Full report: Is Build to Rent (BtR) a viable alternative asset class in a post pandemic world?

Introduction

Recent research released by the British Property Federation (BPF) in April 2020, showed there to be 157,512 BtR homes either new, completed, under construction or in planning – a 12% increase from the same period last year. This is in addition to an increased pipeline of new BtR homes in planning across the UK, which rose by 41% in the past year.

However, previous predictions by the BPF in 2018suggested that within two years, 200,000 BTR properties would be built. From latest guidance and market research, it does not appear that this figure will be achieved.In addition, the Government has confirmed that the UK economy is now in recession, with the unfortunate likelihood that the unemployment rate will increase, and companies fail to survive the economic effects of the pandemic. There are also reports that mortgage funds may become more difficult to obtain, with consequent effects on property sales.

This report analyses the current state of BtR, the challenges it faces and whether it will sustainable long term, offering conclusions and recommendations to the board. The report uses available literature and past studies, with references to external sources and figures detailed in a full list of citations at the end of the report.

In summary, the report covers the following:

  1. How BTR schemes can meet rental demand
  2. Barriers to the completion and profitability of schemes on site
  3. How BTR can address the affordability of decent accommodation to low-paid workers
  4. What effects the Covid-19 pandemic will have on BTR investment in the future
  5. Is the BTR model to be sustainable in the short and long-term.

1.  How BTR schemes can meet rental demand

Despite the increased growth of BtR, there are a number of issues that have led to a lower provision than the 200,000 units BPF suggested would be completed by the end this year. Before Covid-19 put the UK into lockdown, the housing market was already showing signs of slowing, primarily caused by political uncertainty over Brexit. In their Monetary Policy Report 2020, The Bank of England announced that “growth in the UK economy slowed last year” and said “uncertainty about the outcome of Brexit helps explain why UK growth has slowed” and believe “it is the main reason why investment by UK companies has been weak.” Figure 1 (below) illustrates the fall in UK growth and fall in business investing since the referendum. While the BPF made their prediction on 200,000 BtR units post 2016 referendum, the timeline for the UK to leave the EU was continuedly delayed and officially completed on 31st January 2020. The UK is now in a 11-month transition period with further uncertainty of whether a deal (post-Brexit arrangements) will be completed.

Figure 1 – Slowed UK Growth & Weak Business Investment – Bank of England (2020)

In addition to Brexit, there is some evidence suggesting a slowing of residential transaction volumes linked to the Covid-19 pandemic. The Office for National Statistics (2020) reported “various data sources suggest that changes to the housing market in England and Wales primarily happened in April 2020, coinciding with the first full month of the lockdown” and “residential property transactions (based on Stamp Duty Land Tax records) in England, for April and May 2020, were around half that shown for the same months in 2019.” The BPF acknowledged however, that it may be too early to determine the full impact of covid-19 on the BtR pipeline.

Despite both Brexit and the Covid-19 pandemic showing evidence of slowing down the BtR sector, there is much optimism that the BtR sector can offer a solution that allows it to weather through, while continuing to meet demand. In order to achieve this, some argue that the BtR sector should provide accommodation suitable for long term renters built with the needs of their target tenant groups. BtR Developers are identifying locations with high rental demand, designing buildings with greater facilities which are unavailable in traditional single unit homes, offering onsite management, while providing more affordable and secure tenancies. An example of this is Legal & General, who have successfully established a portfolio of 14 schemes in 11 cities totalling 4,900 apartments to date, and have proven that their schemes have launched in “locations offering long-term rental growth potential and income security, developing higher standards of design, service and asset management and delivering long-term rental growth ahead of inflation” (Legal & General, 2020). Figure 2 and Figure 3 show case studies of launched schemes showcasing their ability of meeting rental demand.

