Funding Private Rented Sector Housing
October 5, 2014
The emergence of a significant Private Rented Sector (PRS) development and funding market has been driven initially by the public sector through various initiatives, including the formation of the Government PRS Taskforce and followed closely by investors.
These early investors included M3 Capital Partners, M&G, Apollo, Grainger, AGP, Qatari Diar, Akelius, Oaktree and Sigma, with many following suit in the last 12 months. On a monthly basis new investors are entering this market with c£500m to invest, all seeking PRS developers and suitable investment opportunities in the UK’s top 35 cities.
Sources of Funding
The Government provided the initial PRS market stimulation with the Build-to-Rent fund, which provided debt, equity and mezzanine funding for the development of PRS stock. This was followed by the announcement of the Government’s Housing Debt Guarantee Scheme providing 30 year guarantees to banks for PRS debt funding. The amount of funding available for new PRS development is estimated at approximately £10bn from private sector funding sources and £10bn by way of public sector funding initiatives.
The type of funding offered, duration/term, amount and when it is available, all depend on the party providing the funding. The funders in the PRS market include:
- Annuity Funds (Pension Funds)
- Private Equity/Opportunistic Funds
- Local Authority Public Works Loan Board backed loans
Banks tend to provide funding for the development period only, seeking to exit within a three to five year period and generally wish to see an agreed exit route prior to funding.
The Government’s Build-to-Rent fund is also primarily for the development period, providing funding (debt & equity) for up to 50% of the development costs with an anticipated repayment within five years and a longstop date of March 2025.
Private Equity and Opportunistic Funds generally have a maximum investment time period of six to seven years for PRS and will fund through the development period, stabilisation and finally exit, with each of these stages comprising approximately two years. The Private Equity and Opportunistic Funds will usually sell to a pension fund, however they may also seek a bond issue, securitisation, Real Estate Investment Trust or listed vehicle as an exit. This exit route may not be transparent to the developer who has obtained the funds, as this may be wrapped up in the overall fund’s objectives and may include the exit of multiple PRS investments that the fund has made.
Pension Funds provide the best source of funding for the PRS as they seek out long term (25+ years) income streams which are linked to inflation (rental increases). However, Pension Funds are risk averse and generally shy away from development/construction. The UK PRS is a new form of investment for Pension Funds and has little track record as an institutional investment class.
Essentially the development period of PRS represents a higher investment risk and funding is generally undertaken by Private Equity, Banks or Opportunistic Funds for a higher return on their funding. Once the income on the completed units has stabilised (two to three years) the investment risk is reduced and is of interest to long term investors.
The Funding Deal
There is a significant amount of debate regarding the discount at which PRS should be sold compared to open market private sale housing and how this impacts on developers developing/selling for PRS purposes. There are typically three ways in which PRS funders/investors approach the funding of PRS housing or developments, these essentially are:
- The purchase of existing stock/units
- The purchase of units to be built by the developer (forward purchase)
- The funding and purchase of units to be built by the developer (forward funding)
When an investor looks at purchasing a building that has been completed or is soon to be completed, the investor will apply a discount to the open market sale value of each flat/home on the basis that the purchase is a bulk transaction (i.e. purchasing 200 units not one open market unit). This will also be the case where a forward purchase is agreed (i.e. the funder agrees to purchase all the units once the development has been completed). However, the discount to open market will be higher because the funder may have to commit to purchasing the units up to two or more years in advance and may be exposed to market fluctuations and a cost of capital.
These discounts to open market value will vary depending on the location, number of units, type of product and the developer’s ability to deliver. The discounts to open market value will typically range between 6% and 15% and are unlikely to exceed 20% as this would leave the developer with very little return for undertaking the development risk.
A further discount is applied by the investor to the open market value should the developer require the investor to fund the PRS units during the construction period, this is because the investor will be exposed to development/construction risk and will also require a return on funds drawn-down. However, this seldom results in a further discount to the open market value as the cost of finance during the construction period is normally taken into account in the construction costs in the development appraisal.
While funders will look at the purchase/costs per unit they are primarily interested in the net yield/return from the development as this represents the return to their investors. The net return is calculated by taking the gross rental (including income from other services, internet etc) less the operational costs and voids (usually between 25% to 30%) leaving the net income. This is then divided by the cost of the scheme or unit to reflect a net annual yield/return on investment.
The return required by the investor will depend on the type of product (upper or middle market) and the location. It typically varies from 1% to 7% with the highest investor demand in the 4% to 6% range. The investor return is calculated based on the annual net yield and the capital growth (HPI or yield based) in the property providing a total return (typically of 9% to 10%).
There is a significant level of funding pursuing the PRS development market and property developers with the right product in sought after locations will be in a strong negotiating position with funders.
Public Sector PRS Development and Funding
In the last six months we have seen a phenomenal increase in the number of local authorities pursuing PRS development on local authority owned land, either in joint ventures with developers or by undertaking self-development. Some of the drivers for this development are:
- The lack of housing development being undertaken by the private sector in the boroughs
- Registered Providers’ lack of housing supply in the boroughs
- To create a better rental product/market
- Regeneration of town centres
- To generate revenue income for the local authority
The primary driver is that local authorities can use PRS rental income to provide themselves with a revenue stream on land which they own and which is often underutilised. These revenue incomes have become more and more important to local authorities as the Government places deeper cuts on their finances.
The local authority typically sets up a Special Purpose Vehicle to develop the units with the management and operations being out-sourced to specialist management companies. The local authority borrows the funding from the Public Works Loan Board (20 year fixed funding, at approximately 4%) for the construction of the units and can make a revenue income return from the difference between the rental income from the units and the cost of borrowing. Other variations include private sector funding and ground rental mechanisms, which can all provide similar, albeit lower, income streams.
In conclusion, there are various forms of funding available for PRS development and investment, however there is a significant shortage of “oven ready” development sites particularly as investors wish to commit large capital investment over multiple sites.