Is UK residential property a viable alternative? - Capital Economics
UK Commercial Property

Is UK residential property a viable alternative?

UK Commercial Property Focus
Written by Hansen Lu
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Relative to past norms, returns on residential property will underperform over the next few years. But with commercial capital values dragged down by the retail sector, institutional investment in the residential private rented sector will nonetheless look attractive. What’s more, on the development side, if Help to Buy ends as promised in 2023, the slowdown in demand for owner occupier homes will further boost the build to rent roll out.

In view of the wider interest, this UK Housing Market Focus is made available to clients of the UK Commercial Property service as well.

  • Relative to past norms, returns on residential property will underperform over the next few years. But with commercial capital values dragged down by the retail sector, institutional investment in the residential private rented sector will nonetheless look attractive. What’s more, on the development side, if Help to Buy ends as promised in 2023, the slowdown in demand for owner occupier homes will further boost the build to rent roll out.
  • Over the next few years, the outlook for returns on residential property investment are weak. In the past, returns on residential investment have been driven by capital gains. But the force that had previously driven up house prices – falling mortgage interest rates – has largely been expended. Looking ahead, we think that house prices will struggle to grow faster than 2% or 3% per-year for the foreseeable future, much slower than the 6% or more seen in past decades.
  • Admittedly, there are growing signs of a pick-up in rental growth. On the supply side, that reflects tax hikes, which have driven some buy to let landlords out of the market. And the demand side has been supported by rising wages and low unemployment. Taken together, the growing imbalance between demand and supply is leading to tighter conditions. However, even if rental growth were to accelerate to 3% y/y by 2021, in line with our forecast, rental yields would still be broadly unchanged from their current low level.
  • This means yields on residential property are set to underperform commercial property. Yet there are reasons to believe that those lower yields are justified. Firstly, residential rental growth in the UK has tended to outperform commercial property. And in addition to this, residential capital values have in the past proved more resistant to shocks. Indeed, comparing the last two property price collapses, residential property saw a smaller decline than commercial property, and also saw a faster recovery.
  • As a result, despite being historically weak, residential capital gains are set to outperform commercial property over the next few years, which will be weighed down by a struggling retail sector. As a result, we expect residential total returns to average 5.7% per-year between 2019 and 2023, whereas all commercial property will average 4.7%.
  • Furthermore, institutional investment in the private rented sector may benefit from a weakening build to sell sector. After all, in the past, housing market booms had bolstered build to sell schemes, and government support from Help to Buy had only exacerbated this effect. That had made it harder for build to rent developers to acquire sites – limiting development in the sector. But with housing starts already declining, and with the Help to Buy scheme set to end in 2023, this trend is set to reverse. That clears the way for a further rise in build to rent development, which we expect to continue its ascent in the coming years.
  • The big picture is that, despite the weakness in residential property returns, the prospects for investment in this alternative sector are good. Indeed, if Help to Buy ends in 2023 as promised, the recent rise in build to rent construction should only intensify.

Is UK residential property a viable alternative?

This Focus is an adapted version of a presentation given at the Capital Economics Property Forecast Forum held in London on 20th November 2019.

The outlook for commercial property is fairly subdued across the UK, US and Europe. This Focus will look at whether, in the UK, residential property investment presents a viable alternative.

First, we give an overview of our forecasts for returns on UK housing. Second, we compare this picture of the housing market to commercial property. Third, we discuss how some developments in the housing sector may benefit build to rent (BTR) development. And finally, we examine whether the rise in institutional interest in the UK rental market is justified.

The outlook for house prices is subdued

In recent years, house price growth has weakened. It has slowed from 4% or 5% a year in 2015 and 2016, to what is essentially a standstill in 2019. (See Chart 1.) And in London, house prices have fallen. Compared to their peak in Q1 2017, prices in the capital are down by a cumulative 5%.

Chart 1: House Prices (% y/y)

Source: Nationwide

So why has this happened? Of course, it’s hard to ignore the fact that Brexit uncertainty has hit confidence among buyers and sellers.

But more broadly, the slowdown reflects high house prices. In Q3 of this year, the average house cost seven times the average income – a historically high level. (See Chart 2.) High prices make it harder for borrowers to raise a deposit, and combined with mortgage regulations, limit the ability of buyers to bid up prices further. Both factors constrain house price growth.

Chart 2: HPE and Debt to Income Ratios

Sources: Nationwide, ONS, Bank of England, Capital Economics

That said, mortgage affordability looks fairly good. Despite higher house prices, mortgage payments are still fairly low compared to past norms.

As we have previously noted, the combination of high house prices yet affordable mortgages reflects falling mortgage interest rates. (See our Focus, “Can house prices boom again.”) From around 9% in the 1970s and 1980s, mortgage interest rates have declined – falling to just 2% at the latest count. (See Chart 3.)

