Institutional investors in the UK and other developed markets are finally beginning to wake up to a truth that their counterparts in the U.S., Germany and the Netherlands have long known: residential property is a potentially attractive source of income that can complement 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 a huge under-supply as a result of low development. This is exacerbated by a growing number of homes required to supply an increasing number of households, as 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.
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’s more, the supply constraint gives few alternatives to suit 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 armored 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 are developed 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 also worry 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. For example, an investor could acquire a greatly under-rented property that a bank had repossessed, and by decreasing vacancies could substantially increase the rent roll.
While of course investors favor high rents, ultimately they want our customers to stay and 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. In Germany, the owner loses roughly half that amount.
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.
Fundamentally, the income from residential property can be resilient and long, underpinned by huge supply shortfalls; 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.
Property investments may carry additional risk of loss due to the nature and volatility of the underlying investments and may not be available for investment by investors unless the investor meets certain regulatory requirements. In considering the prior performance information contained herein, potential investors should bear in mind that past performance is not necessarily indicative of future results, and there can be no assurance that such investments will achieve comparable results.