The prospects for large scale investment in residential property

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					                                                                 Housing Research 195
                                                                 October 1996

The prospects for large-scale
investment in residential
The legislation creating Housing Investment Trusts (HITs) has raised the profile
and status of private renting in the UK. The potential rates of return for
investing in this sector look attractive but some practical issues remain
unresolved and restrictions and limitations on HITs may limit their success. A
study by Yolande Barnes of Savills Residential Research Department found:

    Many features which discourage institutional landlords work in favour of
    individual landlords, in particular the tax treatment of direct investment in
    property rather than in an intermediary property fund. HITs, by ending
    double taxation on investors who put money into these intermediate bodies,
    will go some way to redressing this imbalance.

    However, individuals and other investors who pay tax will not gain any tax
    advantages by investing in a HIT instead of directly in property. They will
    pay slightly more tax as well as the extra costs of managing the HIT itself.

    Initial analysis found the returns from residential property to be as attractive as
    many commercial properties at around 10.4% gross and 6.9% net (after deducting
    all property costs but not deducting any fund management costs or tax).

    The long-term prospects for both rental and capital growth look good as they
    appear to be closely related to levels of personal income and wealth rather
    than retail price inflation. The opportunity to spread risk between properties
    of different kinds and in different places also offers an advantage.

    The creation of HITs will be inhibited by:
      - the need to have a value of at least £50m in order to be traded on the
      Stock Exchange;
      - the inability to buy BES companies or properties let on assured tenancies,
      coupled with the difficulty of building sufficient properties to order;
      - Government proposals to exclude properties worth more than £85,000
      (£125,000 in London).

