Spotlight Alternative Residential Investments

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1 Savills World Research UK Residential Spotlight Alternative Residential Investments Spring 2014 SUMMARY As the market strengthens, so does the appetite for reversionary residential investments Ground Rents: we estimate that the English house building industry is currently generating new ground rents worth approximately 170 million a year. Shared Equity: Savills estimates that at least 1 billion worth of loans have been advanced through shared equity schemes in England since January We expect private sector house building to increase by 35% over the next five years, boosted by an improving economy and Government incentives such as Help to Buy. Rising levels of housing supply could generate ground rents worth 230 million by Many of these loans are held on balance sheet by housebuilders. Meanwhile, the investment market for the trading of secondary portfolios has started to gather pace with a catalyst being the transfer of consumer credit regulation from the OFT to the FCA. Shared Ownership: there are 150,000 properties within shared ownership in England managed by Registered Providers. Rates of staircasing are low but increasing. Rising levels of housing supply could generate ground rents worth 230 million by 2018 Susan Emmett, Savills Research House Price Growth: the mismatch between supply and demand will contribute to a price rise of 25% over the next five years. Most of that is likely to come over the next couple of years with the market slowing once interest rates start rising. savills.co.uk/research 01

2 Spotlight Alternative Residential Investments IMPROVEMENTS IN THE MARKET PRODUCE OPPORTUNITIES We are seeing unprecedented appetite from investors for reversionary residential investments as the economy strengthens and the housing market gains momentum. Although property values remain 5% below peak 2007 levels, according to figures from Nationwide, last year marked a significant turning point in the market. Average values rose by 8.4% in the 12 months to December 2013 and while annual growth was even stronger in London, with price rises up 14.9%, the upturn is now spreading further into the regions. The pick up follows the improvement in the wider economy and growing consumer confidence. Demand for housing has been boosted by an improvement in the mortgage market and, to some extent, supported by Government schemes such as Help to Buy. As a result, housebuilders have indicated their intention to increase production and there are signs that more homes are on the way. Levels of house building fell sharply during the economic downturn but are beginning to rise again. The GRAPH 1 House building forecasts 180,000 TABLE 1 House price forecast: UK Mainstream Department for Communities and Local Government (DCLG) recorded 117,110 starts over the year to September 2013, an increase of 16% on the previous year. Savills expects house building rates to gain momentum in 2014, supported by Help to Buy and an improving economy. We forecast that private housebuilders will increase production by 8% a year in the five years to March 2018 a total increase of 35% over the period. This results in an average 107,000 new homes a year over the five years from the private sector. Overall, adding building output from local authorities, we expect to see 119,000 completions in 2014, rising to 167,000 a year by This is much improved but still well short of the numbers we need to meet the needs of a growing population. New estimates of housing demand in England from the Cambridge Centre yrs to end 2018 UK Mainstream 6.5% 5% 4.5% 4% 3% 25.2% for Housing and Planning show that housing requirements are around 240,000, with some 60% of demand and need in the south. The mismatch between supply and demand will continue to push up property prices over the next five years, although we expect growth rates will slow once interest rates start rising again. These trends feed investors appetite for residential property and as market activity picks up, niche reversionary investments linked to HPI are worth considering. This paper sets out the key attractions and size of the opportunity in three principle types of investments ground rents, shared ownership and shared equity 2nd charge loans. We have also drawn on information from our recent survey of ground rent investors and interviews with leading players active in this marketplace. n Private Enterprise n Housing Associations n Local Authorities 160, ,000 Completions (England) 120, ,000 80,000 60,000 40,000 20, Year to March Source: DCLG, Savills Research 02

