or have known in the past, because in absolute terms the prices we are reaching this year are almost unknown to us. This is affecting all the markets and almost all of the segments.” However, she quickly qualifies this assessment, saying “having said that, in relative terms I do believe that the property market remains attractive to other asset classes. However, like a number of investors, I am concerned about how interest rates will evolve in the coming years, about how quickly they will rise and the impact that they will have in the property markets. So, I might say that I am still positive but cautious.”

With international investment into UK real estate still being dominated by Middle East, Asia and Western European money, del Monaco presumes a new dominant player will emerge. “I would expect North America to be back strongly this year, because the currency exchange will help - I think that is their main driver. Also, they will be attracted by the positive outlook that you have in the UK - it is probably the best performing country in the European Union.”

Del Monaco does, though, still see value in the market if you look outside the mainstream. “Most investors are doing the same as us. Not that they are copying us, but they also feel that offices cannot be the only or main asset class to invest in. And they are also taking into account demographic trends and all the other key factors that affect the property market.”

So why does the UK remain the home of choice for all this foreign capital? “For me the investment case for the UK is the legal framework, and the availability of market data, which is not the case in all countries, and for London in particular the availability of a talented workforce. The UK market is largely seen as the most transparent in Europe and this is key for newcomers.”

The alternative options to watch she names as hotels and student housing but believes that “data centres and healthcare will have a key role from now on in the property market. They will become mainstream assets at some point in time.” As a global investor AXA Real Estate mainly focuses on large cities with strong fundamentals related to a strong labour force working in a wide range of activities and services. “And which of course benefit from high liquidity which is essential for us.” That said, she believes there are other opportunities. “If you look at shopping centres, logistics or healthcare, we would be looking at other cities rather than London. From what I have seen, Bristol and Manchester would be the most attractive cities outside of London.”

UK Real Estate: Riding the Wave

“ I would expect North America to be back strongly this year… they will be attracted by the positive outlook that you have in the UK - it is probably the best performing country in the European Union.”

Storms brewing over Europe

Britain’s exit from the European Union is considered negatively by 64% of respondents. For most, doubts focus on the short-term disruption of a break with Europe, combined with the signal that this would send to international occupiers. Standard & Poor’s has now added to concerns by threatening to downgrade the UK’s credit rating due to uncertainty created by the forthcoming EU referendum.

What impact will a UK exit from the European Union have on UK real estate?

64% think an exit from the EU will be bad for UK real estate.

Good 3% Neutral 33% Bad 64% 0

100

Most of those interviewed are sceptical that Britain will exit the European Union, and as a result do not see the need to delay investment decisions ahead of a referendum. By contrast in 2014, the chances of a Scottish exit from the UK seemed very real and resulted in a marked slowdown of Scottish transactions in anticipation of the vote.

Will you delay investment decisions ahead of a forthcoming referendum on the UK’s membership of the European Union? Yes 28%

“ The business community needs to stand up and let people know what the negative impact of a British withdrawal will be.” Mark Titcomb, DekaBank

72%

Just as the Scottish Referendum race became closer over time, there is a chance that the campaign for Britain to leave the European Union will gather momentum as the vote nears, which could lead to a slowdown in activity.

UK Real Estate: Riding the Wave

Scottish drift

Coming just before the Scottish referendum, our 2014 Report found strong opposition to independence, with 81% saying they would be less likely to invest in an independent Scotland. Despite independence no longer being an issue in the short-term, the spectacular rise of the Scottish National Party (SNP) at the General Election has brought some disquiet amongst investors. This is not surprising given the pre-election concerns levelled at some of the SNP’s land reform proposals. An overwhelming 65% said they are less likely to invest in real estate in Scotland as a result of the rise of the SNP. With some commentators predicting a Conservative Government could remain in place until 2025, there is a view that the national Government’s policies will diverge from the Scottish Government’s. This could lead investors to see England, Wales and Northern Ireland as being led by a right-of-centre government, while a Scotland ruled by a more powerful SNP moves sharply to the left. Investors appear worried that Scotland may become too different in its political and legal framework from the rest of the United Kingdom.

