Government is keen to build more houses, meeting huge demand. Charlotte Moore examines how local pension investment can help
The benefits of investing in commercial property, such as offices and retail warehouse, are well understood by the Local Government Pension Scheme (LGPS). These assets offer a long-term inflation-linked income stream which is a good match for benefits paid to their members.
Residential property shares the same investment characteristics, also offering long-term inflation-linked income. And its supply and demand dynamics actually make it more attractive than its commercial counterpart.
Paddy Dowdall, assistant executive director at the Northern Pool, says: “The lack of housing in the UK adds to the appeal to an investor.” By 2020, there will be shortfall of almost one million homes.
While residential property delivers the right type of cash flows, its performance is less correlated with other property asset classes, says Dean Heaney, head of government and strategic institutions at Invesco, an investment management firm.
Yet until recently this was not a market for institutional investors. “The UK residential market is highly fragmented and dominated by individuals holding one to two properties,” Mr Dowdall says.
Finding the right number of properties to match the scale needed by the LGPS would have required buying lots of individual properties. Many of these would then need considerable spending, because they are not well maintained. It was not a viable investment.
Enter institutional investors
In recent years, the advent of ‘build-to-rent’ properties made investing in residential property feasible. Rather than buy sub-standard flats and houses, institutions have purpose-built blocks of flats with the aim of renting and managing them long term.
The impetus for this shake-up in the private rental market was largely driven by the huge demand for high-quality, affordable homes, but government policies also helped to make ‘buy-to-let’ less appealing to individuals.
From April 2016, the government increased the stamp duty surcharge for ‘additional properties’ by three percentage points. The removal of tax relief on mortgage interest for higher-rate taxpayers introduced in April 2017 should further dampen appetite for these assets.
Richard Tomlinson, head of investment strategy at Local Pensions Partnership (LPP), says: “These changes make ‘buy-to-let’ uneconomic for the private investor. Costs are high, yields are low and profits are more highly taxed.”
Improving locals’ lives
For the Northern Pool, providing this type of regional investment is ordinary. Mr Dowdall says: “Greater Manchester has been providing these types of assets for more than 25 years.”
This type of investment kills two birds with one stone. “We aim to make a positive impact on local residents while generating a return which is in excess of the discount rate of the pension fund at an acceptable level of risk,” says Mr Dowdall.
Local authorities can improve the lives of their residents, by providing higher quality maintenance and better services, he adds.
Mr Tomlinson agrees: “There is always pressure on the LGPS for issues which affect constituents, and housing is a key concern.”
We aim to make a positive impact on local residents while generating a return which is in excess of the discount rate of the pension fund at an acceptable level of risk
Mark Hyde-Harrison, chief executive officer at London CIV, says: “Both the national and local government have a role to play in helping to provide high-quality rental accommodation.”
And it is in the interests of the local authority to provide these for affordable rents and service charges. Mr Dowdall says: “These are long-term investments so rents need to be sustainable.” Mr Heaney adds: “Investing in residential property can help pools to adhere to ESG [environmental, social and governance] investment criteria.”
Providing homes for locals helps to improve communities and to attract both people and jobs to their constituencies. As the buildings are brand new, they will also be fully compliant with the latest environmental regulatory standards, Mr Heaney adds.
Fit for purpose
Building rather than buying a block of flats enables investors to make the most efficient use of the space available. This includes ensuring that maintenance teams can fix things such as plumbing by opening access to them from outside of the flats.
Mr Heaney says: “That means the tenant does not have to wait at home to get their plumbing fixed as the pipes can be accessed through a flap in the corridor.”
Mr Tomlinson adds: “The advantage of build-to-rent is the investor can tweak the design to ensure it appeals to the target group of long-term tenants.”
The layout of the flats is important. Two-bedroom flats with equal-sized rooms, both with ensuite bathrooms, are easier to rent. Mr Dowdall says: “These can be easily shared by two adults or two couples, which makes it more affordable.”
Large blocks of flats help investors to use scale to cut costs for design and services. “The investor can focus on ensuring the types of services tenants’ value such as cafes and childcare are included in the block,” Mr Tomlinson says.
Scale also helps ensure regular maintenance is less of a headache and charged at a fair price. Mr Tomlinson says: “The building’s manager can negotiate with a professional plumber to drive down the cost.”
Offering services that make life easier is valued by tenants. “Our buildings offer a concierge service, so they will accept deliveries and sort out the on-site maintenance,” Mr Heaney says.
These benefits are becoming ever more sophisticated. Mr Heaney says: “On-site gyms are popular, as is high speed broadband which works from the moment the tenant arrives in the property.” Some buildings also offer dry cleaning.