Chart 3: Average Interest Rate on a New Mortgage (%)

Sources: Sources: Refinitiv, Capital Economics

Looking ahead, the path for interest rates in the UK will depend on what happens with the General Election and Brexit. But importantly, none of our scenarios predict a big change to the price of credit. Indeed, even if Boris Johnson’s Brexit deal is implemented in January and the Bank of England begins to tighten monetary policy towards the end of 2020, we expect mortgage interest rates to stay below 3% by 2021.

Furthermore, whatever happens over the next few months, mortgage interest rates will likely push housing transactions and prices in the opposite direction to the economy. Interest rates will probably rise if the economy is strong, cooling the housing market. And if the economy is weak, an interest rate cut would help to support house prices and transactions.

Taking all that together, our forecast is for house price growth to stay roughly at its current pace – rising by between 1% and 2% per year between 2019 and 2021.

The outlook for rents is brighter

Compared to the downbeat outlook for house prices, the picture for rents is brighter. That reflects the underlying demand and supply dynamics in that market.

For a start, the number of homes coming up for rent has been falling. (See Chart 4.) This seems to reflect the reduction in mortgage interest tax relief and the introduction of the stamp duty surcharge. Both factors have been driving some landlords to sell up, while discouraging other landlords from entering the market.

Chart 4: Tenant Demand and Landlord Instructions
(% Balance)

Source: RICS

At the same time, tenant demand has been rising, which on the face of it, might seem surprising. In the public eye, a common complaint is that rents are too high. If rents were indeed already unaffordable, then that could choke off demand, constraining rental growth.

But, the notion of high rents is a London-centric view. Chart 5 shows an index of average rents as a percentage of average full-time incomes. Across most of the country, rental affordability is better than it was 10 or 15 years ago. And, driven by faster wage growth and a slowdown in rental growth, rental affordability has, if anything, been improving. (See Chart 5.)

Chart 5: Rents as a % of Average Full-Time Income
(Index, Jan 2006 = 100)

Sources: ONS, Refinitiv, Capital Economics

All that leaves a subdued, but steadily improving outlook for returns on residential property. Table 1 shows our key forecasts for the next few years.

Table 1: Key UK Housing Forecasts
(Brexit on 31st Jan. Leading to Trade Deal)

2010-17

2018

2019f

2020f

2021f

2019-23 avg.

Transactions
(% y/y)

5.9

-2.7

0.0

1.3

2.5

1.7

Rents (% y/y)

1.9

1.0

1.5

2.5

3.5

2.9

House Prices
(% y/y)

3.4

0.5

1.0

1.5

2.0

2.0

Net Yield (%)

3.9

3.6

3.6

3.6

3.7

3.7

Total Return (%)

7.7

4.1

4.6

5.1

5.7

5.7

Source: Capital Economics

We think solid wage growth and a constrained rental supply will push up rental growth to 3.5% per year. But despite accelerating rental inflation, the impact on net yields will be small, leaving them at an average of 3.7% across our forecast. However, house price growth will rise a little, to 2% year-on-year by 2021. That will push up total returns on housing from 4.1% in 2018, to 5.7% in 2021. Across the five years to 2023, we expect total returns to average 5.7% y/y.

In all, that result is unspectacular. For example, returns between 2010 and 2017 averaged 7.7%, while the 2000 to 2010 average was even higher. Of course, these forecasts reflect our most optimistic scenario, where Boris Johnson’s Brexit deal is implemented in January and a trade deal with the EU is agreed without a further extension to the transition period. In reality, many other Brexit outcomes are possible.

Yet we think there’s a good chance those other scenarios would have only a small effect on our forecasts. Indeed, even if Brexit were to be delayed repeatedly from here on, we think total returns would follow largely the same path. After all, the economy would fare a little worse. But interest rates would fall probably fall, and the imbalance between rental demand and supply would be unchanged.

Low residential yields may be justified

In all, over the next few years, housing returns are set to be weak compared to past norms. And in that context, it perhaps seems odd that large investors have chosen this moment to become so interested in the residential sector.

Indeed, our measure of UK net residential yields is at 3.9% now. That is well below the 4.6% initial yield seen across all commercial property. (See Chart 6.)

Chart 6: UK Property Initial Yields (%)

Sources: ONS, MSCI, Capital Economics

But, lower yields for residential property may be justified. Property yields reflect not just the current rental value, but the future expected rental stream too. In the long-run, residential property rents have tended to outperform commercial property. (See Chart 7.)

Our key explanation for this is that residential and commercial property exist for different purposes. For firms, commercial property is a cost of doing business that eats into their profits. So firms have an incentive to improve the efficiency of commercial property use over time.

