Miria Whittle, manager at EY, looks at how insurers can enter the build-to-rent market, what are the risk they should consider, the returns they should expect and most importantly why it is in an asset class that won’t go unnoticed for long.
Low interest on savings and inflated house prices have meant that many in the UK have been unable to climb onto the property ladder. According to the 2016-2017 English housing survey headline report, a fifth of the UK population are now living in private rental accommodation, leading to the nickname ‘generation rent’.
The build-to-rent (BTR) market aims to increase choice and standards for those in rented accommodation. BTR presents an interesting opportunity for insurers who will be vital to fund the 111,000 BTR units that are currently in planning or under construction in the UK. BTR has the potential to provide an asset with a favourable yield, a long-term income stream, with significant collateral backing and well diversified credit risk.
Whilst notable progress has been made in BTR finance in the last few years, the market is still in a relatively early stage in its development. A number of banks and institutional investors have made their debut in the sector. However, it is likely that some of the key longer-term investors have yet to make their first move. To date, investors have found BTR debt challenging to price due to a lack of track record operational data and as a result, the institutional debt market has yet to gain momentum. Investors that are able to get comfortable with the lack of data may be rewarded by higher risk-adjusted returns.
What is BTR?
As it says on the tin, the term BTR is used to describe rental accommodation that has been built (or converted) specifically to rent. The rental block or housing development typically has 50 or more units, owned by a single owner and is operated as a business, by a professional management company. Any investor considering investing in BTR, should therefore consider the opportunity on the merits of the business as well as the value of the physical development.
The business makes profits from rental income in excess of operating and financing costs. High tenant turnover and long vacancy periods reduce income, therefore BTR developments are designed to attract and retain tenants. BTR operators look to attract tenants by offering facilities such as a gym or cinema and retain tenants by offering a customer-focused service and running the development in a way that encourages tenants to build networks and establish roots (for example offering social clubs or having a communal roof terrace). BTR developments are also designed to be operationally and cost efficient. For example, units often have features such as rubbish shoots and are clustered in a single location, making them easier to clean and maintain.
Investment models
BTR caters for a wide variety of investment models. Investors can opt for an equity or debt holding and can take an exposure to the construction and/or operational phase.
Equity - Investors can gain an equity exposure directly, via funds or by purchasing shares of a listed Real Estate Investment Trust (REIT) such as the PRS REIT.
Development phase finance - Investors can choose to invest through the development and operational cycle. Under this model they provide upfront funding to cover the costs of the site, the construction and initial operational costs. In return they receive an income stream that typically starts once the development is operational and return of capital (at eventual sale).
Forward funding - Investors can take a capped exposure to the construction phase through a forward funding arrangement. Typically, the investor pays for the build up to a set amount and commits to buying the development at an agreed price, once it has reached a critical stage.
Take-out funding - those investors less familiar with construction phase risks can opt to provide take-out funding whereby, they only provide funding once the build is passed a critical phase (allowing the developer to ‘take out’ its initial capital).
In general, the earlier in the development cycle an investor invests, the higher the potential for returns, but the larger the risk.
Investor appetite
Insurers may wish to hold BTR debt as part of their annuity portfolio. Annuities offer policy-holders a guaranteed, long-term income stream which is often inflation-linked. To back annuities, insurers typically look for assets with a long-term, stable income stream, that are likely to receive a favourable capital treatment. Operational-phase debt has the potential to meet these requirements, however insurers will need to overcome challenges around liquidity, valuation and capital treatment. In addition, insurers may opt to hold BTR debt or equity in their Shareholder funds but this will depend on the insurer’s risk/return appetite.
Investor rewards
BTR has the potential to provide an asset with a favourable yield, a long-term income stream, significant collateral backing and well diversified credit risk.
Net initial yields on BTR deals averaged 4.3% from 2015 to 2017, according to Savills Operational Capital Markets. Over this period, 18,500 units with an aggregate value of £4.1bn ($4.9bn) changed hands. Two thirds were forward funding deals and the remaining were standing stock. Whilst the initial yield may give investors a sense of the income return available, that is only part of the picture. Savills’ research found that over the last 15 years capital growth has contributed a further 5.2% p.a. to total returns on UK BTR assets (however this is based on relatively small portfolio of existing assets).
What are the risks?
Risk exposures can be separated into 4 main buckets:
- Construction risk - The construction phase considers the design and the physical build. It is capital intensive, subject to regulatory risk and can suffer from time and cost overruns. Whilst planning permission is also a major factor, the majority of funding agreements are implemented once planning permission has been granted.
- Tenant demand – Macroeconomic and demographic risks impacting the rental market as a whole. For example, the impact of changes in house prices, population growth, wages, government initiatives for first time buyers etc.
- Property and location risks – Risks specific to the property, both in terms of its value and desirability for tenants. For example, what if the location of the property becomes less desirable or the facilities outdated?
- Operational management – Risks relating to the ability of the operator, including reputational risk and the ability to maintain a high utilisation rate whilst minimising costs.
How is the BTR market likely to evolve?
BTR is similar in many ways to Purpose-built Student Accommodation (PBSA). For example: they both consider large residential developments, that aggregate a number of individual units; the buildings are designed to specifically to rent; the assets involve a construction and an operational phase; and the developments are operated as a business where the primary objective is to maximise occupation and retain tenants (albeit student accommodation is occupied during term time only).
The UK PBSA market is comparatively more mature than the UK BTR sector, with a proven track record and according to Knight Frank a total market value of c. £48bn. Looking at the evolution of the PBSA market, may give us insight into how the BTR market will evolve.
The development of the PBSA can broadly be broken down into four phases:
Today, the UK BTR market can be considered to be in the Growth Phase. The purchase and conversion of the London Olympic site, East Village, in 2011 was widely considered to be the birth of BTR in the UK. In the following years a number of institutional investors made their debut sector, largely in an equity capacity.
Today the majority of developments are still under construction and the availability of institutional debt is limited. According to the British Property Federation, as at Q2 2019, there are c.32,000 completed BTR units in the UK and a further c.111,000 either in planning or under construction.
As the BTR market matures and more operational data becomes available, long-term investors are likely be enticed by the opportunity to receive a long-term stable income stream, collateralised on a significant tangible asset.
For insurer investors, BTR provides an interesting opportunity both in terms of meeting investment objectives and its social contribution. Whilst a number of institutional investors have contributed to BTR to date, the investor profile is likely to significantly evolve over the next few years as the sector builds up a tangible track record and the BTR debt market matures.
Longer-term institutional investors will continue to monitor the risk-reward trade off. First-movers that are able to get comfortable with the lack of operational data may be rewarded by higher risk-adjusted returns.
Miria Whittle is a manager in EY’s EMEIA insurance - risk and actuarial services team. She authored EY Investment Advisory’s latest thought leadership paper on BTR, on which this article is based.