Housing Research 195

October 1996

The prospects for large-scale

investment in residential
property
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
factors
The study identified the barriers which have
prevented large-scale residential property investment
by institutions in the UK. Many of the features which
discourage institutional landlords were found to work
in favour of individual landlords. One such was the
tax treatment of direct property investment as
opposed to property fund investment. HITs will go
some way to redressing this balance but other barriers
to institutional involvement remain.
Amongst these are investors’ poor perceptions of
the sector, fear of a future government putting
restrictions on tenure rights and rents, lack of liquidity
in the sector, lack of information such as investment
returns, and unquantified risk. These are set against an
environment in which institutions are, on balance,
reducing their investment in commercial property.
Many of the factors that discourage institutional
investment do not seem to affect small landlords to
the same extent; some may even be seen as
advantages. Factors which motivate small-scale,
individual landlords are: familiarity with the
medium; ease of buying properties for investment;
potential for mortgage borrowing to make capital
investment go further; the possibility of investing
both in small individual properties and in a diverse
range of properties; perception of high returns; low-
cost do-it-yourself property management; favourable
returns in comparison to other personal sector
returns; favourable taxation treatment; perception of
lower, or at least more quantified, risk.
Investment returns
A lack of information regarding investment returns
in residential property was a major barrier to
investment. The study aimed to begin redressing this
lack by quantifying and measuring returns using new
data relating to the lettings market deregulated after
1989.
Gross yields
Gross yields throughout the UK are higher than most
commentators have previously found, averaging
around 10.4%. There is a very wide range around this
average, however.
Gross yields were highest amongst the type of
properties which are popular with tenants but
relatively unpopular with owner-occupiers. Capital
values tend to be low and rental values relatively
high for this type of property. Many small flats and
terraced houses fall into this category as affordability
has increased and owner-occupiers favour larger
properties whilst the first-time buyer properties of the
1980s fall in value.
Net yields
Capital and on-going costs typically reduce gross yields
by 3.5 percentage points, from 10.4% to 6.9%.
Investors must also pay taxation and portfolio
management costs. Capital growth is therefore critical
if total returns are to be enhanced. Gross income
returns in the high teens may be available for certain
types of property in certain locations, but it is very
much more difficult to find the net yields above 10%.
Comparative yields
Analysis of total returns for prime central London
residential property shows a correlation with returns
on retail property but very little similarity to those
from offices and industrial property. This would
suggest that there are significant benefits in
diversifying property investment to include
residential property.
Rental growth
The study found evidence that rental growth levels
are more closely related to household income than to
general inflation.
How do HITs enhance returns?
HITs will only enhance net - not gross - returns.
Under the existing tax regime, institutions are taxed
twice on capital gains and income, once through the
investment itself and once through the company or
vehicle which holds the investment. This is
particularly onerous on tax-exempt (or ‘gross’) funds
such as pension companies who would not have to
pay tax if investing directly. HITs are designed to
remove this double taxation whilst conferring the
benefits of liquidity, collective ownership of
property, ‘investment unitisation’ (the possibility of
holding small, tradeable units of investment which
may represent only a share of the property) and
professional management on residential property
holdings.
Under HITs, professionally managed funds are
still penalised compared with individual direct
investors because they have to pay corporation tax at
24%. To level the playing field with direct investment
income tax on HITs would have to be 20%.
How might HITs deplete these returns?
There are costs associated with an investment medium
to hold properties (such as a HIT) which do not exist
for direct property investment. Fund administration
costs may reduce investment yields by a further 1%.
However, inefficient or profligate fund management,
characteristic of some BES schemes, should be kept in
check by some of the proposed Stock Exchange
regulation. Ultimately, the Stock Exchange rules could
ensure better returns in the medium to long term, but
possibly at the cost of a stillbirth of HITs due to over-
regulation in the short term.
HITs will also have to overcome the hurdle facing
all quoted property companies on the Stock
Exchange: that the market may discount share values
below net asset value.
The advantages of diversifying into residential
property as part of an investment portfolio may also
be diluted as a result of being quoted on the
securities market (‘securitisation’). It is possible that
HITs will perform more like other property company
shares than their underlying assets. They could also
be prone not just to property market fluctuations and
market sentiment but to overall stock market
movements too.
Investor’s yield gap
Consultation with fund managers suggests that some
require a total property return of 13% to 14% per
annum before they would be willing to enter the
residential investment market. They believe capital
growth will only contribute 3 to 4% per annum of
this, which means that a HIT would have to produce
a net rental return of 10%, substantially above the
current average of 6.9%.
If a HIT only distributes 85% of its income, a
gross yield of around 16% will be required, which is
much higher than the national average of 10.4%. A
very limited number of residential properties show
these returns.
Investors will need to be very much better
educated on residential property returns and the
place of residential property in a portfolio before they
