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Infraread issue 11 | UK 16 Apr 2018 Unlocking the potential of Build to Rent housing: the key to solving the UK's housing crisis?

Purpose-built, institutionally-run rental housing is a major growth sector in the UK. The development pipeline has grown fivefold in just five years, and investment in the sector is estimated to reach £50 billion by 2020. We provide a guide to this growing market.

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A few years ago, institutionally owned, professionally managed, purpose-built residential accommodation barely existed in the UK. Now, the "Build to Rent" market, as it has become known, is growing strongly: nearly 20,000 Build to Rent units have been built in the UK, and over 80,000 more are either in planning or under construction. Both local and national government have come out strongly in favour of the development of Build to Rent as a means of increasing the supply of high quality housing in the UK. And UK and international investors, as well as a wide range of developers and builders, are seizing the opportunity: UK investors such as Legal & General and M&G have been joined in the market by investors from North America, the Middle East and Australia; and builders and developers such as Telford Homes, Balfour Beatty and Willmott Dixon have been actively promoting Build to Rent schemes.

Build to Rent schemes bring specific challenges and opportunities that are different from those encountered in traditional housing which has been built for sale, or other real estate and infrastructure investments.  This article looks at these issues, and how they are being addressed in practice.

What makes Build to Rent different?  

"Build to Rent" accommodation is purpose-built, institutionally owned, professionally managed private rental accommodation.  It is distinct from traditional private rental accommodation which, typically, consists of individual flats and houses that have been designed with owner-occupiers in mind, and which are let by private "buy-to-let" landlords who own at most a handful of properties. Although some of this traditional private rental housing is of very good quality, many units in this sector are poorly managed and ill-suited to the tenants using them, giving the sector a bad name both with renters and policy makers.

The British Property Foundation (BPF) has proposed a definition of Build to Rent, which proposes that developments are:

  • newly developed, or converted from other uses, and designed specifically for renting; 
  • in blocks of at least 50 units (or adjacent blocks providing at least 50 units in aggregate), providing sufficient scale for high quality services to be provided;
  • specifically dedicated to private rental for a specific period (typically 15 years);
  • owned by a single owner; and
  • managed in an integrated way, delivering high standards of management and service including comprehensive maintenance.

Why now? The housing crisis is the main reason…

Why has Build to Rent suddenly come to prominence, when the UK's house building industry has, for decades, been so dominated by building houses for sale? 

Build to Rent accommodation is not a new phenomenon in other global markets. In North America,  for example, the "Multifamily" sector is well established, and delivered over 250,000 new units across the key US markets in 2017; and in Germany and the Netherlands, fully 45 per cent of institutionally held property is residential. However, it is only now that the model is being successfully imported to the UK.

The principal reason for the rise of Build to Rent is the shortage of suitable housing across large parts of the UK. The supply of new houses has been failing to keep up with demand for a number of years, and prices have been rising to an extent that many individuals and families have been priced out of the market. It is estimated that the UK needs over 300,000 new homes per year to satisfy demand, but in 2014 only 112,370 homes were completed: as a result, the average house now costs almost eight times average earnings, an all-time record.

Build to Rent can help with the housing shortage in five ways:

  • firstly, Build to Rent can be delivered faster than housing for sale, as it does not have the same issue of market saturation risk.  No house builder will bring a 2,000-unit scheme to market in one go, on account of concerns that releasing such a large number of properties at the same time will depress sales value, whereas a rental landlord will often be confident of letting a scheme of that size rapidly;
  • secondly, Build to Rent investors will often look to build larger schemes than house builders. As can be seen from the BPF definition of Build to Rent, 50 units is often seen as the minimum size for a Build to Rent scheme, and developers often look for bigger schemes in order to drive economies of scale: for example, Quintain are currently delivering 5,000 units at Wembley Park;
  • thirdly, Build to Rent offers an attractive option for those who are unable or unwilling to buy their homes, allowing people to live near the jobs and services they need;
  • fourthly, Build to Rent is a way of attracting alternative sources of capital into the UK house building market: traditional house building – with high-risk and short investment cycles – does not appeal to pension funds seeking long-term income whereas Build to Rent is ideally suited to them;
  • fifthly, because Build to Rent investors are looking for returns over a period of decades, it is hoped that Build to Rent investment will be less sensitive to economic cycles than house building for sale.  Private house buyers are inevitably very sensitive to immediate economic changes, making house building notoriously stop/start, whereas long-term investors who can see a long-term demand for the product may be keen to snap up bargains in a downturn.