    Whilst the HITs legislation is a welcome first step towards a mature
    residential property investment sector, the author recommends further work
    to improve/simplify taxation and other policies, perhaps in conjunction with
    similar measures in the commercial property sector.
Residential investment: critical success                     Net yields
factors                                                      Capital and on-going costs typically reduce gross yields
The study identified the barriers which have                 by 3.5 percentage points, from 10.4% to 6.9%.
prevented large-scale residential property investment        Investors must also pay taxation and portfolio
by institutions in the UK. Many of the features which        management costs. Capital growth is therefore critical
discourage institutional landlords were found to work        if total returns are to be enhanced. Gross income
in favour of individual landlords. One such was the          returns in the high teens may be available for certain
tax treatment of direct property investment as               types of property in certain locations, but it is very
opposed to property fund investment. HITs will go            much more difficult to find the net yields above 10%.
some way to redressing this balance but other barriers
to institutional involvement remain.                         Comparative yields
     Amongst these are investors’ poor perceptions of        Analysis of total returns for prime central London
the sector, fear of a future government putting              residential property shows a correlation with returns
restrictions on tenure rights and rents, lack of liquidity   on retail property but very little similarity to those
in the sector, lack of information such as investment        from offices and industrial property. This would
returns, and unquantified risk. These are set against an     suggest that there are significant benefits in
environment in which institutions are, on balance,           diversifying property investment to include
reducing their investment in commercial property.            residential property.
     Many of the factors that discourage institutional
investment do not seem to affect small landlords to          Rental growth
the same extent; some may even be seen as                    The study found evidence that rental growth levels
advantages. Factors which motivate small-scale,              are more closely related to household income than to
individual landlords are: familiarity with the               general inflation.
medium; ease of buying properties for investment;
potential for mortgage borrowing to make capital             How do HITs enhance returns?
investment go further; the possibility of investing          HITs will only enhance net - not gross - returns.
both in small individual properties and in a diverse         Under the existing tax regime, institutions are taxed
range of properties; perception of high returns; low-        twice on capital gains and income, once through the
cost do-it-yourself property management; favourable          investment itself and once through the company or
returns in comparison to other personal sector               vehicle which holds the investment. This is
returns; favourable taxation treatment; perception of        particularly onerous on tax-exempt (or ‘gross’) funds
lower, or at least more quantified, risk.                    such as pension companies who would not have to
                                                             pay tax if investing directly. HITs are designed to
Investment returns                                           remove this double taxation whilst conferring the
A lack of information regarding investment returns           benefits of liquidity, collective ownership of
in residential property was a major barrier to               property, ‘investment unitisation’ (the possibility of
investment. The study aimed to begin redressing this         holding small, tradeable units of investment which
lack by quantifying and measuring returns using new          may represent only a share of the property) and
data relating to the lettings market deregulated after       professional management on residential property
1989.                                                        holdings.
                                                                   Under HITs, professionally managed funds are
Gross yields                                                 still penalised compared with individual direct
Gross yields throughout the UK are higher than most          investors because they have to pay corporation tax at
commentators have previously found, averaging                24%. To level the playing field with direct investment
around 10.4%. There is a very wide range around this         income tax on HITs would have to be 20%.
average, however.
     Gross yields were highest amongst the type of           How might HITs deplete these returns?
properties which are popular with tenants but                There are costs associated with an investment medium
relatively unpopular with owner-occupiers. Capital           to hold properties (such as a HIT) which do not exist
values tend to be low and rental values relatively           for direct property investment. Fund administration
high for this type of property. Many small flats and         costs may reduce investment yields by a further 1%.
terraced houses fall into this category as affordability     However, inefficient or profligate fund management,
has increased and owner-occupiers favour larger              characteristic of some BES schemes, should be kept in
properties whilst the first-time buyer properties of the     check by some of the proposed Stock Exchange
1980s fall in value.                                         regulation. Ultimately, the Stock Exchange rules could
ensure better returns in the medium to long term, but           It appeared from the study that demand for, and
possibly at the cost of a stillbirth of HITs due to over-   supply of, rental accommodation was likely to
regulation in the short term.                               remain in equilibrium over the medium to long term.
     HITs will also have to overcome the hurdle facing      This equilibrium would however be affected by
all quoted property companies on the Stock                  investors’ perceptions of capital growth prospects.
Exchange: that the market may discount share values
below net asset value.                                      Practical issues
     The advantages of diversifying into residential        The impact of portfolio size
property as part of an investment portfolio may also        It is estimated that a HIT will need to have a value of
be diluted as a result of being quoted on the               at least £50 million in order to be viable and traded
securities market (‘securitisation’). It is possible that   on the Stock Exchange. If average property values in
HITs will perform more like other property company          the HIT are £50,000 this translates into at least 1,000
shares than their underlying assets. They could also        properties. This is a very big portfolio to amass in
be prone not just to property market fluctuations and       single units bought one by one, so bulk acquisitions
market sentiment but to overall stock market                would be necessary.
movements too.                                                    The purchase of existing companies, such as BES,
                                                            is effectively barred by the HITs legislation. This is
Investor’s yield gap                                        because HITs cannot buy properties let on assured
