Institutional investors in the UK and other developed markets are finally beginning to wake up to a truth that their counterparts in US, Germany and the Netherlands have long known: residential property is an attractive source of income that complements commercial property beautifully.
The bedrock of the appeal of residential is the shortfall of homes across most of Europe. Even if populations stay stable, there is already huge under-supply as a result of low development and this is exaggerated by the total number of homes required is growing, because the number of households is increasing: people are more likely to live alone and less likely have large families. In Germany, for example, the population has increased by only 12% since 1961, but the number of households has risen by 110%. Housing supply is notoriously unresponsive to changes in demand – certainly much less so than commercial property. Because of planning restrictions, particularly in countries in Europe with a strong tradition of preserving green open spaces, residential does not work like a free market. This supply constraint buoys rental incomes and, indeed, values.
Residential has another attractive characteristic that commercial property does not: people still want as much space as ever, as notions of an acceptable standard of living continue to rise in line with income growth. In commercial property, by contrast, space is being trimmed in an effort to cut costs – every square foot counts. The growth in the number of people working either entirely or partly at home has prompted companies to cut office space. In retail, the growth in online sales makes it harder to justify sprawling stores: the dogma of keeping sales per square foot high still rules.
Given these trends, it is not surprising that residential has outpaced prime office rental growth for decades in most European countries, with a particularly striking gap between the two in the UK, Italy and Denmark. In the UK office rents have almost halved, in real terms, since the 1980s, while housing rents have advanced merrily upwards – buoyed by rising house prices, which have forced even quite affluent younger people to rent rather than buy. Rents are also less volatile: commercial rents rise and fall strongly depending on economic conditions, but residential rents in Europe tend not to collapse because the need for space to live is as inescapable as death and taxes. What is more, the supply constraint gives few alternatives to the residents’ needs.
Potential investors in residential property still need, however, to have one question answered: it’s all very well saying that rental growth is strong and stable, but does this count for anything if investors cannot keep the fruits of this rent? Investors have shied away from the sector largely because of a fear that even if gross rental income is high, net rental income is too low. They worry about the cost of managing a large number of small properties, some of which have high maintenance costs because they are old.
They worry too much. Humanity has bred domestic animals to meet its needs – creating horses, over the millennia, with the power first to pull chariots, and then to carry heavily armoured warriors. In the same way, institutional investors have finally created housing property designed to meet their needs: large apartment blocks in urban locations with low maintenance costs, specifically for renters – reliable tenants who pay their rent on time and keep the property in good condition. These blocks typically have specialist management onsite, which allows the investor to keep a close watch on matters and respond to any needs quickly.
Investors worry, too, about the difficulty of keeping vacancy levels low in residential properties, because it might be hard to judge what the right rental level is. However, an experienced investor can manage levels downward. In 2015 we acquired a greatly under-rented property which a bank had repossessed on Stratford High Street, close to the Olympic site in London. By decreasing vacancies we increased the rent roll from £2.7 million to £3.6 million.
The large size of our operations makes this kind of achievement easier for us: because we have thousands of rental units in major European cities, and monitor the live letting data for them, we can closely refine asking rents to ensure that we price them appropriately. While of course we favour high rents, ultimately we want our customers to stay; we see huge operational efficiencies in treating them fairly and keeping them. Tenants who stay longer result in less loss of income. For example, in the UK market standards suggest an owner loses on average a quarter to a third of income to management costs. While our experience in Germany is that we lose roughly half that erosion.
We don’t mean to suggest that residential property is necessarily better than commercial. Net yields in commercial property are, still, often higher than in residential. In any case, there is not yet enough suitable residential property to fill institutional investors’ desired property allocations. However, as an investment, residential behaves differently from commercial, providing welcome stability at times when commercial property is in crisis. It is also enjoying progressive gains in attractiveness, relative to commercial.
The income from residential property is resilient and long, underpinned by huge supply shortfalls and management efficiencies will further improve the position. Residential is firmly knocking at the door of institutional investors. It can’t be ignored for much longer.
Head of Global Property Research and Strategy, Aberdeen
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