Why the private rented sector offers schemes property diversification

Since the 1960s, with the legacy of prohibitive rent controls, PRS has been overshadowed by more traditional property investment.

However, the past 12 months have seen a real resurgence in interest, with investment managers trying to launch new products and investors starting to take notice of a sector backed by strong fundamentals linked to the UK’s housing problems.

It is estimated that the UK needs to build a further 100,000 homes a year to cope with population growth and changes in living patterns; not only does this provide a solid base on which to invest, it also means that for those who can build high-quality, purpose-designed rental accommodation, the arguments are even more compelling.

In the current low-yield environment, PRS is a sector pension funds should be exploring.

With the exception of a few locations, yields are at attractive levels and offer pension funds a substantial premium over government bonds, compensating them for the risks involved. 

With the exception of a few locations, yields are at attractive levels and offer pension funds a substantial premium over government bonds, compensating them for the risks involved.

The sector should generate income that has a strong inherent link to inflation; a feature that suits pension funds’ liability profiles.

A real return of 3-4 per cent a year over the long term seems like a reasonable expectation, accepting that there remain some significant uncertainties around the development of this market.

The sector should also appeal to those looking to diversify their asset base – the correlation of returns with commercial real estate and other mainstream asset classes has historically been low.

First-mover advantage

Investors need to take a long-term approach. The sector is changing and pension funds need to commit for a substantial amount of time in order to benefit. There is likely to be a first-mover advantage.

The sector is first and foremost an income play. Investing to benefit from possible house price inflation and gradual unit sales is not a strategy pension funds should consider.

The preferred approach is not predicated on house price growth but on net operating income and gradual income growth.

The common argument that house prices are too high to invest has its limitations, because high house prices prevent more people from buying a property, which fuels demand in the rental market.

Another argument levelled at the PRS is that it is still a cottage industry. This is where pension funds and other institutional investors can make a difference.

By establishing a more professional-quality offering, many of the risks around management costs, tenant retention and reputation can be mitigated.

There have already been developments in lettings and management agent regulation, which we support.

There are also signs the major political parties share at least a modicum of common ground in promoting the sector, and although the new government seems to have home ownership at its heart, the scale of the problem means the PRS will continue to have a place in housing the nation.

Bespoke strategies

To create suitable accommodation in which to invest, there is merit in considering development strategies.

Creating bespoke rental products can be a lower-risk long-term approach than acquiring existing assets that may not have been designed specifically for rental.

Although contractual income streams are far shorter than those on commercial property, the length of tenure tends to be in excess of three years and the strong fundamental mismatch between supply and demand should serve to deliver robust income generation.

Getting access to land – and planning – has become easier, but remains challenging.

This strengthens the investment case on the supply side, but it means development opportunities can be difficult to source.

Investors with access to land have a head start relative to others and should consider taking advantage of this.

Matthew Abbott is a principal in Mercer’s real estate boutique