Prior to the Government’s market turmoil inducing mini-budget, net initial yields in Build to Rent (BTR) had been stable for some time and investors had been experiencing strong rental inflation.
This followed the rental decreases seen during the pandemic. With the Bank of England stepping into the bond markets and hinting at continued interest rate hikes it’s hardly surprising that investors, in arguably the most attractive alternative UK real estate market, hit the pause button on their Build-to-Rent plans.
Some are now starting to tentatively come off the fence in these early days after the mini-budget reversals, the subsequent despatching of the Chancellor of the Exchequer and our third Prime Minister in seven weeks. However, the market hasn’t returned to normal, and some investors are saying that they are unlikely to transact this side of the new year. Several market commentators are musing that a market correction in BTR is inevitable. However, as the economic and political mists begin to clear there are two fundamentals underpinning the UK’s rental market which may serve as a brake on such a correction – barriers of entry to home ownership for first time buyers and shrinking supply in the private rented sector (PRS).
Barriers for first-time buyers
The importance of this element cannot be understated. As shown below, house price-to-earnings ratios are now well above their previous peak, ahead of the Global Financial Crisis. With the average UK house price almost nine times the average salary. With interest rates rising and likely to stay at or around this level for the next two to three years, servicing the large amounts of debt most first-time buyers need is a major barrier that will exclude most from becoming homeowners.
Add to that, the Help to Buy equity loan scheme closes this month without a credible alternative. Published two year projected take-up for the First Home scheme is equivalent to only 4.5 days of take up for Help to Buy, and private developer schemes will struggle to be as financially attractive as a government backed scheme or reach anywhere near the same volume of buyers.
Shrinking supply in the PRS
Over the next two years there will be c.100,000 Help to Buy Equity Loan buyers who will have to start repaying their equity loan. There will also be many who will find it harder to make mortgage repayments given new higher interest rates. This may see more households returning to the rental market, just as more buy to let landlords are exiting the market due to increasing mortgage costs and EPC requirements. In the four years between April 2017 and March 2021 the private-rented sector in England shrank by c.300,000 homes and this could now accelerate. With the PRS net outflow set to continue in the coming years, and BTR not yet in a position to fully fill the void, undersupply in the wider PRS offers a sizable buffer to downward rental pressures. Even in a strong market, build to rent will be unable to replace the net loss in rental properties.
So what will investors do?
The fundamentals supporting BTR investment have not changed but interest rates are having a real impact on the cost of debt and the 10-year Gilt rate has moved out from 1.8% on the 1 August 2022 to 3.47% today. The weight of capital that was there for BTR investment just before the mini-budget is either generally sat on the fence for now, awaiting a potential price correction (e.g. equity investors) or has retreated for the time being (e.g. highly leveraged investors).
The viability of BTR forward funding transactions was a real challenge before the mini-budget largely because of construction cost inflation. If yields are to increase, this will become even more of a viability challenge. And believe it or not, construction costs are forecast by my QS colleagues to increase by 8-10% over the next 12 months due to supply-led inflation. So, something will need to give. We envisage investors wanting to become more closely involved in BTR transactions. We expect to see more joint ventures than traditional forward fundings where cost, risk, upside and downside are more evenly shared. And with the weakened pound there are opportunities for overseas investors from Asia, the US and Canada. We’re already hearing from those who are looking to take advantage of this domestic blip.
And we expect to see more market liquidity now that the farcical mini-budget fiscal measures have been discarded and the path to a relatively stable political environment appears to have begun.
Andrew Stanford is Head of Build to Rent at Colliers, he works with developer and investor clients within this growing asset class. He is also chair of the British Property Federations Build to Rent committee and previously led the Government’s PRS Taskforce which was charged with kickstarting build to rent.
To contact Andrew, email Andrew.Stanford@colliers.com