How does the rise of the Scottish National Party affect your likelihood of investing in real estate in Scotland? More likely 3% No change 32% Less likely 65% 0

100

“ Scotland must not make itself appear too different as an investment destination.” Bill Hughes, Legal & General

65% said they are less likely to invest in real estate in an SNP dominated Scotland.

Interview

Ross Blair, Senior Managing Director, Hines

With $85bn under management, global property company Hines is one of the biggest players on the world stage, with assets stretching from the USA to Asia, Western Europe, South America and Eastern Europe. In the UK it has also become a formidable player, with assets in London complemented in the last year by a major push into Scotland, including a large shopping centre in Livingston acquired on behalf of HSBC Alternative Investments Ltd where it will act as asset manager.

Blair says: “A British exit from the European Union would be bad for us, even though I think the chances of that happening are close to zero. For an office market like the City of London, an EU exit would create nervousness and slow down take-up.

Hines has already bought in Birmingham, which Blair names alongside Manchester as one of its cities outside London to watch. “Birmingham’s proximity to London helps. It is a bustling city centre but also quite a tight office market. High Speed 2 is good news, but it’s not what’s driving us to Birmingham now.

“When there are many cheaper capital cities than London to locate your European headquarters, would big companies remain committed if we were to exit the European Union?”

“Manchester has a buzzing, thriving city centre that’s a fun place to be. It has more scale than Bristol or Leeds, and having that liquidity in the market helps when you are a global investor.” Blair is currently cautious about London, believing some parts of the capital to be over-valued, with the risk of a property bubble being created in fringe areas like Shoreditch and North Farringdon where tenant demand might not match developers’ aspirations. While Hines is best known as an office-focused investor around the world, it is also seriously exploring the student accommodation sector in the UK, where Blair believes demographics and a lack of supply all support the argument that rents will continue to rise annually. Among office occupiers he names professional services as the sector likely to lead tenant demand. This is based on increased regulation keeping accountants, lawyers and other advisers busy as legislation stemming from the last financial crisis is gradually introduced. With its global perspective Hines is also well placed to observe international trends, and Blair believes that the biggest inflows of capital into the UK will over the next two to five years come from Asia. However, like many other executives he is nervous about the impact on the UK market of a possible British exit from the European Union.

UK Real Estate: Riding the Wave

On the subject of airport expansion, Blair is a fan of Gatwick. His view is that expanding Heathrow will only lead to a need for a further runway in another 30 years, and that Gatwick is “the best of all worlds” as it has scope for growth and would offer increased competition. And on devolution to the UK’s big cities he is a fan of the idea, but strong leadership is needed, as is the case in Manchester and Birmingham, which have created the framework for Hines to make big investments in these cities. Strong leadership is crucial as devolving power to weak leaders who will “only make decisions by committee” could hold cities back, he says.

Local squalls

With increasing awareness of High Speed 2, Manchester and Birmingham have gained in appeal over the last 12 months. In our 2014 survey, asked to pick two from the “Big Six” regional cities which they saw as the most appealing investment prospect, 73% named Manchester and 42% named Birmingham. This year, 79% named Manchester as one of their top two cities to watch followed by Birmingham (risen to 52%). Doubts about Scotland’s future within the United Kingdom and the rise of the SNP continue to impact perceptions of the Scottish cities as investment locations, particularly Edinburgh which is favoured by just 15% of respondents, down from 23% last year.

Of the “Big Six” regional cities listed below, which two are most appealing as investment prospects? 79

80 70

Per cent

What is your “City or Town to Watch” outside of the “Big Six” cities? Cambridge Reading Liverpool Newcastle Oxford Sheffield

50 40 30 22 20

17 15 9

10 0 Birmingham

Bristol

Edinburgh

Glasgow

Leeds

Manchester

The top six “cities or towns to watch” are Cambridge, Reading, Liverpool, Newcastle, Oxford and Sheffield. The collapse in the oil price has had a dramatic impact on investors’ perceptions of Aberdeen. Having been the top “city or town to watch” outside the “Big Six” in the 2014 report, it fell out of the top six to watch this year, with the tech boom helping to lift perceptions of the intellectual powerhouses of Cambridge and Oxford.