Figure 2 – L&G Blackhorse Mills, Walthamstow – Case Study – Legal & General (2020)

Figure 3 – L&G The Whitmore Collection, Birmingham – Case Study – Legal & General (2020)

In contrast to BtR, new stock that entered the private rented sector historically were previously units within build-to-sell properties that were either unable to be sold, or were existing units converted into by-to-let properties. Vidhya Alakeson (2013) argued this meant “the development of most private rented stock didn’t start with the needs of a particular tenant group in mind and is not built for long term renting.” If BtR developers continue to capitalise on build communities built for the needs of the customer, they will make further progress in meeting rental demand.

Another benefit of BtR is its growing role in providing housing at more affordable rent. In 2017, the government released the Housing White Paper, a report which recognised the important of BtR and how it could address the housing shortage and support the increase of other tenures including affordable housing. The following year, The National Planning Policy Framework announced that “affordable housing on build to rent schemes should be provided by default in the form of affordable private rent, 20% of the units is generally a suitable benchmark for the level of affordable private rent homes to be provided (and maintained in perpetuity) in any build to rent scheme” and “national affordable housing policy also requires a minimum rent discount of 20% for affordable private rent homes relative to local market rents” (GOV.UK, 2018).These measures sought to bring further clarity and have provided an ongoing solution for BtR to meet rental demand and aid the ongoing housing crisis.

Notwithstanding the above solutions, it should also be acknowledged that BtR remains a small percentage of those living in rental accommodation. The Office for National Statistics recorded “the number of households living in the private rented sector in the UK was 4.5 million in 2017” (ONS, 2019). However, BtR is growing and so is the sectors popularity with tenants; BtR investors and developers can feel encouraged by this.

2. Barriers to the completion and profitability of schemes on site

With construction sites being suspended as a result of the Covid-19 pandemic, there are questions as to whether BtR schemes will be profitable in the short and longer term, and what those barriers might be. To answer this, Figure 4 (below) illustrates the risks across development, investment and operations in delivering a BtR scheme regardless of whether construction sites are delayed. The lockdown will only have caused the risks to become more problematic, both short and longer term.

Figure 4 – Risks in the BtR sector – Turner & Townsend (2017)

Short-term

As a result of the UK lockdown, the ONS (2020) reported “the number of people claiming unemployment benefits surged to 2.6 million between March and June” (BBC, 2020). With the unemployment rate expected to continue rising, the biggest concern facing BtR companies is tenants being unable to pay their rent and threatening their rental income (see operations in Figure 4). Furthermore, when viewings were unable to take place this increased the probability of void periods, and may be set to increase if tenants choose to move out of a BtR scheme and into to a cheaper rental accommodation. Fortunately, Rishi Sunak announced measures during the lockdown which supported those in financial need, but it may not be enough for all. Further details on the measures announced are detailed on page 11 of this report.

As well as loss of rent, some BtR schemes have also lost alternative streams of income such as the ability for tenants to pay to use additional or premium amenities within an apartment block. For example, Tipi London frequently allowed tenants to purchase event space for an allocated time slot which is no longer in use. In the absence of amenities and communal areas, Keystone Law (2020) argued “if a landlord closes a centre or any common parts, you will need to check the lease as to the landlord’s obligations and any potential claims” and “payments should be reduced or suspended.” Despite this, some BtR companies have proactively looked at alternative ways of engaging with their tenants during this period. For example, Sarah Quinn (Head of Residential at Moda Living) said “a creative shift has been needed to switch things into the virtual mode” and has introduced  “gym classes online, nutrition sessions, mental wellbeing sessions” which prompted “positive feedback from our residents” (Property Investor Today, 2020). Fortunately, these barriers to profitability are short term.

Long-term

Whilst the BtR sector has gained popularity, the risk and returns for schemes are different to usual traditional build-to-sell model investors are used to (see investment section in Figure 4). High equity financing models can cause some problems for BtR companies, especially in the delay of construction. British Property Federation (2015) argued “when building for sale, capital is tied up for significantly less time – until the new homes are sold and the housebuilder derives a profit. When building for rent, the investor is tying up capital for 10, 20 or 30 years. There is no instant profit; the investor (say, a pension fund) will derive income to pay pensioners, and will only get capital receipts when it sells the homes at the end of its holding.” This therefore means a fundamental issue facing BtR is viability; there is no instant profit, and in many cases build-to-sell builders have outbid BtR investors for land for this reason.