...but other factors have come together to help

Historically, the biggest issues with getting Build to Rent schemes built were making the numbers work and persuading investors and policy makers to believe in the product.  In the past few years, both local and national government have come to see the potential for Build to Rent, and have given the sector encouragement – although more would be welcome. Certain planning authorities (in particular, the Greater London Authority (GLA)) have adapted their existing planning frameworks to encourage Build to Rent, and both Homes England (the Government's housing agency) and the GLA have given financial support to Build to Rent, through a combination of direct investment, loans and guarantees. The Government has also made traditional private "buy-to-let" investment less appealing through tax changes, making space for institutional investment in the rental sector – although, as we will see later, Build to Rent has also been penalised by tax changes.

In addition, public authority landlords are promoting Build to Rent schemes on their own land, firstly as a way of meeting their housing targets and secondly as a way of generating a regular income from their land holdings, rather than simply selling them for a capital receipt.  This is particularly valuable at a time when central government grants are reducing and local authorities need to find alternative sources of revenue.

And, finally, the investment landscape has been favourable to Build to Rent in that continuing high valuations of other real estate classes – in particular, offices and retail – have encouraged institutional investors to look for alternative sectors to generate returns, and the lack of housing in the UK has persuaded investors that there is a strong demand for Build to Rent.

Funding Build to Rent

Build to Rent caters for a wide range of investment models, both at the development stage and in the lettings phase.

Some developers, Grainger and Quintain, for example, have followed a design, develop and invest model, where the developer both builds the asset and lets and manages it. But this approach is not for everyone, as it requires investors to take on very different types of risk at the various stages of the scheme:

  • the planning stage, which can be very time consuming and can be derailed by a number of factors outside the developer's control;
  • the construction phase, which is highly capital-intensive for a short period, and notoriously at risk of cost and time overruns;
  • the stabilisation period, while the development is let, and teething problems around management, etc, are resolved; and
  • the trading period, in which success is down to keeping the operation running smoothly, drawing what is expected to be a steady income stream over a long period.

Ring-fencing the development risk...

As a result, many schemes are planned and built by developers, but forward-funded by investors. This approach, familiar in the commercial environment but new to the residential market, has the advantage, from the investor's perspective, that development risk is ring-fenced. It also allows schemes to be funded efficiently. A typical forward-funding has the following key features:

  • the investor commits before works start on site to buy the development site, and separately commits to fund the development as costs are incurred;
  • the developer commits to deliver the development for a robust guaranteed maximum price, sometimes backed by a cost overrun guarantee from its parent company;
  • the development site is sold to the investor as soon as the foundations have been completed and the building is starting to come out of the ground, a stage known as "Golden Brick"; the investor pays for the land at this point;
  • following land sale at "Golden Brick", the developer is employed by the investor to complete the development on its behalf.

As well as ring-fencing the development risk by limiting the investor's exposure to an agreed guaranteed maximum price, this structure keeps funding costs below the costs of conventional development finance, which is not only more expensive but will also fund only a proportion of the construction costs, leaving the remainder to be found from other sources.

Forward-funding is also tax efficient, as it minimises both Stamp Duty Land Tax (SDLT) and irrecoverable VAT. A transfer at Golden Brick allows the developer to recover most of the VAT on its construction costs, while also not passing VAT on to the investor (which will not be able to recover that VAT) and, so long as the contract is structured correctly, SDLT will only be payable on the value of the land plus the works carried out up to the date of sale. By contrast, if the site was purchased following completion of the development, SDLT would be payable on the entire value of the finished construction.

... and the lettings risk?

In the same way as many investors are ring-fencing the development risk, some are also passing the lettings risk to third parties by bringing in a tenant/manager which will operate the property at its own risk, and pay a guaranteed, indexed income strip to the investor by way of headlease rent. This model has not really taken off in mainstream lettings, as investors are tending to back their investments, and are keen to share in the anticipated upside.  However, it is finding a niche as an alternative method of funding affordable housing. Cheyne's Social Property Impact Fund is funding new developments which are then leased to local authorities and housing associations, which in turn let them as affordable housing. This provides an alternative source of capital for affordable housing, while allowing an index-linked, secure return for investors.

Even where investors are happy to take trading risk, they may want to share an element of risk with developers during the stabilisation period, either through the developer taking a minority stake in the investment vehicle, or through keeping a retention which is payable against key management milestones.