Tidal pulls North

Chancellor George Osborne’s Northern Powerhouse initiative – boosting a corridor from Liverpool to Newcastle through improved transport links among other measures – gets a ringing endorsement from the real estate sector.

“ All the UK’s major cities need to demonstrate they have got real strength, depth and resilience.”

What impact will the Government’s Northern Powerhouse initiative have on real estate markets in the North? 80 70

David Partridge, Argent

Per cent

60 50 40 30 20

10 0 Very positive

Slightly positive

No impact

Slightly negative

Very negative

Northern England is now seen as particularly promising for residential development and investment. Apache Capital has this year funded a £1bn programme by developer MODA Living for new rented apartments across Manchester, Leeds and Liverpool. Offices and logistics and distribution are seen as having potential, but retail is still challenging in line with the wider UK market, mentioned on page 10. Whilst a decision on the Capital’s airport awaits the Government’s reaction to the Davies Commission, Manchester is investing £1bn in its airport facilities over the next decade. This will maximise its potential as a global gateway to the Northern Powerhouse and allow it to compete with London. Whilst the general concept of devolution is considered positive by 74% of our respondents, on probing some of our interviewees were more cautious. They are impressed by the strides made by the likes of Sheffield and Manchester City Councils. However, they also believe that for every best-in-class devolved city, there may be a less ambitious and less pro-development council which, given greater powers, could act as an impediment to the real estate sector.

What effect do you think the Government’s proposed devolution of more powers to major UK cities would have on the UK real estate market? Very positive 12% Slightly positive 62% No impact 13% Slightly negative 9% Very negative 0% Don’t know 4% 0

Interview

Stephen Down, Head of Central London and International Investment, Savills Savills was founded in London in 1855, so if anyone knows the investment market it is their Head of Central London and International Investment, Stephen Down. “London is the destination of choice globally for the majority of international capital that is flowing around the world,” he says. He also cites New York as a competitor for that money and parts of Europe – France and Germany in particular. “However, London is where the majority of global investment flow is currently coming to and will continue for the foreseeable future.” Down manages a team of three dozen professionals and so “has a very good feel for where the international appetite is for London at any one time because we have these people go around the world on a monthly basis”. He has also seen the investors change, “compared to this time last year there is more interest from Asia and there is as much interest still, if not more so, from North America.” Interestingly, he has seen a change in who the investors are from the Middle East, “it is not just the Qataris, it’s the whole of the UAE and all the other countries in the region.” So with all these new investors and vast sums of international money targeting London, has it become overpriced and difficult to make money in? “There are pockets that look expensive,” but he puts this in context of a low interest rate environment globally. Prime real estate yields are being priced against a low bond rate benchmark and if you price in rental growth it is little

“ Devolution is a good idea. I think that people work better within localised and identifiable communities.”

wonder that we are seeing yields on some product at very low levels indeed. “I think the general consensus is that interest rates will remain relatively low compared with other cycles for a while and therefore, excluding any ‘Black Swan’ event, I don’t see any reason why that trend of lower yields will reverse for the time being. “Some investors, particularly the Chinese institutions, are struggling to get to the very low yields on the core stock; their preferred initial yield is closer to 5% than 4.5% for stock. The most aggressive institutional buyers from abroad at the moment are the Taiwanese insurance companies. The recent purchase of the Walbrook Building in the City by Cathay Life of Taiwan was close to 4.0% at approximately £575m.” The new Conservative Government has already made noises about devolving more power to the regions. “Devolution is a good idea. I think that people work better within localised and identifiable communities.” And on the Northern Powerhouse initiative, “this is a route that we have to go down. We have to make sure that what is happening in London is spreading out far more quickly into the regions. There is a need for infrastructure improvements - connectivity between cities is important.” And here he believes we should take a lesson from Germany and the superb links by rail, road and air they have connecting their regional centres. Down doesn’t believe that London’s bubble is about to burst. “At the macro level, for investors, I cannot see anything that is going to change. I don’t see interest rates rising significantly, they cannot rise globally because the world is so indebted. I think that even looking beyond the next five to ten years. “I think that it is only geo-political factors that might shake confidence. The UK is seen as a straightforward place to trade with limited transactional costs and it is open for global business.”

