Valuation: build to rent
In it for the long term
14 May 2015
As the build-to-rent sector finally takes off in the UK, Jason Hardman and James Coghill summarise key issues from RICS guidance on valuing this new kind of asset
The residential investment market has experienced significant change in recent years. The private rented sector (PRS) has virtually doubled in the past 15 years and this growth is forecast to continue. While house prices have largely recovered and in some locations are forging ahead since the 2008 crash, rental values have also seen large annual increases. These factors have in part led to the increasing attractiveness of the sector to a broader range of investors.
In recent decades, the ownership of residential investment housing stock has largely been in the hands of small buy-to-let landlords with institutional investors such as pension funds seeing too many barriers to entry. Some of these barriers, such as a lack of stock on a large scale or the volatility of the wider housing market have started to reduce in recent years and both domestic and international investors are actively seeking or securing blocks or portfolios of residential assets to hold for long-term rental.
Government policies and funding such as Build to Rent are also encouraging new participants to enter the market. According to CBRE Research, having regard to both standing investment stock and forward funding/purchase opportunities, there were more than £2bn of transactions in the new PRS during 2014, with institutions such as M&G forward funding the development of 150 flats in Acton, Greater London, followed shortly after by Invesco forward funding a similar development in Hayes, Middlesex. Both will be held for long-term rental.
Such investment is not confined to the south east, with the Hermes/Countrywide JV having secured a number of residential blocks in Manchester, Birmingham and the East Midlands. CBRE and Savills agree that there is more than £20bn of funds allocated to PRS and actively looking for assets, following the example of the East Village, where Delancey/Qatari Diar JV bought the 1,400 private flats that made up the London 2012 Athletes' Village plus development plots for a further 2,000 flats in a £560m deal, the largest investment in this sector to date.
Government policies and funding are encouraging new participants to enter the market
PRS is perceived as a new market, and it was vital to ensure that valuers and valuations properly reflect the investment rationale of this world. RICS, particularly Alan Collett during his period of presidency, saw a potential valuation conundrum and asked Dr Robin Goodchild of Lasalle Investment Management to chair a working group to prepare an information paper. The resulting Valuing residential property purpose built for renting appeared in autumn 2014.
Before looking at the paper's implications for valuers, it is important to consider how residential investment properties were treated historically.
Traditional valuation methodology for residential investments has principally comprised an application of an initial, typically gross, yield and an assessment of the discount to the owner occupier value or vacant possession value. The main reasons were either a trading approach to estimate the level of return by crystallising the discount achieved at purchase through retail sales or a rudimentary appraisal of income return.
While these approaches will continue to be the yardstick of many investors active in the market, change is coming, with income driven investors very much in evidence.
Until now, transparency around operational costs has generally prevented a detailed assessment of net income. This is beginning to change as new investors request a more thorough financial appraisal, including detailed projections of income and expenditure.
The key driver for many of these new entrants is income and long-term income growth where net yields and discounts to vacant possession (VP) are being supplemented by cash flow analysis. Investors will still have regard for initial yields, both gross and net, but the relationship to VP is becoming more of a benchmark than a principal method of comparative appraisal.
Identifying the market
The key principle for the valuer is unchanged, of course, with the fundamental question to be asked at the outset of any instruction: 'Who would the purchaser (or category) be of this property?' Hence, to understand the approach adopted in assessing value, we must understand the investment drivers for the now varied players in the market.
Short-term, 3-5 year trading strategies will still be very much part of the market. These investors will typically seek higher returns from opportunities that are generally perceived as having more risk and market exposure, i.e. by selling down in the owner occupier market.
Recent transactions clearly show that there are new entrants in this space, too, particularly targeting non-performing loan sales and distressed asset sales opportunities.
They are, though, joined by an increasing number of traditionally commercial real estate investors, which now see residential as an opportunity to balance investment risk across their real estate portfolios and seek a hedge against inflation in the longer term.
These new investors have a different rationale, more closely linked to long-term income. The assessment of likely returns over 10 or more years in a net income and growth explicit cash flow is therefore likely to be increasingly required and the valuation approach adopting either this or a net income and day one capitalisation yield must reflect this.
