- Residential buy-to-let (BTL) has been a hugely profitable investment for the last 20 years. However, the combination of restricted liquidity, structural unaffordability and increasingly draconian tax measures will render leveraged BTL financially uneconomic for higher rate taxpayers by 2020
- Specialist property funds’ reputation as a safe haven has been fundamentally compromised by the post-referendum debacle, which saw many leading property investment funds suspend dealings in their units on an indefinite basis
- UK real estate equities and REITS offer significantly lower yields than managed purpose built student accommodation (PBSA), and share prices are hinting at imminent downgrades to net asset values (NAV)
- Certain subsectors of commercial property, especially retail, face structural long-term threats as a consequence of the growth of the digital economy
- By contrast, the fundamentals for managed PBSA have never looked stronger: a chronic shortage of student accommodation in many university towns and cities, robust demand from students and an investment vehicle with sustainable long-term yields coupled with integral capital growth
The residential housing market: situation analysis
The UK housing market has enjoyed a continuous upswing since 1993, pausing only briefly during the credit crunch of 2007-2009. Unsurprisingly, the conventional wisdom that property investment is a dead cert bet still holds sway. However, residential BTL is facing inexorable headwinds:
- The latest ONS data shows that the average UK house price to household income ratio is 7.6. In 1997, it was 3.6. By any measure, housing has become increasingly unaffordable
- Stamp Duty Land Tax (SDLT) increases have dampened market activity, with all second home residences now subject to a surcharge
- The abolition of mortgage interest being chargeable against rental income by 2020 means that for a leveraged BTL investor paying the higher tax rate, BTL will become financially uneconomic
- Yields from BTL have already fallen, partly as a function of steady price appreciation. In parts of London, yields are barely 3%. Further erosion looks inevitable as the changes in the taxation of BTL income take effect
- The more stringent lending criteria imposed by the Financial Conduct Authority (FCA) at the start of January 2017 is already having an impact and will continue to do so. In February, new mortgage approvals fell to 68,000 – significantly below forecasts.
Will there be a property crash?
Since records began there have been two major property collapses: 1973 -1975 and 1989-1993. In both cases, the crashes were caused by the same Unholy Trinity:
- Strongly growing unemployment rates
- Sharply rising interest rates
- Severely squeezed liquidity
Of these three factors, rising unemployment and rising interest rates look relatively unlikely. The latest Bank of England guidance indicates that no rise in rates is envisaged for 18 months. Even allowing for the contingency that inflation could pick up more quickly than expected, rate rises in response are forecast to be modest.
With international corporations, such as Google, Apple, Nissan and Jaguar Land Rover, pledging support to a post-Brexit economy, unemployment looks unlikely to rise strongly either. Political expediency should also play its part – all governments know that blowing up the economy ahead of the next General Election is a passport to oblivion for a generation.
The ongoing contraction in liquidity looks to be the asset class’s biggest threat. Higher levels of SDLT and discreetly pernicious income tax reforms are already causing the market to slow down.
The most likely outcome for house prices going forward appears to be an extended period of stagnation. A prolonged period of negligible capital growth together with tax-driven yield compression looks ever more likely.
Direct property funds: safe as houses?
The shenanigans that engulfed the direct property funds after last June’s referendum were a timely reminder to investors that just because an investment is regulated by the government doesn’t mean it’s always safe.
Within days of the referendum result, almost all direct property fund managers – including Standard Life, Aviva and Threadneedle – had suspended dealings in their property fund units in order to liquidate assets to meet expected redemptions. Dealing moratoria did not start to lift until September. When the music stopped, property funds turned out to be just as illiquid as most other forms of property.
Liquidity issues aside, property funds offer a range of yields from 4.5-6% – noticeably inferior to managed PBSA. Capital growth is dependent upon the fund manager’s ability to identify winning and losing subsectors within the property universe, and is by no means guaranteed. Most property funds will divide the portfolio between retail, industrial, office and commercial. The relative illiquidity of such assets makes it difficult for a fund manager to implement a rapid change in strategy.
Real estate equities: starting to discount a decline in asset values?
Real estate equities are valued by the market at a premium or discount to their underlying NAV. In a steady economic environment, shares typically trade at a 5-10% discount to NAV. At the bottom of a recession, such shares can be trading at a 30-40% NAV discount.
At the top of the economic cycle, a small premium to NAV is often seen as the market anticipates a further NAV upgrade.
The table below shows the current share prices, NAVs and dividend yields for the UK’s leading real estate stocks and REITS:
The companies named above announce their full year results next month. The market appears to be anticipating NAV downgrades. Given that the economic outlook appears to be stable, what is the market worried about?
The digital economy: the elephant in the commercial property sector’s room
“It is legitimate to question the long-term viability of retail stores and whether the possession of a retail portfolio is an asset or liability.”
– Lord Wolfson, Chief Executive Officer, Next plc
Christmas 2016 was a watershed in UK retailing history. For the first time, online sales exceeded those made on the High Street or in shopping malls. Far from being a one-off phenomenon, this looks like an established trend:
- Debenhams is expected to confirm at its forthcoming interims that it will progressively move its clothing sales online
- In the last 6 months, BHS, Agent Provocateur, Austin Reed and Jaeger have gone into administration
- Over the next decade, 900,000 retail jobs in the UK are forecast to disappear
- In the US, shopping mall footfall is 50% down over three years
- In the US, 3,500 outlets are forecast to close according to “Business Insider”. This includes established names, such as Macey’s, Sears, K Mart and RadioShack
The food retailers, notably Tesco and Morrison, are currently trialling same-day delivery. Tesco has already quietly admitted that many of its superstores are redundant in their current form. Once same-day delivery has been perfected, many of their superstores have the potential to be converted into distribution centres.
For retailers located in shopping malls, redeployment of their property assets will not be as simple. Direct property funds and the quoted real estate majors typically have 20-30% of their portfolios invested in retail assets. The market is right to place these shares on a heavy NAV discount until the downgrades come through.
Conclusions: why managed PBSA is a safe haven
- The investment case for residential BTL going forward has been fundamentally undermined by the unaffordability of residential property in all but the most run down areas, together with the changes to the SDLT and income tax regime
- Direct property funds have proven to be illiquid, offer inferior yields and highly debatable capital growth prospects
- Real estate equities offer similarly inferior yields and appear to be discounting imminent NAV downgrades
- The emergence of the digital economy will lead to radical changes of use in commercial property, with a period of painful readjustment in prospect. NAV downgrades and rising numbers of voids will diminish the retail subsector’s investment attraction until the process of reinvention is under way
- Managed PBSA increasingly looks anomalous: safe yields and deliverable capital growth underpinned by favourable supply/demand dynamics