Difficulties with debt

Although the forward-funding model is starting to work well, the market for debt funding of Build to Rent developments has not yet hit its stride. There are various reasons for this, but they tend to revolve around the fact that Build to Rent is a new product which works in different ways to conventional residential development. Unlike housing for sale, Build to Rent does not have the benefit of a large number of sales on completion of the development, thereby creating a bullet payment that will repay the loan almost immediately; instead it has certain characteristics of infrastructure finance, in its reliance on a long-term income stream. This, combined with a lack of data, makes it hard for funders to price, and means that the debt that is on offer is likely to be expensive. While there has been some lending in the sector, it has mostly either been by the Government, or backed by Government guarantee.

Getting it built

Build to Rent developers can struggle to compete for sites with developers building for sale, for various reasons. Firstly, local authorities have become increasingly dependent on payments received from private developers in order to provide social infrastructure such as affordable housing and schools. But the different financial structure of Build to Rent, with long-term returns rather than a pay-out from sales at completion, makes it hard to deliver such upfront costs.  As a result, if planning authorities apply the "normal" expectations to Build to Rent, scheme viability suffers.  Secondly, some authorities have been reluctant to grant permission for Build to Rent schemes at all, associating all rental housing with poor management and a transient resident population.

At least in theory, national government is keen to help the sector, but in practice its track record is more mixed. The Government issued a Housing White Paper in February 2016 (cautiously welcomed by the sector), which proposed expressly encouraging local authorities to consider Build to Rent in their plans and decisions as well as consulting on various specific measures to promote Build to Rent. But over a year later there has been no action from the Government to follow up on this. At the same time, the Government continues to penalise Build to Rent through the taxation system: on the one hand, it charges SDLT at a higher rate than for private residential sales; but on the other hand the VAT treatment is less favourable than for commercial properties. As discussed above, it is possible to mitigate the effects of this tax treatment, but not to eliminate the disadvantages completely.

At local government level, planning departments' attitudes to Build to Rent range from highly supportive to the complete opposite. In London, for example, a recent report1 by Nexus Planning identified that, across London's 33 local authorities, planning policy in relation to Build to Rent was positive in 30 per cent of local authorities, neutral in 24 per cent and negative in 46 per cent. As more Build to Rent schemes complete and move into the operation phase, some authorities have come to realise that such schemes are well managed and can help to build communities, whereas others remain sceptical.

The GLA has published guidance for London authorities which is intended to support Build to Rent developments, not least by encouraging consistent practice across London. It proposes a specific planning "pathway" for schemes which fall within the GLA's definition of Build to Rent (which is broadly the same as the BPF's, but specifies that the owners will covenant to keep the development as Build to Rent for at least 15 years, and also requires owners to offer tenants leases of at least three years). Under this regime:

  • developers are permitted to provide affordable housing by way of flats which are managed directly by the Build to Rent owner, rather than separately managed by a housing association. This allows more efficient management of the development, as a single manager is responsible for everything; and
  • authorities are expected to "recognise the distinct economics of the Build to Rent sector and undertake viability assessments that are specifically designed to deal with this model".

However, politics seems to be getting in the way of allowing Build to Rent schemes to provide a smaller proportion of affordable units than schemes for sale.  The GLA's Executive Director of Housing and Land recently commented that, in an increasingly politicised environment, the Build to Rent sector cannot give the message that it will deliver less affordable housing than conventional house building.

But there are cards in Build to Rent's favour, both in relation to acquiring land and obtaining planning permission. As noted above, many public authorities are keen for their land to be used for Build to Rent. Both traditional house builders and planning departments are attracted by the ability of Build to Rent to fill a scheme, and create a community, quickly: for a house builder, a couple of Build to Rent blocks in a regeneration scheme can ensure that the scheme is lively, which helps private sales on the development. And Build to Rent developers are increasingly emphasising the ability of Build to Rent schemes to help create a sense of community. At a time when loneliness is increasingly regarded as a national policy issue - the Government recently appointed a Minister for Loneliness -Build to Rent schemes are specifically designed to encourage residents to make connections, so that they put down roots in the development.

What does Build to Rent look like in practice?

The Build to Rent market is still in its early stages - there are four times as many Build to Rent units in development as have been completed – but clear trends are emerging as to what Build to Rent looks like in practice.