Requirements for advice
It is acknowledged that the residential sector offers a wide range of assets, which generate different styles of financial return, from ground rents and houses in multiple occupation to dispersed portfolios of houses and bespoke private rented apartment blocks.
Different assets must therefore be appraised in different ways. An understanding of the nature of the asset and the investment strategy of the likely purchaser will inform the valuer of the most appropriate methodology to arrive at an opinion of value.
For example, fragmented portfolios of residential housing, which may lack management efficiencies and could be more suited to a break-up strategy, are likely to be assessed on a shorter term trade out. In this situation, acknowledging the differential between wholesale pricing to retail values will be a key driver.
Where an asset is designed to drive management efficiencies and specified more to the rental market, an income approach may also be considered.
Short-term 3-5 year trading strategies will still be very much part of the market
It is also important to note that while the private rented sector does not at present have its own planning use class, the sector is now starting to implement restrictive covenants of use as PRS for defined periods.
On the face of it, this is a new area for valuers of residential property and will require a different approach to straight C3 residential. For the income investor, Plan A was always long-term rental, but there is now no Plan B. How does this impact on value?
Those at the coalface of residential investment valuation will be debating this and other questions as the shape of the market changes. Without a plethora of evidence of similar transactions, it is necessary to rely on core valuation principles and interpret the situation as it presents itself. The question is 'What is being sold?'
If the answer is the right to receive the net rental income for the defined period (because this is what the asset will generate) followed by either a sale as an investment or a break up to vacant possession value, we must then interrogate the income potential.
The valuer could provide an explicit yield calculation for the defined period with a reversion to vacant possession or investment value. However, at this stage in the emergence of the market, investors are looking for a more detailed projection of income and expenditure during the 'term'. This suggests an explicit cash flow and reference to an overall internal rate of return approach might be required.
The information paper Valuing residential property purpose built for renting looks in detail at the emerging PRS market and seeks to raise awareness among valuers. It should be noted that, as far as valuation approach is concerned, it is limited to residential properties designed to be rented for a defined period. This does not mean that the subject property has to be limited to being rented only – although we are starting to see planning and fundingrelated restrictions – it is more the fact that the property will appeal to this new PRS market. The document is clear in advocating an income driven approach to such assets having regard to:
- rental income: from the residential units and probably other elements such as car parking, storage
- costs: including both life cycle (by way of a sinking fund possibly) and day-to-day running costs such as letting /property management fees, maintenance and upkeep
- assessment of market rent: are current rents above or below market levels?
- future growth rates: relating to both income and costs
- appropriate void or rate of occupation: or if a new asset, the rate of letting up
- net capitalisation yield and overall return (IRR).
So, a fair question seems to be: 'Does this mean vacant possession values are irrelevant?'. Of course, the answer is 'no', unless there is restriction on renting in perpetuity or long period. However, the principal approach to the valuation of PRS assets going forward is likely to be a net income one with vacant possession values providing a useful benchmark.
It is likely that we will see an end to subjective discounts to aggregate vacant possession values for entire blocks or portfolios and any difference between the sum total of the parts of a block from an owner occupation perspective and the market value will be defined by the yield.
What does this mean for valuers? The information paper means that valuers will need to have a thorough understanding of the performance of private rented portfolios. They must also seek to ask for detailed management accounts to underpin the assumptions in their cash flows and increasingly use their wider knowledge of the sector to ensure that market assumptions are adopted as opposed to the incumbent landlord’s current expenditure analysis.
Valuations should be supported with comparable evidence. As mentioned previously, the lack of transparency in management accounts proving net operating income will continue to be a challenge to valuers where investors increasingly seek clarity. Over time, this is likely to develop to the point of more detailed accounts being available through investment transactions.
As the UK population continues to grow and the demand for housing increases, largely unmet by supply, house prices and rental values are likely to rise. With significant global equity sources continuing to seek a home with income-producing assets, demand for residential investment stock designed and built for long-term rental will emerge. The valuation of these assets will therefore follow the same path.
Jason Hardman is Head of Residential Valuation, Valuation and Advisory Services at CBRE and James Coghill is Head of Residential Capital Markets at Savills. Both were members of the working group that produced the Valuing residential property purpose built for renting information paper