Mark Weedon: Winning Over the Residential Doubters
April 11, 2011
Head of Residential Services, IPD (Investment Property Databank)
UK investment grade residential property continues to gain in attraction and maturity, with investors drawn by the asset classes’ competitive returns in relation to other asset classes, and low volatility.
This attractive combination has drawn increasing attention to the market, which now benefits from an IPD annual index with a performance hi story spanning a decade, as well as a new biannual series launched last summer to deepen market transparency.
At the launch event at Central London’s One Moorgate Place on March 16th, I presented the 2010 annual results of the IPD Residential Property Index.
The 200-strong delegates who attended comprised a broad mix of the property industry – from residential specialists to mainstream investors, fund managers, brokers to derivatives traders and members of the press. Importantly, all had a keen interest in the investment performance in both the UK residential property market and the private rented housing sector.
The index independently measures investment returns on residential properties with market-let leases (principally ASTs) across the portfolios of our 17 subscriber clients. At the end of 2010, these portfolios amounted to more than 7,500 units worth almost £2.5bn, reflecting an estimated 33% of the entire residential investment market.
In addition to market performance transparency, IPD Residential Service clients further benefit from a confidential benchmarking service which identifies the drivers of portfolio performance, from the asset level upwards, comparing individual investors’ portfolio returns against the market benchmark.
The IPD Residential Index provides the most accurate reflection of residential property performance in the UK. Notwithstanding the deepening of the databank in recent years, the performance profile of the market and its evolving maturity and institutional investment in the residential market remains insubstantial. In this article I will seek to outline this year’s results, and to highlight their significance amid the continued drive to convince institutions to invest in the UK residential market.
Headline Residential Performance
First to the results, residential property delivered a total return of 10.4% in 2010, according to the IPD Residential Annual Property Index, comprising capital growth of 7.4% and an income return of 2.8%. But the headline return masks significant regional divide in performance.
Central London, as in previous years, continued delivering the strongest returns, buoyed by restricted supply, location desirability and the dominance of cash rich local investors. All of which contributed to a capital appreciation of 10.7%, driving a total return of 13.1%. At the same time, rent jumped a staggering 10.2%, compared to 7.6% for the whole market.
Outside the capital, performance deteriorated proportionally in line from each region’s distance from London: Inner London returned 11.4%; Outer London delivered 7.9%; the South East, 5.7%; South West, Midlands & Wales, 4.6% and; the North of England and Scotland produced the market’s only negative return, at -6.4%.
Conditions across our housing market are evidently diverse, as such, it would take a bold (if not reckless) investor to ignore the esoteric drivers of regional economies when allocating to residential property.
The Longer Term View
A longer term review provides a heartening tonic to those invested outside the capital. Over 10 years to 2010, regional disparity was reduced to a mere 1.7 percentage points year-on-year – with top-ranking inner London, at 10.2% pa, at one end of the spectrum, and the North & Scotland with a still respectable 8.5% pa.
The long-term story provided the most interesting analysis. Next to which w as the relative performance of residential returns against commercial property as well as other major asset classes. Taking a medium term view, residential property has proven more resilient in the face of the economic downturn, managing to maintain a positive annualised return, at 1.3%, compared to -2.5% for commercial property.
Equities posted a marginally superior 1.4% pa, while gilts, unsurprisingly, outstripped all asset classes by some margin, delivering a three-year annualised return of 7.7%. Over five years, residential property rises to the top performer, with an annualised return of 7.4% outperforming other assets. Finally over the full 10 years for which there are IPD residential returns, the residential market justified its reputation for strong long term performance relative to other asset classes with an annualised return of 10.1%, compared to 6.7% pa for commercial property, 5.9% for gilts and 3.7% for equities.
Overcoming uncertainty and effectively hedging against inflation
Over the past three and a half years, the UK economy has suffered with both an economic and a financial crisis, resulting in declining GDP, bank nationalisation and careful monetary policy balancing to re-invigorate liquidity into the economy while staving off the very real threat of rising inflation.
In the property market, the capital write-downs of assets, combined with the erosive effects of inflation have been a bitter pill to swallow. To fully understand the true performance of residential property, an analysis of inflation-adjusted ‘real’ returns is, therefore, required.
Adjusting for inflation doesn’t alter the relative positions of competing asset classes but does provide a better feel for the true return on investment as well as the likely profitability of companies employing specific investment strategies.
Over three years, steep price increases in the economy have pushed real residential property returns into negative territory at -1.3% pa. Commercial property, already below the zero during this time period on a nominal basis, falls to -5.0% pa, while equities perform better than both, at -1.2%. On a three-year basis, only gilts delivered positive returns, with a recession-defying real return of 4.9% pa.
The longer periods demonstrate the real value investors in the private rental sector have enjoyed: over five and 10 years real residential returns were 3.9% pa and 7.1% pa, comparing extremely favourably to the lower real returns delivered by other assets.
Understanding Risk in Residential Investment
Fund managers are always prepared to take risks where there is a compelling investment story. However, after the capricious movements of property values in recent years, appetite for volatile investments has diminished. To better understand risk within residential property, both standard deviation and sharpe ratio analysis help.
First, look at the standard deviation, which is a measure of risk distribution, and over 10 years it would be typical to expect a higher variation to go hand-in-hand with higher returns. This is not the case with market-let residential, which posted the second lowest volatility (to gilts) – reflecting an enviable risk/reward profile compared with commercial property, the main commercial sectors (office, retail & industrial) and equities.
Employing the Sharpe ratio allows us to mathematically indentify the premium investors have derived from the risk taken. Taking a 10-year gilts return as the risk-free rate and divide each asset classes’ total return “premium” above this rate by its standard deviation, shows that residential investors enjoyed a premium for relatively low risk, compared with commercial property and equities (which offered little or no bonus beyond the risk-free rate).
Income performance, the “myth”
It’s well known that residential property is lower yielding than its commercial cousin. Potential investors have struggled to come to terms with this investment profile and continue to site the higher income return to current capital employed as grounds for not investing professionally in residential. However, further drilling into IPD’s cauldron of data will reveal that quarterly and annual income returns and yields do not tell the whole story of income performance.
Companies are concerned with profit and the net cash profit which flows from their rental income stream is ultimately more significant to their business than the income yield number they see in their IPD benchmark report. The figures above demonstrate that residential has enjoyed significantly higher capital appreciation than commercial property in the last decade.
Prior to this, house price indices demonstrate this pattern has continued for at least 50 years with commercial capital values depreciating sharply in real terms. We have now taken the assets present in our residential data sample for the full 10 year history and recalculated their annualised income return assuming that they appreciated at the commercial property growth rate in order to strip out the impact of residential’s superior capital growth on its income performance.
The result is eye-opening, with the income return increasing from the original 4.5% to 6.3% which is actually higher than the annual commercial rate of 5.9% over 10 years. This suggests that true residential income performance is much closer to commercial property than is perceived to be the case and demonstrates that yields do not provide a full account of income return.
IPD are partners of the property investment industry rather than a player in it. We take the role seriously and understand the importance of using our numbers to shed light onto investment performance. In the case of the UK private rented sector, we are supporters of investment in housing and pleased to be able to use our analysis to demonstrate its considerable merits.
To this end, we are very happy to have entered into a sponsorship agreement and working partnership with Young Group who display great enthusiasm for the growth of the sector and bring fresh ideas to the table.
Some of the residential naysayers will never run out of arguments but these will be increasingly difficult to make in the next few years if IPD are able to deliver an index of greater which includes several new large institutionally managed residential funds. For now, Young Group and the PRS as a whole must keep knocking on the door and believe that the institutions will open.