3 Spring 2014 GROUND RENTS Of the reversionary residential investments analysed in this paper, ground rents are the best known and most mature. A ground rent is a regular payment required under a lease from the owner of leasehold property, payable to the freeholder. They were originally the result of leases sold by the owners of landed estates to speculative builders in the early 1900s and are now commonplace in new developments, in particular with apartments. Historically, the market has been dominated by a small number of investors buying directly from developers. Why invest? The key attraction of investing in the ground rent market is security of income and the relatively attractive return from low risk, long term and inflationary linked income streams. Ancillary income streams from insurance, notice fees and block management may also play a part in delivering the total returns that investors require. Savills Research conducted a survey of investors active in the ground rent market. The respondents collectively invest over 4 billion in real estate, of which 50% is allocated to ground rent investments. This is split between property fund managers (50%), property companies (40%) and insurance companies (10%), with half the respondents specialist ground rent investors. Our research suggests that there are just five investors with ground rent portfolios valued at over 1 billion. Acquiring stock at scale is the single biggest barrier to growing portfolios. Our expectation is that 600 million of equity will seek to acquire ground rent stock over the next two to three years but appetite is likely to plateau when interest rates start to increase. Market potential The vast majority of stock is sourced directly from housebuilders. It would seem that housebuilders are not recognising the potential of aggregating ground rent investments on new build developments. One of the constraining factors is the way in which housebuilders are structured divisionally, with many operating independently from other parts of the Group business. Given that our respondents indicated that they acquire over 80% of ground rent investments directly from housebuilders, there is a real opportunity for housebuilders to create best value by aggregating sizeable portfolios where lease lengths and review patterns are structured to maximise investor returns and appetite. In , flats made up 29% of new homes in England, down from 46% in However, we expect that there are still 35,000 units with ground rents attached that could be offered to investors. At current market prices, this is approximately 170 million which we are forecasting to increase to 230 million by In London, we expect the proportion of new build flats to remain at around GRAPH 2 Capital Values of New Ground Rents 450,000, ,000, ,000, ,000, ,000, ,000, ,000, ,000,000 50,000,000 90% of all completions. Both the East and South East regions will also see higher levels of flats and apartments than other parts of the country. GRAPH 3 Annual leasehold completions and ground rent income: 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10, Q1 TABLE 2 Ground rents: investment fundamentals Number of apartments in building 100 Average flat price at original sale 150,000 Lease term 125 years Average initial ground rent (pa) 150 Total initial ground rent (pa) 15,000 Rent review frequency Rent review type Approximate market yield 5% 20 years Doubles Assumed purchase price 300,000 IRR (50 years) 6.5% n Estimated Capital Value of New Ground Rents n Forecast Capital Value of New Ground Rents Q Q Q Q Q Q Q Q Q Q Q Q Q Q1 n Annual Leasehold Completions n Initial Ground Rent Income 2007 Q Q Q Q Q Q Q Q Q Q Q Q Q3 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 savills.co.uk/research 03

4 Spotlight Alternative Residential Investments GROUND RENTS: SURVEY RESULTS Our survey reveals what is required from ground rent investment Strong competition Over the past five years, 1.2 billion has been invested in the market by respondents to our survey. Aggregating portfolios is a highly intensive activity, given that over half the portfolios offered for sale in the market are sub 500,000. We have seen strong demand for ground rent investments from a wide range of investors over the past 12 months. However, there is an expectation that small investors and more recent entrants to the market will seek to dispose of portfolios that have failed to meet their demands in terms of quality, scale and returns. Pension backed funds are also expected to have less appetite in a higher interest rate environment. Lease terms Lease terms will vary between developers and location but will outline any covenants and specify who is responsible for organising buildings insurance and property management. GRAPH 4 Why invest? Attractions of ground rent investments Relative importance rating GRAPH 5 Achieving scale is a major obstacle Acquisitions tend to be sub 1m 35% 30% 25% 20% 15% Security of income Long income streams Link to inflation Ancillary income Large and diverse n Importance of investment attributes Reversionary Upside on default n Typical Lot Size Typical lease lengths are 125, 250 or 999 years. The ground rent is payable to the freeholder (the developer). The homeowner or investor is the leaseholder. 10% 5% 0% 0 to 250k 250k to 500k 500k to 1m 1m to 3m Over 3m Rents are usually reviewed every 10, 20 or 25 years and review terms are either fixed in the lease or linked to an external index such as HPI, RPI or the actual building value. Our findings show that lease terms of over 80 years are the most attractive to investors seeking to gain scale in the market. There are some investors who are pursuing the reversionary angle. Other investors think mixed lease lengths are attractive. GRAPH years most attractive lease length 70% 60% 50% 40% 30% n Least attractive n Attractive n Very attractive Respondents also revealed that investments that are linked to RPI are the most attractive while terms with fixed review patterns offer the least appeal to ground rent investors. 20% 10% 0% <80 years years Over 100 years Mixed lengths 04