There is no single model for Build to Rent. Attention is often focused on large, high-rise, high-end schemes with extensive resident amenities – this is the "glamour" end of the market. And there are plenty of large, glamorous schemes: Moda Living's Angel Gardens scheme in Manchester, for example, will have nearly 500 units, and includes a cinema room, gym, four restaurants and a multi-functional roof terrace with gardens, terraces, games and BBQ stations.

It is easy to see why many developers are targeting the young, affluent market with these extra amenities. Research suggests that 51 per cent of renters are under 35 years old, and 54 per cent are without children.  Higher anticipated rents enable developers to pay higher sums to obtain land. But that still leaves a large proportion of the rental market which comprises older renters and those with families; and, in any event, many under-35s cannot afford premium rents.  Equally, although Build to Rent schemes are often in inner city locations, and are built as blocks of flats, there is also demand for more suburban schemes consisting of terraced or semi-detached houses. Amid the glitz of the high-end US Multifamily products it is easy to forget that roughly 70 per cent of the US Multifamily sector is low rise, suburban, and focused on families. Besides, extensive amenities are only really affordable on schemes of at least 500 units, and - according to some developers - they are only really economic on schemes of over 2,000 units.

Developers are therefore creating a variety of schemes, e.g. Dolphin Living, which is committed to providing rental homes in high-value areas that are affordable to those on modest incomes; Grainger, which is aiming to deliver 5,000 new flats across the UK targeted at the mid-market; and the PRS REIT, which is building and operating low-rise flats and houses across the UK Midlands and North.

Driving efficiency and customer loyalty

What all of these schemes have in common is a need to run efficient, well-managed buildings that residents want to stay in. Build to Rent schemes will only make a profit if the difference between gross rental income and the investor's income after costs (the "gross-net income leakage") is kept under control; and if the scheme is as close as possible to fully let. So there is a keen focus on developments that are built to last, with letting use in mind, and also on keeping tenants happy - so that they stay and (even better) recommend the development to their friends.

Running costs for traditional "buy-to-let" properties are high. Research by Standard Life Aberdeen, which has a large residential portfolio in Continental Europe, has shown that gross-net income leakage is about 15 per cent for modern properties in Germany, 20 per cent in the Netherlands, but 27 per cent for buy-to-let properties in the UK - and the buy-to-let market does not provide any amenities beyond basic repair.  Gross-net income leakage on many of the initial Build to Rent schemes in the UK is reportedly well above 27 per cent.  But schemes are becoming more efficient: developers are using the practical experience of completed schemes to optimise "second generation" schemes, finding valuable efficiencies even in mundane matters such as how bins are emptied.  In addition, they are increasingly using standardised modular components - and even whole buildings - constructed off site, in order to increase build quality and reduce the need for repairs.

Equally, developers are learning from experience which amenities tenants really value, raising resident satisfaction in often inexpensive ways.  A scheme's target market may point to amenities which will be popular, but relatively inexpensive - for example, in a scheme focused on families, a key amenity might be a central area offering community events and play spaces.  In smaller, less high-end schemes, residents may not expect any physical amenities beyond the basics of a post room, security, etc., provided the scheme is well run and, crucially, the residents enjoy living there.

And in all schemes, developers are realising the importance of the personal touch in making residents feel like developments are their home and not just a staging point.  There is an increased focus on employees who deliver a great tenant experience, rather than simply providing the basic service.  Also, residents' feedback shows that they really value developments where there is a sense of community – and that makes them more likely to stay in a development and recommend it to friends. Therefore, increasingly, designs include facilities which encourage residents to meet informally.  In the end, buildings that reflect how people want to live will keep attracting people.

What next?

The story of Build to Rent over the last few years is one of increasing understanding and acceptance of the sector by policy makers, investors and developers, combined with an increasingly detailed focus on the practical business of making developments work. There is every reason to assume that this process will continue, as what was once a fringe sector becomes increasingly mainstream.

There are potential clouds on the horizon, though. As noted above, housing is a politically sensitive subject at the moment and, if schemes become targets for political opposition, they may well never get off the ground – here effective community engagement is key. Equally, some commentators are concerned that a Corbyn government could introduce rent controls, damaging business models.

Political changes may well place obstacles on the road - and we live in politically turbulent times. But, going back to the point made at the start of this article: the housing crisis continues unabated and, while that remains the case, it is hard to see any government putting an end to a sector that is currently delivering 100,000 new homes, and that is capable of producing millions more.

 

 

  1. "Planning for London's Build to Rent future"; Nexus Planning; March 2018.

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