In addition, BtR has faced long term challenges against legal restrictions and tax barriers (see development section in Figure 4). Osbourne Clark (2017) argued BtR was “caught in the middle of tax rules which tax non-residential owners of high-end residential property, private rented sector landlords and commercial property owners. In practice this results in increased tax and adviser costs and the need to manage tax risk.” The VAT spent on maintenance and repairs of schemes is therefore taken from profit and discourages investment. In addition to VAT, the Stamp Duty Land Tax brought in during 2016 served a major blow to the sector. “Corporate investors were hit by the 3% surcharge introduced in April 2016 for purchasers of additional residential properties” (Boodle Hatfield, 2016). Lucian Cook (Director – Residential Research at Savills) argued “the failure to give relief from the additional stamp duty levy for large investors could inhibit the development of a much-needed institutional private rented sector” (Savills, 2016). The temporary closure of sites will only delay the timetable of opening schemes to start recuperating income, adding further burden to investors. It is important to note however, while there are long term consequences, construction site were able to reopen in May 2020 and the BtR sector is expected to recover from this delay quickly.

3. How BTR can address the affordability of decent accommodation to low-paid workers

Whilst BtR is making progress in providing more affordable housing to tenants, there is evidence that some schemes are unaffordable to low-paid workers. For example, JLL Residential Research (2017) undertook analysis of 25 schemes across London and found tenants were typically paying 11% more than the local rental market rate. In addition, research by room share platform, Ideal Flatmate, found renting a room in a BtR scheme was 15% higher than renting in a buy to let (BtL) property. This has created some uncertainty as to whether BtR schemes are only suited to affluent professionals, and not low-paid workers.

There are steps in addressing this issue however; BtR developments should ensure they are offering a range of rental levels and target tenants within the local population. In practice, boroughs could look into building intermediate rental housing and allocate the units to local people rather than the rents beings set by the market. Figure 5 presents a case study where LB Barking & Dagenham successfully adopted this approach by providing affordable housing and discounted rents. The allocation or discount was determined by whether the person was in employment, their income level and their locality to the area, which in turn created transparency and aided affordability for low-paid workers.

Figure 5 – LB Barking & Dagenham Affordable – Case Study – Future of London (2017)

BtR companies could also look to prioritise their affordable homes allocation to local key workers, including NHS staff and other critical public services employees. Legal & General’s flagship BtR scheme, Blackhorse Mills (discussed in Figure 2) offers local key workers a 20% discount in rent (Waltham Forest, 2018). In addition, the UK’s largest listed residential landlord, Grainger plc, promised “Manchester’s key workers high quality, accessibly priced apartments” (Design & Build UK, 2020) for their 614-unit BtR scheme, Clippers Quay. This initiative is beneficial in tackling this issue and should be replicated across all schemes.

In order to further support the continued provision of affordable housing in BtR schemes, the GLA released additional guidance that recommended BtR schemes were given covenants for a defined period, in order to retain private market rent homes in the event the units are sold. “Planning authorities should recognise that build to rent operators will want sufficient flexibility to respond to changing market conditions and onerous exit clauses may impede development. However, the sale of homes from a build to rent development should not result in the loss of affordable housing without alternative provision being made” (GOV.UK, 2018). This practice means a development (with affordable homes for rent) remains in the rental market longer term, thus providing further security to lower income tenants.

4. What effects the Covid-19 pandemic will have on BTR investment in the future

As discussed in section 2, the Covid-19 pandemic will affect BtR in a number of ways, with reports of a possible lack of funding, redundancies and staggered working patterns. Analysis of solutions to each problem and whether BtR investors/ developers should change their model to suit possible changes in the employment market is explored below.

Lack of funding/ investment

The BtR started 2020 strong with over £1bn of investment in Q1(CBRE, 2020). Like all real estate sectors however, BtR saw a sharp fall in investment in Q2 as the lockdown effectively halted activity (Figure 6). “As a result, there were only two transactions concluded in Q2, totalling £83m” (CBRE, 2020).

