12 Dec 2022
Craig Wright, Head of European Real Estate Investment Research
Housing markets around the world are facing strong headwinds. Household finances and purchasing power are under pressure from falling real incomes, surging household bills and higher borrowing costs.
When we talk about ‘housing markets’ we must be clear what we’re talking about, though. House prices and private rented residential sector (PRS) asset values, while related as parts of the same housing ecosystem, are two very different things.
Some forces that're to the detriment of house prices can be supportive for PRS values. The main difference is the cashflows that PRS apartment blocks produce. PRS assets are by no means immune to the challenges in the economy today, but the drivers of their performance are sufficiently nuanced to write about here.
House prices have been on an incredible run for around a decade, as low mortgage rates and low supply created a highly competitive marketplace. According to data from the OECD, real house prices across the countries in the group increased by 45% in the last 10 years; 16% has been in the two-year period since the onset of the Covid-19 pandemic. Prices hit record levels in many countries, particularly in Europe where central banks have run negative interest rates for almost a decade – until now.
Times are changing. US economist Robert Shiller, famed for accurately calling the 2008 US housing market crash, recently warned of at least a 10% drop in US house prices in 2023 as the Federal Reserve (Fed) presses on with interest rate hikes that will push mortgage costs higher. Meanwhile, other countries, such as the Netherlands, Sweden, Australia and the UK are all beginning to see clear declines in house prices. A painful consumer recession in the next 12 months is likely to be damaging for housing markets in many economies globally.
Investors have been ramping up allocations to the PRS sector in recent years, as it has matured into an institutional-grade investment sector. The appeal of long-term stable cashflows, often directly linked to inflation, have resonated with many pools of capital. According to non-listed funds association INREV, global investor allocations to rented residential property increased to 23% of total assets under management in 2021, second only to offices (35%). At the current rate, residential allocations could exceed offices in the next five-to-10 years.
In this context, do PRS investments face the same outlook as home ownership markets? The short answer is not exactly. It is fair to say that investment property values are also experiencing downward pressures from rising interest rates, and PRS is not entirely immune to the economic cycle, either. But the critical difference for PRS investments is the value that their cashflows offer investors looking for stable income. The PRS sector continues to receive strong tenant demand and, indeed, it could ultimately benefit from the housing market correction outlined above.
While rents have also been rising in many countries, prices have been rising faster in most cases. This makes home ownership relatively more expensive. Now, with malaise in the home ownership market setting in, this is driving more people into rental properties. According to data from trade body Propertymark, there was an average of 141 new applicants registered per lettings agency in the UK in August this year – a new peak level recorded. We believe that the core drivers of rental demand remain in place and could become more acute in coming years.
A lack of affordability of mortgage payments and the inability to raise enough equity for a deposit (and associated transaction costs) is one key reason for continued growth in rental demand. The rental model is not always the most affordable option and it does vary by country. But the rental model will continue to prove the preferred, if not the only, option for some households, especially with rising energy bills eating into peoples’ ability to save for deposits. The requirement to find a deposit, and be accepted for a loan on increasingly tight lending criteria and at higher interest rates, is not for everyone. Equally, for those poised to enter the market with equity saved, sentiment towards prices is likely to encourage them to rent temporarily.
And why not? Modern PRS apartments are typically more energy efficient, well designed and come with a range of amenities that are increasingly driving the decision to rent, rather than to own, across all age groups.
What would have to happen to change demand trends for the rental model? Our estimates, based on the German housing market, suggest that renters currently save around €525 per month by renting compared with owning the average two-bed apartment. We estimate that for the affordability of renting and owning to reach parity, either rents would need to rise by 42% or house prices would need to fall by 30%, based on current elevated mortgage rates. A simultaneous 21% increase in rents and a 15% fall in house prices would also result in affordability finding an equilibrium.
Income from PRS can rise from open market rental growth or from the indexation of rents to inflation, which is the convention in some jurisdictions. This provides a further insulating quality as cashflows from PRS investments could have a hedging benefit against the corrosive effects of inflation. This income growth characteristic carries a value to which the home ownership model has no link. It is also a key reason why PRS investments behave differently to the wider housing market.
Today’s high-inflation environment is an issue for the sector. Households are currently having to absorb stronger-than-normal uplifts in their rental agreements in many places. While this is unsustainable for tenants in the long run, it is also not helpful for landlords, either. The investment case for PRS schemes is to generate long-term stable cashflows, with as few costs or empty apartments as possible. This avoids erosion of the gross rent collected. A spike in rents, resulting from high inflation rates, could lead to tenants leaving. This creates higher turnover costs, more vacant units and increased operational costs associated with redecorating and re-leasing apartments. Investors would prefer more modest uplifts that are affordable for their tenants in the long term and that more closely match real wage growth.
As we've seen, the media is filled with negative news stories about the housing markets. However, it's critical to remember that this is not directly applicable to PRS investments. The motivation to buy a house is completely different to the motivation to invest in PRS properties. The differing market forces will also ebb and flow at different times and at different speeds. That is not to say PRS investments are immune, but the drivers are fundamentally different. And we expect the share of people renting their homes to rise in most economies for many years to come.
While the markets are linked and there are similar pressures from an affordability perspective, the current challenges for home ownership support demand for the rental market. PRS rents have grown in most markets this year, as house prices have been falling. True, a painful recession would likely be a drag on most assets, but we believe the rental market will show a level of resilience.
RISK WARNING
The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.