By contrast, residential property is primarily purchased as a form of household consumption. Households want bigger and better housing as incomes rise – raising housing consumption alongside wages. These diverging preferences and incentives favour faster growth in residential rents, compared to commercial.

Chart 7: Real Rents (Index, 1982 = 100)

Source: Sources: ONS, MSCI, Capital Economics

Residential property also attracts favourable comparisons in terms of risk. As we noted previously, the risk of an imminent house price collapse is limited. Past collapses in prices have tended to come hand in hand with a sharp deterioration in mortgage affordability.

But affordability currently looks very favourable. What’s more, even if Bank Rate were to rise to 1.5% following a Conservative win at the upcoming election – our most bullish interest rate scenario – mortgage affordability would still be comfortably away from the danger zone.

Of course, we cannot entirely rule out a house price collapse. Yet residential capital values are also no more at risk than commercial property. After all, the main threats to capital values – a spike in interest rates or slump in economic growth – also threaten the commercial sector.

Indeed, history shows that commercial property capital values have tended to be more risky. Chart 8 takes an average of the collapses in commercial and residential property prices in 1992 to 1993, as well as in 2008 to 2009. In both cases, commercial property prices fell further and took longer to recover.

Chart 8: Comparison of Past Property Corrections (Index)

Sources: Nationwide, MSCI, Capital Economics

In any case, low yields on residential property will be offset by stronger capital growth. Despite the fact that, at just 1% or 2% per year, house price growth looks weak by past standards, with commercial property capital values dragged down by the retail sector, we expect residential property to still comes out on top over the next few years. Between 2019 and 2023, we expect residential total returns, at an average of 5.7%, to beat the 4.7% average for all commercial property. (See Chart 9.)

Chart 9: Comparison of Total Returns on Property
(% y/y)

Sources: Nationwide, MSCI, Refinitiv, Capital Economics

More opportunities for build to rent

Looking ahead, the prospects for BTR development are also improving. In the past, a key challenge facing developers has been viability. Housing market booms had bolstered build to sell (BTS) schemes, making it harder for BTR developers to acquire sites.

Government schemes like Help to Buy (HTB) exacerbated this, artificially boosting owner occupier demand. Chart 10 shows the total value of equity loans granted under the HTB scheme so far. Support has totalled £12.4bn to Q1 2019. That is equal to £17,000 for every new home built over the period.

Looking ahead, HTB has much further to run. If fully used, the scheme could rise to £29 billion by 2023 – equivalent to an additional £4 billion a year over the next four years. (See Chart 10 again.)

Chart 10: Help to Buy Completions and Approved Funding (£ billion)

Sources: MHCLG, Capital Economics

Yet beyond that, there are no plans to renew the scheme. And given growing political opposition, even if HTB is replaced again, it probably won’t be as generous as it is now.

As a result, the outlook for BTS is weakening. On a four-quarter rolling basis, housing starts have already declined by 5% y/y in Q2 2019 – a sign that construction has hit a roadblock. (See Chart 11.)

Chart 11: Housing Starts and Transactions
(000s, 4 qtr. Total)

Sources: MHCLG, HMRC, Capital Economics

True, part of the slowdown reflects Brexit uncertainty. But an end to HTB could be more influential. It takes around two years to build a home, from start to completion. If the scheme ends in 2023, construction in the BTS market may be pared back as early as next year, for fear of oversupply. Indeed, in the run-up to the general election in 2019, no political party has made a concrete pledge to renew HTB beyond 2023. And even if the scheme is eventually renewed again, given political opposition to the scheme, it is unlikely to be as generous as it is now.

All that creates space for BTR. Indeed, to accelerate delivery in the face of weakening owner occupier demand, parts of some ongoing developments are already being converted into BTR. Looking ahead, this activity is likely to intensify as long as the future of HTB hangs in the balance. And it suggests that the recent rise in BTR construction will only intensify for the foreseeable future.

Conclusions

Looking ahead, our long-run view is that residential returns will stay weak by past standards. A boom in house prices is not on the way, and while accelerating rental growth is a plus for landlords, the impact on rental yields will be limited.

But despite this, institutional interest in residential property is still justified. Residential returns in the UK will beat commercial property over the next five years. And on past form, residential property capital values appears to have less downside risk, while residential rental growth have tended outperform commercial property rents by a long way.

Furthermore, owner occupier housebuilding has come off the boil and is unlikely to pick up again soon. That has created a gap in the market BTR development. Combined with the fact that returns will be favourable, we expect institutional investment in the private residential sector to pick up further in the years ahead.


Hansen Lu, Property Economist, 020 7808 4988, hansen.lu@capitaleconomics.com