Very few fund managers have experience in operating truly international, large-scale residential portfolios. While some markets – such as Germany and the Netherlands – have long histories of an investible institutional private rented sector, others – such as the UK, Spain and Ireland – are in their infancy. We can learn a great deal from sharing knowledge about residential markets across Europe and moving beyond the prejudices of any domestic residential market experience. We advocate adopting best practice from a variety of national residential markets in order to deliver the best risk-adjusted returns for investors.
1. Efficient building design is key to maximising net income
Our experience in Germany, where we have over 100 residential assets, suggests that large, modern, purpose-built and well-designed private rented blocks are extremely efficient to operate and manage with minimal gross-to-net income leakage (the difference between an investor’s gross rental income and their income once costs have been deducted). These units are ‘unbroken’, i.e. they are one block with a single entrance rather than a number of small individual units/blocks as is typical in the UK buy-to-let sector for private investors. They are wholly owned by the investor and not ‘pepper-potted’ blocks where individual units have been sold off to private investors (which has occurred in the Netherlands). Having one entry point and a single core for lifts means that there is less wasted space from stairwells, atriums and corridors, and this makes it cheaper to maintain. And bedrooms of a similar size make apartments much easier to let as they are more suitable for multiple occupation.
Our experience in Germany shows that these newly built blocks lose only around 15% of their gross income. This compares with an average of over 30% for the German listed sector as a whole. For older stock with a small number of units, rents are lower and maintenance costs are much higher as a proportion of income; here, the leakage can be as high as 60%.
2. Ensure tenants stay for longer
Another lesson we have learned from Germany is that longer tenancies result in lower costs, which can provide much higher overall net income. Treat tenants as customers, so that they want to stay. If tenants live in a building for the whole 10 years instead of 10 one-year tenancies, it means that the overall income has effectively grown by 50% – mainly because of lower voids and letting fees, and reduced administrative and refurbishment costs between tenancies.
‘Churning’ tenants to generate higher rents, as is common practice in the UK, may be a false economy because of higher refurbishment costs, fees and voids, and the limited ability to raise rents significantly in the short term. In Germany, our turnover rates are below 10% per annum on high-quality, new-build schemes. This means that average tenancy durations are over 10 years.
3. Don’t fear indexation
In the UK, there is a fear of long, index-linked rental contracts among investors as they prefer annual open-market reviews with the potential for large increases in rents and incomes. A higher overall level of net income may be achieved using rental increases tied to inflation. A measured/appropriate rent control could work.
In addition, continued strong rental increases in the UK look less likely as rents, especially in London, are already high and affordability is becoming stretched. Rental growth rates in England are already lower than people imagine, averaging just 1.6% per annum outside London over the past 10 years. Indexation should appeal to long-term investors who would be happy with very secure income that grows steadily with longer leases. This is in contrast to investors with a shorter-term mindset who are looking for a rapid, and perhaps unsustainable, growth in rents.
Tenants much prefer this type of rental contract, too, as rent increases are modest and predictable, providing security. This encourages them to stay for much longer, as in Germany where indexation is the norm.
4. Rental and capital growth can be stronger than expected
One area where we think continental European investors could learn from the UK is that sometimes rental and capital growth can be stronger than historical experience might suggest. In Germany, rents and capital values were very stable for approximately 20 years up until about five years ago. But the demand/supply imbalance in the major German cities, as a result of rapid population growth and subdued development levels, is so pronounced that rents and capital values are rising sharply. That said, we also think that rents are still relatively affordable and that this growth could continue for many years, as indeed it did in the UK.
5. Adopt new technology
Lessons can be learned from the US where billion dollar ‘multi-family’ (private rented) residential portfolios have been run by listed institutional investors for decades. Utilising new technology means that portfolios can be run much more efficiently with faster letting, better revenue management and quicker handling of customer communications. There is less paperwork and lower staffing costs, and less need for physical viewings because of key fobs for automatic access and online tours. Revenue management is enhanced with automated, demand-led price modelling, which helps identify opportunities to increase rents where letting data is strong.
We believe that we have barely seen the beginning of this trend. We strongly suggest that investors pay close attention to it, as it has the potential to significantly increase income and reduce inefficiencies. The growth in data available to residential managers is expanding and, consequently, so will the sophistication of the decisions around it.
Our Nordic portfolios show that remote-controlled and forecast-based, heating-optimisation systems can significantly reduce energy costs. This is especially important in Sweden as the landlord bears heating costs, which can be substantial in such a cold climate.
6. Local knowledge is key
National residential markets in Europe are very different and inexperienced investors can be caught out. In Germany, for example, most of the costs in terms of heating, electricity, cleaning and insurance are borne by the tenant. But in other markets, such as Sweden, most costs are borne by the landlord. It is vital to be aware of all costs, as the differences between gross income (the rent the tenant pays) and net income (received by the landlord after costs, voids and expenses) can be large. It is vital to capitalise income on a consistent basis.
While Germany is much more efficient in that it has a tighter gross-to-net income ratio given that the tenant bears more costs, the opportunity to improve net income is more limited. In other countries where the landlord bears more costs, there may be more scope for growing net income by improving the efficiency of how portfolios are managed – such as using economies of scale and utilising new technology.
Finally, there are some approaches that we find are consistent throughout our European residential portfolios. We have a strong preference for residential assets that are in ‘triple A’ locations: those that deliver affordability, accessibility and amenity. A thorough understanding of these factors at an asset level is key to successful investment in the residential sector.
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