UK Real Estate: Riding the Wave

Surf lessons Top 3 reasons to invest in the UK

Legal framework It is pleasing to see the legal framework topping the table of reasons to invest in the UK. Our report shows that we are in a fast paced market and investors should be ready to move quickly to capitalise on this. Nabarro led a working party of industry experts which published the Investment Property Forum’s Readiness for Sale Guide. It’s a useful summary of how to get the legal issues right up front, something we urge investors on the buy or sell side to do if they are to take full advantage of the dynamic opportunities available to them in the real estate market.

Clare Thomas

+ Legal framework + Tax regime + UK as the “gateway” to Europe

Real Estate Partner T +44 (0)20 7524 6906 c.thomas@nabarro.com

“ For me the investment case for the UK is the legal framework, and the availability of market data, which is not the case in all countries.” Amal Del Monaco, AXA Real Estate

Top 3 deterrents for investing in the UK

– Planning laws – Infrastructure investment – Tax regime

Tax It’s interesting that tax is seen by our respondents as both an incentive and a deterrent to investors. In fact, compared to a lot of jurisdictions, the UK has quite an attractive tax regime for both UK and overseas real estate investors. There is generally no UK tax on capital gains for non-UK resident investors buying property in the UK. Rental income is subject to tax at 20% for both UK and non-UK investors, although this can be reduced by the use of debt (particularly effective for offshore investors) and capital allowances. UK investors are subject to tax on capital gains at a rate of 20%, however certain investors can benefit from an exemption under the REIT regime. Stamp Duty Land Tax (SDLT) at 4% is often seen as a deterrent to investing in UK real estate, but despite the increase in anti-avoidance legislation it is still often possible to reduce SDLT on real estate transactions by the use of corporate structures.

Kirsten Prichard Jones

Tax Partner T +44 (0)20 7524 6581 k.prichardjones@nabarro.com

“ We have to make sure that what is happening in London is spreading out far more quickly into the regions. There is a need for infrastructure improvements - connectivity between cities is important.”

Planning The planning system is complex, but also fair and consistent. The Government has recognised that developers in London, like in the rest of the UK, grapple with one of the most complex development consenting regimes in the world. The Government has responded to this both at national and London Plan level with a programme to reduce red tape for developers and asset managers and to free up more development without the need for permission, for example by expanding permitted development rights (office to residential and retail to leisure). In the absence of a third party right of appeal, judicial review remains the key threat to development consents. However the new planning court presides over a judicial review system that still makes it relatively difficult to successfully challenge the grant of a robust permission. Overall the perception might be that the system favours those who know it well and are well-advised.

Josh Risso-Gill

Stephen Down, Savills

“ Once infrastructure commitments are made, there is a degree of certainty that things are starting to unfold and happen. Investors will respond fairly rapidly once the plans begin to crystallise in order to try to unlock opportunities.” David Paine, Standard Life

Planning Partner T +44 (0)20 7524 6124 j.risso-gill@nabarro.com

Infrastructure The National Infrastructure Plan 2014 stated that the UK has an infrastructure pipeline of £466bn of infrastructure projects. While this should be encouraging, many investors are of the view that the UK Government is not doing enough to prioritise investment in infrastructure. Lengthy and complex procurement processes, cancelled projects, burdensome regulatory frameworks and a perceived lack of clear political support and direction have eroded investors’ confidence in the UK’s ability to deliver infrastructure in an efficient and cost effective manner. REPORT

Nabarro Infrastructure Index Attracting investment

The Nabarro Infrastructure Index, which rates the levels of infrastructure across a number of different countries, reported that the UK only spends 6% of its GDP on infrastructure. This compares to 12% by top spender Qatar. Going forward, the UK Government needs to ensure that there is a clear pipeline of infrastructure projects which attracts investors and gives them confidence that the projects will be delivered.