5 Spring 2014 GOVERNMENT SCHEMES Government initiatives aimed at supporting homeownership, shared ownership and shared equity schemes have been around for over three decades. We have seen many versions over the years, often with similar names but different rules. They aim to help buyers reduce their initial costs, such as the need to raise a deposit, whilst allowing them to own the property outright eventually by increasing their share over the years a process known as staircasing. GRAPH 7 Units in shared ownership Shared ownership stock 180, , ,000 90,000 60,000 30,000 n Shared ownership stock First tranche sales 12% 10% 8% 6% 4% 2% There are two main models for these schemes: Shared ownership: the buyer purchases a proportion of the property with a traditional mortgage and pays rent, usually to a social landlord, on the remaining element. Shared equity: the buyer purchases the whole property with the help of an equity loan to cover part of the value. The most recent version of this is the equity loan element of Help to Buy launched in April 2013, aimed at buyers of new build homes. SHARED OWNERSHIP The opportunity For income seeking investors, shared ownership properties can offer indexlinked long-term cashflows. There are currently 150,000 shared ownership properties in England, an increase of 15% since Given that property prices are rising faster than earnings, only a very small number of individuals embarking on these schemes manage to staircase their way up to full home ownership. 0 Source: HCA, TSA TABLE 3 Shared ownership: investment fundamentals The potential returns on offer, based on a hypothetical portfolio and some typical market parameters, are as follows: Number of shared ownership properties 100 Ave MV-VP 150,000 So aggregate MV-VP (100% ownership) = 15,000,000 Say landlord s average retained % = 50% Landlord s aggregate retained equity therefore = 7,500,000 Sum receivable if all units staircase day 1 = 7,500,000 Typical pricing of landlord's retained equity (% of figure above) 60% - 70% Typical net initial yields (rent only) using pricing above 4% - 5% Potential IRR assuming long term hold to maturity at low rates of staircasing >8% Impact of increased / incentivised staircasing on returns KEY FEATURES Year to March Typically enhanced The typical characteristics of the freehold ownership of these assets are as follows: 0% There are currently 150,000 shared ownership properties in England Savills Research Freeholds under individual long leasehold interests, typically 99 or 125 years Protection of the rights of both parties as defined within the leases Strong incentive for leaseholders to continue paying rent, to avoid forfeiture Rents reviewed annually, typically index linked with a premium of 0.5% - 1% above RPI. Leaseholder takes all repair and maintenance responsibility Service Charges are Fully Recoverable There are administrative fees for transactions Lump sum receipts linked to house prices when leaseholders purchase the retained share (staircasing) either in whole or in part savills.co.uk/research 05

6 Spotlight Alternative Residential Investments Why invest? Many of these characteristics are aligned with freehold residential ground rents, and, in common with ground rents, a portfolio of shared ownership properties has the potential to produce very secure long term income. There are, however, some key differences: Shared ownership rents are reviewed annually, and are almost always index linked, and often ahead of the index. Staircasing gives an element of unpredictability to the cashflow. Staircasing by a leaseholder to 100% ownership represents buying out the future rent obligation through making a payment linked to the value of the house. Staircasing therefore erodes long term cashflow, but improves the shorter term position. As Graph 8 below shows, staircasing rates are low. In % of all shared ownership properties staircased to 100%. While this is less than the 5% that were staircasing a decade ago, it represents an increase from the very low levels we have seen over the last five years. It is not certain that all residents in shared ownership will be able to staircase fully. However, over a very long term (50+ years) most are likely to. As such, whilst it is a freehold equity investment, a portfolio of this stock has parallels with a fully-amortising debt asset. So the borrower can repay at any time, but that payment is linked to house price growth, and the borrower makes index linked interest payments until such time as the principal repayment takes place. The asset therefore has a combination of long term cashflow and reversionary characteristics. The majority of shared ownership properties are within the Registered Provider sector, and the Homes and Communities Agency (HCA) requires on-going RP management in the event of a private sector acquisition of existing stock, together with regulatory approval. There is a track record of this being achievable. Some shared ownership leases are written to give priority to the leaseholder s mortgagee in the event of a disposal following default. The worst case scenario is that the mortgage is interest only for the full amount of the leaseholder s equity. Careful consideration therefore needs to be given to current house prices against the original sale prices. In practice landlords are more likely to dispose of older portfolios (say over 10 years in management) where HPI has resolved this issue. There can be several different versions of lease within any one portfolio. The planning status on the land may include S106 obligations, which generally fall away once staircasing to 100% has taken place. The performance of individual assets will vary over time, with staircasings for example more likely at certain maturities. The analysis process is similar to that of a pool of mortgages. Cashflow performance is dependent on staircasing rates, which is dependent on the leaseholders. Hence there is an element of unpredictability Savills Research GRAPH 8 Staircasing rates are low 6% 5% 4% 3% 2% 1% 0% Staircasing to 100% as proportion of all shared owners Source: HCA/TSA RSR with data before from Understanding the second-hand market for shared ownership properties by Anna Clarke and Andrew Heywood, Cambridge Centre for Housing & Planning Research, University of Cambridge 06

