Tenant demand for private rental accommodation is not only expanding but also becoming more long-term, as a result of the challenges of getting onto the property ladder. But what are the implications for the supply side of the private rental equation?
We estimate that £200 billion of investment is required in the next five years, if the demand for private renting is to be met. But banks remain much more constrained in their buy to let mortgage lending, and it’s expected that only £50 billion of the required investment will take the form of buy to let loans. Attention is therefore increasingly focused on the attractions of the private rental market for institutions and investment funds, and to a lesser extent, those private investors
with equity.
The key factor in this respect, of course, is the rental income yields available, and how they compare with alternative income-producing asset classes. Historically, residential property investment has attracted investors primarily on the basis of strong house price growth, and has struggled to attract income-seeking institutional investors because of the low net yields available.
But the past years have seen a shift in market fundamentals. First, tenant demand is fuelling sharp rises in rent. Across the UK as a whole in 2011, rents rose by 5.2%, though London saw a 7.2% increase over the year. Rental demand is expected to continue to outstrip supply in the coming five years, keeping rents under upward pressure. At the same time, the housing market recovery remains sluggish and there’s little sign of any dramatic upturn in capital values looking ahead.
Improvement in yields
This combination is leading to some improvement in yield levels nationally. Our joint research with Rightmove shows average gross income yield now stands at 5.8% nationally, but there are significant variations within the market as a whole, for various reasons.
One factor is size: yields are much higher on smaller properties, where owner-occupier demand has been hardest hit by the squeeze on mortgage lending and rental demand is naturally concentrated. Thus, income yields on one-bedroom properties average 6.7%.
Regional differences are relatively slight, although yields tend to be higher in the North than in the South. But within regions there
are also significant variations in yield, according to the value of the local market.
An analysis of yield on two-bedroom properties according to postcode reveals an average yield of 7.8% in the 10% of postcodes with the highest yields (where two-bedroom property prices average less than £100,000). This contrasts dramatically with the average 4.4% achieved in the lowest-yielding 10% of postcodes (where two-bedroom properties average £326,000).
There are therefore opportunities for investors to improve on headline gross yields, whether by buying smaller units or in lower-value local markets. Large-scale investors buying units in bulk are also able to boost yields by buying at a discount to the vacant possession rate (the price paid by an owner occupier).
The headline average gross yield of 5.8% rises as high as 7.7%
for those investors in a position to negotiate discounts through
bulk purchases.
A reliable income stream
Of course, investors do not pocket their gross yields in entirety. After accounting for costs and void periods, the average net yield for typical private landlords comes in at around 4.1%.
Nonetheless, relative to cash returns averaging less than 2%, and given the outlook for a continuing mismatch between rental demand and supply over the coming five years, it’s perhaps unsurprising that investors are increasingly focusing attention on the potential of the private rental sector to generate a reliable income stream.
A survey conducted by Rightmove in October 2011 discovered that over 40% of investors in residential property pointed to attractive yields as their primary reason for holding the asset class.
Total returns are of course also influenced by capital growth in the housing market, which averaged 6.7% a year over the past 30 years. Based on Savills house price forecasts, total returns (net of rental expenses) are likely to average around 6.9% a year over the coming 10 years.
But investors need to delve below the headline figures and have a clear grasp of the underlying complexities and trade-offs of particular markets. Different locations will offer different combinations of rental yield against capital growth prospects or capital stability, as well as opportunities to enhance that yield further, for example by focusing on specific market segments.
Ultimately, as the residential rental market gains in significance as an income-generating asset class, it’s likely that investors will move away from their historical focus on a property’s capital value to owner occupiers, and concentrate increasingly on the income stream as a measure of value, in line with other income-producing assets such as bonds and commercial property.
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