James Snape

Infrastructure Partner T +44 (0)20 7524 6804 j.snape@nabarro.com

“UK Real Estate: Riding the Wave” is the third instalment in Nabarro’s thought leadership series. To receive copies of the first two reports, please email info@nabarro.com.

About Nabarro

About FTI

We are an international law firm renowned for our positive and practical approach to our clients’ business needs. Our commercial real estate group has a stellar reputation for advising on the largest and most complex UK and European real estate transactions and investments for some of the world’s most significant investors, developers, funders, occupiers and advisers. Our team consists of more than 200 real estate lawyers, well known for being specialists across the whole real estate life cycle, from acquisition, financing, planning to development, asset management and sale. Our market leading teams also specialise in funds and indirect real estate, environment, construction, litigation and tax.

FTI Consulting is a global business advisory firm that provides multidisciplinary solutions to complex challenges and opportunities.

Our real estate practice is Tier 1 in Legal 500 and was awarded “Real Estate Team of the Year” by the directory. The firm’s headquarters are in central London with offices also in Sheffield, Manchester, Brussels, Dubai and Singapore. For cross-border work we draw on longstanding relationships with a network of selected firms worldwide and via the Broadlaw Group which comprises GSK Stockmann + Kollegen in Germany, Lefèvre Pelletier & associés in France, Nunziante Magrone in Italy and Roca Junyent in Spain, which combined is more than 1,000 lawyers. In 2014 Nabarro was voted “European Law Firm of the Year - Transactions” in the Private Equity Real Estate Awards. More information can be found at www.nabarro.com.

We are advisers to 64 of the world’s 100 largest companies, 89 of the world’s top 100 law firms and 9 of the world’s top 10 bank holding companies. With more than 3,800 professionals located in most major business centres in the world, we work closely with clients every day to address complex business challenges in areas such as business strategy, litigation, M&A, policy and regulatory issues, reputation management and restructuring. Property and infrastructure capabilities at FTI Consulting includes over 400 professionals who are committed to protecting the enterprise value of our clients. We deploy experts from every major financial centre to every corner of the globe so that we can serve our clients wherever challenges arise. www.fticonsulting.com @FTI_EMEA

Nabarro offices London 125 London Wall London EC2Y 5AL T +44 (0)20 7524 6000 Sheffield 1 South Quay Victoria Quays Sheffield S2 5SY T +44 (0)114 279 4000 Manchester 1 The Avenue Spinningfields Manchester M3 3AP T +44 (0)161 393 4700 Brussels 209A Avenue Louise 1050 Brussels Belgium T +32 2 626 0740 Singapore Marina Bay Financial Centre Tower 3 12 Marina Boulevard 35-01 Singapore 018982 T +65 6645 3280 Dubai Office 105 Level 1 Tower 2 Al Fattan Currency House DIFC PO Box 506873 Dubai United Arab Emirates T +971 4302 6000 You can find out more about us at: www.nabarro.com Twitter: @nabarro LinkedIn: nabarro-llp MEMBER OF

Over 1,000 lawyers | 27 cities Europe, Asia, Middle East, North Africa www.broadlawgroup.com

Nabarro LLP Registered office: 125 London Wall London EC2Y 5AL. Nabarro LLP is a limited liability partnership registered in England and Wales (registered number OC334031). It is a law firm authorised and regulated by the Solicitors Regulation Authority. A list of members of Nabarro LLP and of the non-members who are designated as partners is open to inspection at the registered office. The term partner is used to refer to a member of Nabarro LLP or to an employee or consultant with equivalent standing and qualifications in one of Nabarro LLPâ&#x20AC;&#x2122;s affiliated undertakings. Detailed specialist advice should be obtained before taking or refraining from any action as a result of the comments made in this publication, which are only intended as a brief introduction to the particular subject. This information is correct on the date of publication. ÂŠ Nabarro LLP 2015