Figure 6 – Multifamily investment volumes, Q1 2015 – Q2 2020 – CBRE (2020)

There is much optimism for BtR investment to recover quickly however and will perform better than other real estate sectors. This is supported by Savills (2020), who argue “the fundamentals underpinning investment in the UK private rental market have not changed. Build to Rent is likely to see a short-term impact on landlord revenues but longer term the coronavirus lockdown is unlikely to dampen investors’ growing appetite for the sector.” Furthermore, in recent periods of economic difficulty, rental growth has proven to be less volatile which further gives BtR a boost in confidenceIan Fletcher ,director of real estate policy at BPF, acknowledges “pain is being felt across all sectors of the economy, but build-to-rent remains attractive to investors and we know from past experience that demand for rental housing usually leads homes-for-sale out of any recovery” (BPF, 2020). CBRE (2020) also noted that “there is a substantial investment pipeline with just over £1.4bn worth of deals currently under offer. This is broadly equivalent to the investment pipeline at the end of 2019, which then translated into £1bn of investment in Q1 2020.” This suggests that lack of funding and investment is short term, and investor/ developer confidence will return quickly and can continue under its current model.

Redundancies

Research by Shelter (2020) showed almost one in five renters in England (an estimated 1.7 million adults) were expected to lose their job three months from May. With redundancies on the rise as a result of companies struggling financially, the ability for some tenants to pay rent will be a big concern to investors. To address this issue, there have already been a number of measures put in place by the government to support both landlords and tenants. For example, Chancellor Rishi Sunak announced £500 million available to fund households in hardship, increased universal credit and housing benefits, extended the pre-action protocol requirement to the private rented sector to allow reasonable repayment plans where rent arrears may have arisen, blocked landlords evicting tenants for 3 months, and helped many keep their rent payments on time with the use of the furlough scheme which covered 80% of workers’ wages (GOV.UK, 2020).

While the furlough scheme and other measures have proved successful for some during this period, further redundancies have become inevitable and with the scheme winding down in October, more hardship is expected after. While there may be a case of reducing rent to support some renters, others argue the concept of reducing rents if the economy is in recession is unclear and perhaps too early to determine. Jacqui Daly, Director of Residential Research at Savills (The Planner, 2020), argued that “high levels of economic uncertainty typically increased demand for rented housing, as people look to avoid longer term commitments such as mortgages. This means that once lockdown is lifted, build-to-rent developers should be confident”, suggesting rental demand will increase thus investors and developers won’t require rent reductions.

Staggered working patterns

In July 2020, the ONS released data which found 46.6% of people in employment did some work from home in April. In addition, other those who did some work from home, 86% did so as a result of the Covid-19 pandemic. Despite some offices reopening, many office spaces and transport methods are unable to promise social distancing in its current capacity. As a result, guidance has been proposed to allow employees to safely return the workplace by introducing staggered shifts or hours. “This would reduce the likelihood of large numbers of people travelling at peak times and therefore, hopefully, reduce the risk of COVID-19 infection” (CIPD, 2020). As a result, more tenants in BtR schemes will require adequate workspace, and may seek their building to offer additional workspace outside their individual apartment.

In the latest Yardi Think Tank series, Property Week contributing editor Simon Creasey chaired a discussion with key figures in the BtR sector and addressed a number of solutions to this very issue. Hannah Marsh of HomeViews argued “if you’ve got the opportunity to flex your offering and maybe use the communal areas for coworking in the week and then change that around at the weekend to provide space that can be used for communal events, it’s going to be those buildings that can be a bit nimble in the current situation that I think are going to bounce back more quickly” (Property Week, 2020). Michela Hancock of Greystar agreed and suspected “we’ll probably design in more workspace in the units” and they’ve started “seeing some people upgrading from one bedroom to two bedrooms” (Property Week, 2020). Therefore, when considering changes to the BtR model to suit changes in the employment market, investors and developers should ensure they are future proofing their buildings and have the ability to alter their amenity space in the case of changes in the employment market and workspace accessibility. The need of the customer will always evolve, so this practice should be adopted full-time.