Providing long-term rental contracts also helps to give peace of mind to the occupant. “All too often private landlords decide to sell up and the tenant has to scramble to find a new home at short notice,” Mr Tomlinson says.
Although most of the capital is being invested in two-bedroom flats, rental accommodation for families is starting to be provided.
Mr Dowdall says: “We have a partnership with Manchester City Council called Matrix Homes, which is building properties in the suburbs to provide a combination of two, three and four bedrooms.”
While these are individual houses rather than flats, institutional investors can still find economies of scale. “But it is less scope than there would be in a block of flats,” Mr Dowdall says.
The right structure
Even though the investment narrative of residential property is appealing, it is important to keep focused on the basics. Mr Dowdall says: “The price at the entry point needs to be correct: it’s important to get the right yield and to have realistic rental growth assumptions.”
It is vital to structure these deals correctly. That means a local authority needs to determine how it wants to finance this investment.
“The strength of the collateral in a residential property investment gives us flexibility over the how the deal is structured,” Mr Dowdall says.
He adds: “In some cases, the Northern Pool will provide either senior or mezzanine debt [with different repayment priorities] to the investment.”
In other projects, such as the Matrix partnership with Manchester City Council, Northern provides the capital.
Working with a partner that understands what types of properties are in demand helps the pool to achieve high returns. Mr Dowdall says: “Providing the types of homes that people need and want is also good for our bottom line.”
That partner should also be able to source the land as well as have established relationships with construction firms to ensure the building is delivered on time and to budget. Nor should that partnership end once the building has been completed.
The price at the entry point needs to be correct: it’s important to get the right yield and to have realistic retnal growth assumptions
Few local authorities have the skills required to manage property. Mr Dowdall says: “We split the ownership of the property from its management, which helps to manage the risk and add value.”
While Northern has a long history of regional property investment, different local authority pools will take different approaches. Mr Tomlinson says: “It will depend how the pool allocates its assets.”
For example, the LLP portfolio invests in both commercial and residential. Mr Tomlinson says: “Residential includes retirement home as well as ‘build-to-rent’ assets.”
LPP will only add to those residential property assets if it there is a sound investment case. “It’s more challenging to make the economics work today than a few years ago,” Mr Tomlinson says.
It is particularly difficult to make a decent return on existing property assets.
Mr Tomlinson says: “There is much more scope to make good returns by being involved in building property which is fit for purpose.”
Investing from the start ensures the property is designed to be attractive to tenants over multiple decades. “Then a pension scheme has an asset with a shelf life of 30 to 50 years,” Mr Tomlinson says.
A longer-term project
Other pools are less able to focus on making investments in residential property, as they are currently grappling with the complexities of effectively merging existing property investments.
John Harrison, interim chief investment officer at Border to Coast Pensions Partnership, says: “Migrating existing property investments from individual funds across to the pool is legally difficult.” Border to Coast faces a particularly challenging situation because it has a plethora of ‘unitised’ vehicles with individually reported unit values for investors run by external managers, he adds.
Before the pool can consider whether it wants to invest in residential property, it needs to determine the correct framework. Mr Harrison says: “We need to determine the right structure of our property investments and our goals for this asset class.”
Despite the current structural challenges faced by the fund, investing in build-to-rent could be part of the pool’s allocation to alternatives.
Mr Harrison says: “We might view residential property as social infrastructure, and it could form part of that allocation.”
Investments in infrastructure will be rolled out in the second and third quarters of 2019. “While we see it as a legitimate asset class, we’re not clear about where it would fit within our alternatives allocation,” Mr Harrison says.
“Whether an allocation to UK residential property will fit into an alternatives allocation will depend on how it stacks up relative to other global opportunities,” adds Mr Hyde-Harrison from London CIV.
Focus on risk-return profile
As with other investments, it is important not to get carried away by the appeal of the story. Mr Hyde-Harrison says: “The key consideration is what the risk-return diversification of the portfolio should be.”
If a pool decides that an allocation to residential property makes sense, it then must decide how the performance of that asset should be assessed to determine whether it continues to be the right investment.
Mr Hyde-Harrison says: “If you have a property team, they will need to decide the right allocation between commercial and residential property and how that should be invested around the world.”
Different pools will take different approaches. “Some pools may prefer to invest in their local areas while others might like to spread properties out across the country to add diversification,” adds Mr Heaney.
With well-developed build-to-rent markets across the developed world, it is also possible for pools to build an international portfolio. Mr Heaney says: “We have assets equivalent to £9bn in the US, Asia and Europe.”