might be prepared to accept lower yields.
A model of the residential investment
market
Capital values are dependent on the yield that is
applied to rent. Different types of owner pay a
different yield for property. These yields have been
modelled in the study. From this model, it would
appear that, in current market conditions, individual
investors, who are able to accept a relatively low
yield, can compete with owner-occupiers for
property, especially in the market for smaller flats
and houses which are currently eschewed by first-
time buyers. Institutional investors, on the other
hand, require a relatively high yield and would
therefore have little hope of outbidding owner-
occupiers or individual investors for most properties.
Until the income returns that these investors require
are reduced, perhaps in the expectation of price rises,
it is unlikely that they will be attracted to HITs or any
other residential investment vehicle.
It appeared from the study that demand for, and
supply of, rental accommodation was likely to
remain in equilibrium over the medium to long term.
This equilibrium would however be affected by
investors’ perceptions of capital growth prospects.
Practical issues
The impact of portfolio size
It is estimated that a HIT will need to have a value of
at least £50 million in order to be viable and traded
on the Stock Exchange. If average property values in
the HIT are £50,000 this translates into at least 1,000
properties. This is a very big portfolio to amass in
single units bought one by one, so bulk acquisitions
would be necessary.
The purchase of existing companies, such as BES,
is effectively barred by the HITs legislation. This is
because HITs cannot buy properties let on assured
tenancies.
HITs are allowed to invest in property let on
assured shorthold tenancies, but this type of property
is rarely available in bulk. Vacant possession values
are higher than tenanted values so investors will,
where possible, serve notice on their tenants before
they sell.
Converting or buying large single buildings could
be another route to obtain properties in bulk. It
seems unlikely that there would be very many
buildings of any size where all the flats were within
the HITs’ value limits. Aside from the MoD Married
Quarters Estates there are very few vacant or let bulk
holdings that may be available to HITs.
Perhaps the only way to ensure that the right
properties, in the right place and at the right value,
are amassed for purchase by a HIT is by building
them to order. This will be a highly time-consuming
activity taking longer than the six months allowed
under the proposed Stock Exchange rules at the time
of writing. HITs may therefore be effectively
prevented from this course of action and required to
provide a three year track record before listing if they
are considered to be carrying out development
activity.
The impact of Stock Exchange requirements
Even if portfolios can be built or acquired, the
prototype HIT will probably need a period of time
before it is of sufficient size to gain full investment
trust status on the Stock Exchange. Property
companies or other vehicles which form ‘seed corn’
HITs will have to compete in the currently
unfavourable tax regime before being brought under
the shelter of a HIT umbrella.
The impact of value limits
The Government proposes to disallow properties
worth more than £85,000 (or £125,000 in London)
for inclusion in HITs. This will exclude one in five
privately owned residential dwellings. In the South
East, one-third of all private sector stock will be
excluded on these grounds alone. This will clearly
exclude more than just the luxury properties that the
Government intended.
Overseas experience
There are lessons to be learnt from the successful
securitisation of property overseas. A combination of
different legislative frameworks, different historical
experiences and different tax solutions has enabled
securities backed by property to be freely and widely
traded in other countries.
Perhaps the largest and most successful property
investment vehicles are Real Estate Investment Trusts
(REITs). These have been in existence for over 100
years and now have a market value of $45 billion.
They allow investment in all property types but
residential property usually forms a sizeable
component of the portfolio. They are ‘tax-
transparent’, liquid and valued at the full value of
property assets, with no value limits.
Conclusion
The practical problems associated with amassing and
managing HITs, together with their tax position, may
limit their success. As HITs do not involve any grants
or subsidies it is difficult to see why so many
restrictions should be placed on them. It seems
sensible to move towards a fully tax transparent
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
Joseph Rowntree Foundation
The Homestead, 40 Water End
York YO3 6LP
Tel: 01904 629241 Fax: 01904 620072
ISSN 0958-3084
About the study
The rental data on which yields were based were
gathered during August 1995 from a survey of letting
agents. Information was collected for five common
types of property, in three different types of location
and from 112 different centres across Britain. Capital
values were based on Land Registry figures.
Further information
Further information or copies of the full report (Beyond
HITs, price £55) are available from Yolande Barnes,
Director of Research, Savills, 20 Grosvenor Hill, Berkeley
Square, London W1X 0HQ. Tel: 0171 409 8899;
Fax 0171 495 3773.
Related Findings
The following Findings look at related issues:
165 Funding shared ownership (Dec 95)
191 Homebuy and equity loans: their relevance for
low-cost home-ownership in England (Sept 96)
192 Housing associations and the private lender
(Sept 96)
194 Index of private rents and yields (Sept 96)
The following Housing Summary is also relevant:
14 The outlook for Housing Investment Trusts
(Jan 96)
For further details on these and other Findings,
contact Sally Corrie on 01904 615905 (direct
line/answerphone for publications queries only).
The Joseph Rowntree Foundation is an independent, non-political
body which has supported this project as part of its programme of
research and innovative development projects, which it hopes will
be of value to policy-makers and practitioners. The findings
presented here, however, are those of the authors and not
necessarily those of the Foundation.