5. Is the BTR model to be sustainable in the short and long-term.

Investors are more likely to be in BtR for the long term. The sector has demonstrated in its own right that its model is successful and sustainable in the short term. BtR has also provided opportunities for landlords, with its ability to provide reliable rental income, control over the investment and long-term gains. To add more confidence to landlords, the projected growth and demand of the private rented sector shows further growth in the future. Based on expected future trends and observed historic relationships, PwC (2015) projects “the trend towards increased private renting will continue, reaching just under 25% in 2025.” Furthermore, Bentley (2015) argues “the private rented sector is growing as a proportion of the UK’s housing stock, with greater numbers of people forced to rely on it as house prices rise and social housing declines. It is expected to account for more than a third of the UK’s housing stock by 2032.” Figure 7 below illustrates PwC’s projections of a sharp incline of private rental households by 2025.

Figure 7 – Projections for UK housing tenure, share of households, 2015 – 2025 – PwC (2015)

Whilst its short-term success is clear, its long-term sustainability will be dependent on a number of factors. Like all investments, some risks are unavoidable, and investors might see the possibility of a volatile market as a disincentive to retain properties and sell them on. In study of Risk and mitigation, Savills (2018) argue there are three flavours of risk categories specific to BTR, namely planning, letting rates and regulation.

Planning is seen as an issue to the lack experience local planning authorities have within the sector, but this should ease over time as the sector grows evidence of how its developments works and increased communication of BtR’s advantages between developers and investors. When looking at letting rates, Boules and Daly (2018) acknowledge that when BtR developments launch large number of units at once, “generally, that means you have an initial letting period as the scheme fills up, during which it won’t generate its full potential income. It’s in the interests of investors to keep this period as brief as possible.” To mitigate this risk, operators can either register tenants before the building is launched or release a proportion of the units in phases to avoid overwhelming the market. The third and perhaps most prominent risk is whether the government introduced new regulation to the private rented market. In their last manifesto, Labour (NLA, 2019) proposed “new rent controls, to limit rent increases to inflation as well as offering cities the powers to bring in further caps” if they were to be brought back in power. David Cox, Chief Executive ofARLA Propertymark, argued“rent controls do not work; it hits hardest those its designed to help the most. The last time rent controls existed in this country, the private rented sector shrunk to the lowest levels ever recorded. At a time of demand for PRS homes massively outstripping supply, rent controls will cause the sector to shrink” (Property Industry Eye, 2020). However, there is some comfort for investors when looking at regulated rental markets in the US and Germany, which confirm that “BtR investors are comfortable with modest caps on rent inflation. They provide greater certainty of income while reducing perceived risk” (Boules and Daly, 2018).

Conclusion

In summary, this report has analysed the opportunities and threats that BtR faces but has overall shown much optimism that the model will be sustainable long term. To achieve this, the sector must ensure it caters for all demographics, levels of affordability and future proof their buildings to suit the tenants needs as and when they evolve. As the sector grows, more available data will allow greater transparency in companies understanding methods of success, how to combat barriers to profitability and how to increasingly meet the needs of the customer, a practice widely adopted in the US multifamily market.

Nick leads our build-to-rent division at deverellsmith, advising a wide range of clients on hires across investment, development and operational management. His team has advised on some of the most exciting and innovative build-to-rent developments in the UK and European markets.

He graduated from The University of Manchester with First Class Honours in B.A. Management in 2016, and has worked in real estate search and advisory for four years. Clients working with Nick will benefit from unrivalled knowledge of the sector, high quality service and a long-term partnership offering within your business.

Contact Nick directly at nick.hammond@deverellsmith.com or on 020 7291 0917.

Deverell Smith Limited, 2nd Floor, Cannon Green, 1 Suffolk Lane, London, EC4R 0AX Tel: 020 7291 0900