7 Spring 2014 SHARED EQUITY As loans against a percentage of the value of a home, shared equity products help buyers onto or up the ladder by reducing the size of a deposit needed. Typically, these loans are provided by the developer/housebuilders to the purchasers of new build properties. They enable the buyer to acquire 100% of the value of the property, without the need for a third party mortgage on the total value of the home. These loans have been a popular way for developers to maintain sales rates in times of constrained mortgage availability. In the past, the funding was made available either in partnership with Government schemes (such as HomeBuy Direct) or directly from the developer. The latest version of Help to Buy differs in that the equity loan is fully backed by Government with no impact on developers balance sheets. This has effectively replaced developers' own schemes. There is no single source of data on the size of the equity loan market. Savills estimates that at least 1 billion worth of loans have been advanced through shared equity schemes in England since January This is based on calculations from the Home Builders Federation showing that 835 million of shared equity loans were made available between January 2008 and February 2011, resulting in 28,000 sales. Since then we have seen a further 10,000 equity loan supported sales through the Governmentsupported FirstBuy scheme, as well as further deals offered by individual housebuilders. Housebuilders new funding of equity loans will have dropped dramatically since the introduction of Help to Buy in April 2013 as this three year initiative does not require housebuilders to contribute. However, given the improvement in the economy and the rising demand for homes from a growing population, developers are keen to free up their balance sheets and invest the funds in building more new homes. KEY FEATURES A loan against a % of the value of the home Lender = Developer Borrower = Homeowner (Purchaser) Loan of 20% - 25% of the value of the house Redeemable on the 10-year anniversary of the purchase, often an opportunity for the borrower to extend for a further five years if financial hardship can be proven Often no interest is payable at the start. Some schemes are interest free throughout the loan term, whereas others may have index linked interest payments after, for example, five years The redemption sum is calculated as the original percentage loan applied to the value of the house at the time of redemption TABLE 4 Shared equity: investment fundamentals Pricing and returns will be dependent on a large number of factors including local market performance. We have set out the basic fundamentals of how this product scales up and becomes attractive to an investor. Number of 2nd charge loans secured against property 1,000 Average house price at original sale 150,000 % of equity loan 20% Aggregate loan principal at issuance 30,000,000 Loan term Hardship clause Loan interest rate Average house price growth assumed 10 years Additional 5 years 0% per annum 2.5% per annum Redemption sum at year 10 38,402,536 Redemption sum at year 15 43,448,945 Pricing of aggregate loan sum at issuance Say 50% Price paid for portfolio 15,000,000 Purchase date IRR if held to maturity (10 yrs) 14.4% IRR if held to maturity (15 yrs) 9.3% Housebuilders' core business is not to provide 2nd charge mortgage loans and with the transfer of consumer credit regulation from the OFT to the FCA in April 2014, the administration of these loans is expected to increase. This represents an opportunity for investors to either acquire loan portfolios or work with developers who might wish to outsource the asset management role. Investment risks Some parallels can be drawn with the Residential Mortgage Backed Security (RMBS) market, which gained notoriety during the financial crisis Year 3 of loans for interest defaults, optimistic credit ratings and rapid price falls. However, in the case of non-interest bearing shared equity loans, the underlying strength of the credit is tied to the performance of house prices over a period longer than typical market cycle downturns. This has little direct reference to the individual borrowers and their ability to make regular interest and principal payments. Risk can of course be further diversified through the acquisition of a portfolio with a wide geographical spread. An analysis of the risk profile is set out in Table 5 overleaf. n savills.co.uk/research 07

8 Spotlight Alternative Residential Investments Spring 2014 TABLE 5 Risk profile analysis Risk Category Default Risk Principal sum Default Risk Interest Payments Maturity Risk Liquidity Risk Pre-payment Risk Risks things to watch Product Characteristics Protection within the loan documents Principal linked to house prices, not borrowers At maturity, if house price is below original sale price then not all principal may be recovered First charge mortgagees will have priority of claim on the proceeds of a disposal in the event of default on the first charge mortgages No risk with interest free products Risk linked to underwriting criteria for interest paying products Enforceable maturity dates, albeit with potential 5 year hardship clauses Most units held by primary developer / lenders, but secondary market beginning to develop Borrowers have the ability to repay second charges at any point New build premiums on original sales Timing of original sale and subsequent market movements Mortgage default rates House price forecasts until redemption OUTLOOK What's ahead for reversionary residential investments? The residential investment sub-sectors provide exposure to secure income, with short/medium term reversions linked to HPI and in the case of shared ownership, both. The ground rent market is maturing as developers realise the value of ground rents but there is likely to be some consolidation in the sector as recent entrants dispose of portfolios that do not meet their expectations. There is currently little activity in the market for shared ownership properties as most are held within the Registered Provider sector. The question is whether private sector pricing will encourage more of these properties to trade out of sector. As the responsibility for consumer credit regulation is transferred from the OFT to the FCA in April 2014, the administration of 2nd charge loans is anticipated to be more onerous. The investment market has started to gather pace which has coincided with developers disposing of their portfolios. The ground rent market is maturing as developers realise the value of ground rents Piers de Winton, Savills Savills team Research Residential Investment Susan Emmett UK Residential semmett@savills.com Jacqui Daly Investment Research & Strategy jdaly@savills.com Neal Hudson UK Residential nhudson@savills.com Piers de Winton Residential Investment pdewinton@savills.com 08