Protection against inflation for your investments THE CASTEL UK RESIDENTIAL PROPERTY FUND

Castel is a specialist fund investing in UK residential property. It provides investors accessible exposure to this historically attractive asset class; delivering the benefit of future long-term capital gains combined with a secure, inflation-protected income. The unique investment strategy of the fund is to purchase quality, freehold, residential properties in desirable postcodes, leased into the supported accommodation sector through an established charity. Visit our website at: www.castelfund.com for all you need to know. Or call us on: +44 (0)1624 647097

CASTEL FUND: Knox House, 16-18 Finch Road, Douglas, Isle of Man IM1 2PT. Tel: +44 (0)1624 647097 Email: info@castelfund.com www.castelfund.com The Castel Residential Property Fund is a Dedicated Fund of KMG SICAV – SIF (the “Company” or the “Fund”), a Luxembourg-registered “Société d’Investissement à Capital Variable” authorised and regulated by the Luxembourg regulator, the Commission de Surveillance du Secteur Financier (“CSSF”), governed by the Law of 13th February 2007 and qualifies as an Alternative Investment Fund (“AIF”) of the specialised investment funds type, managed by KMG Capital Markets Ltd (“KMG”), an external Alternative Investment Fund Manager (“AIFM”), established in the Republic of Cyprus, in accordance with Chapter II of Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers (“AIFMD”) and regulated by the Cyprus Securities and Exchange Commission (‘CySEC’). By accessing this information you shall be deemed to accept and agree to be bound by the terms of this notice. This communication is directed only at institutional investors, professional investors and other well-informed investors. It should not be distributed to, or relied on by, any other investors. The Fund cannot be promoted to investors for whom it has not been deemed appropriate. If you do not fall into these categories do not read this document. The information contained herein is confidential and is intended only for the persons to whom it is transmitted by the company or authorised distributors. Any reproduction of this document in whole or in part, or the divulgence of any of its contents, without the prior written consent of the Fund or the AIFM, is prohibited. Any information that is specified in article 23(1) of the AIFMD, will be delivered by the AIFM to potential investors upon request, before they invest in the Dedicated Fund. This information is not directed at you if we are prohibited by any law of any jurisdiction from making the information in this document available to you and is not intended for any use that would be contrary to local law and/or regulation. This document and its contents are only intended to provide general information about The Castel Residential Property Fund to “well-informed, institutional/professional” investors as specified in Directive 2011/61/EU of the European Parliament (“AIFMD”). Neither we nor any third parties provide warranty or guarantee as to the completeness, timelines, or adequacy of the information provided herewith. Past performance of any investment is not always indicative of future perfor-mance and investments are subject to many risk factors. The value of The Castel Residential Property Fund and its share classes are calculated without taking into account any placement or redemption fees and assuming constant reinvestments of dividends. The use of any information or materials in this document is entirely at your own risk, for which we expressly exclude liability to the fullest extent permitted by law. It shall be your own responsibility to ensure that any products, services or information available through this document meet your specific requirements. Nothing in this document should be regarded as an offer or solicitation to conduct investment business or buy or sell any investment products, nor does it constitute any form of personal recommendation. This document does not constitute legal advice and is merely intended to raise awareness of issues relating to The Castel Residential Property Fund. We shall not incur liability of any kind should this document be used as a basis for responding to legal questions.

LA F OR U M The case for Residential Investment

LA Forum 2 Statham Court Statham Street Macclesfield Cheshire SK11 6XN Telephone 01260 226 610 Mobile 07429 652 970 Email enquiries@laforum.co.uk ÂŠ Copyright 2015 LA Forum All rights reserved LA Forum is a division of EduPensions Ltd Company Number: 8974277 Detailed specialist advice should be obtained before taking or refraining from any action as a result of the comments made in this publication, which are only intended as a brief introduction to the particular subject. This information is correct on the date of publication.