Consultation with fund managers suggests that some          tenancies.
require a total property return of 13% to 14% per                 HITs are allowed to invest in property let on
annum before they would be willing to enter the             assured shorthold tenancies, but this type of property
residential investment market. They believe capital         is rarely available in bulk. Vacant possession values
growth will only contribute 3 to 4% per annum of            are higher than tenanted values so investors will,
this, which means that a HIT would have to produce          where possible, serve notice on their tenants before
a net rental return of 10%, substantially above the         they sell.
current average of 6.9%.                                          Converting or buying large single buildings could
     If a HIT only distributes 85% of its income, a         be another route to obtain properties in bulk. It
gross yield of around 16% will be required, which is        seems unlikely that there would be very many
much higher than the national average of 10.4%. A           buildings of any size where all the flats were within
very limited number of residential properties show          the HITs’ value limits. Aside from the MoD Married
these returns.                                              Quarters Estates there are very few vacant or let bulk
     Investors will need to be very much better             holdings that may be available to HITs.
educated on residential property returns and the                  Perhaps the only way to ensure that the right
place of residential property in a portfolio before they    properties, in the right place and at the right value,
might be prepared to accept lower yields.                   are amassed for purchase by a HIT is by building
                                                            them to order. This will be a highly time-consuming
A model of the residential investment                       activity taking longer than the six months allowed
market                                                      under the proposed Stock Exchange rules at the time
Capital values are dependent on the yield that is           of writing. HITs may therefore be effectively
applied to rent. Different types of owner pay a             prevented from this course of action and required to
different yield for property. These yields have been        provide a three year track record before listing if they
modelled in the study. From this model, it would            are considered to be carrying out development
appear that, in current market conditions, individual       activity.
investors, who are able to accept a relatively low
yield, can compete with owner-occupiers for                 The impact of Stock Exchange requirements
property, especially in the market for smaller flats        Even if portfolios can be built or acquired, the
and houses which are currently eschewed by first-           prototype HIT will probably need a period of time
time buyers. Institutional investors, on the other          before it is of sufficient size to gain full investment
hand, require a relatively high yield and would             trust status on the Stock Exchange. Property
therefore have little hope of outbidding owner-             companies or other vehicles which form ‘seed corn’
occupiers or individual investors for most properties.      HITs will have to compete in the currently
Until the income returns that these investors require       unfavourable tax regime before being brought under
are reduced, perhaps in the expectation of price rises,     the shelter of a HIT umbrella.
it is unlikely that they will be attracted to HITs or any
other residential investment vehicle.
The impact of value limits                                About the study
The Government proposes to disallow properties            The rental data on which yields were based were
worth more than £85,000 (or £125,000 in London)           gathered during August 1995 from a survey of letting
for inclusion in HITs. This will exclude one in five      agents. Information was collected for five common
privately owned residential dwellings. In the South       types of property, in three different types of location
East, one-third of all private sector stock will be       and from 112 different centres across Britain. Capital
excluded on these grounds alone. This will clearly        values were based on Land Registry figures.
exclude more than just the luxury properties that the
Government intended.                                      Further information
                                                          Further information or copies of the full report (Beyond
Overseas experience                                       HITs, price £55) are available from Yolande Barnes,
There are lessons to be learnt from the successful        Director of Research, Savills, 20 Grosvenor Hill, Berkeley
securitisation of property overseas. A combination of     Square, London W1X 0HQ. Tel: 0171 409 8899;
different legislative frameworks, different historical    Fax 0171 495 3773.
experiences and different tax solutions has enabled
securities backed by property to be freely and widely
traded in other countries.                                                 Related Findings
     Perhaps the largest and most successful property     The following Findings look at related issues:
investment vehicles are Real Estate Investment Trusts
(REITs). These have been in existence for over 100        165 Funding shared ownership (Dec 95)
years and now have a market value of $45 billion.         191 Homebuy and equity loans: their relevance for
They allow investment in all property types but               low-cost home-ownership in England (Sept 96)
residential property usually forms a sizeable             192 Housing associations and the private lender
component of the portfolio. They are ‘tax-                    (Sept 96)
transparent’, liquid and valued at the full value of      194 Index of private rents and yields (Sept 96)
property assets, with no value limits.
                                                          The following Housing Summary is also relevant:
The practical problems associated with amassing and       14 The outlook for Housing Investment Trusts
managing HITs, together with their tax position, may         (Jan 96)
limit their success. As HITs do not involve any grants
or subsidies it is difficult to see why so many           For further details on these and other Findings,
restrictions should be placed on them. It seems           contact Sally Corrie on 01904 615905 (direct
sensible to move towards a fully tax transparent          line/answerphone for publications queries only).
vehicle for all property investment, not just
residential. USA REITs may be a suitable model to use
here. Investors will be much keener to participate in a
vehicle offering choice and diversification potential
rather than one hidebound by unnecessary rules.

                   Published by the                       The Joseph Rowntree Foundation is an independent, non-political
                   Joseph Rowntree Foundation             body which has supported this project as part of its programme of
                   The Homestead, 40 Water End            research and innovative development projects, which it hopes will
                   York YO3 6LP                           be of value to policy-makers and practitioners. The findings
                   Tel: 01904 629241 Fax: 01904 620072    presented here, however, are those of the authors and not
                                                          necessarily those of the Foundation.
                   ISSN 0958-3084