Welcome to the latest episode of Gowling WLG's list of podcast where we look at a range of topics trending in the legal and commercial landscapes.
Nick Mumby: Hello and welcome to the first episode of the Gowling WLG Build to Rent (BTR) podcast. I am Nick Mumby, a partner in the Real Estate group and lead partner for our BTR subsector. Today I am joined by Andrew Screen, the head of Residential Capital Markets at BNP Paribas Real Estate.
We are going to be taking a look back at what happened in the markets in 2022 and try and make some predictions for the coming year of 2023. Andrew great to have you with us. I cannot think of a better person to pick through some of the issues and some of the investment topics that we are going to be covering today.
Andrew Screen: Nick, delighted to join you this morning.
Nick: So let's start with 2022, it was a fairly tumultuous year for many reasons, both with macro-economic and political instability and all sorts of other things causing a hard time for the markets. But with all that going on, BTR held up pretty well and for at least most of the year, it was both a successful investments product and there was quite a lot of activity.
Andrew: Yes so 2022 started off, we had obviously construction cost increases that have come out of 2021 but those were sort of very much on everybody else's mind, as well as our contractors and a lot of person investors. We also had an increase in interest rates coming forward, which obviously made everybody very much concerned particularly with funding development costs, but again investment was still very strong. We saw new investment coming in about June/July through to about August/September and these are new entrants into the market with lower cost of capital. So, basically cheaper money to invest in the sector and obviously interest in the sector purely from its growth in the past.
We then went into the mini budget, which was at that stage - we went into -literally the shutters came down on investment or what I like to call a financial state of suspended animation. The money was there but it wasn't moving…
Nick: Yes
Andrew: …and that was certainly kind of into the last quarter. What's great is we have seen the money coming back in, in the last month in January and these are investors who are certainly looking at investment, they want to see all types of investment, but larger investments so that is of the normal standard 350 units plus on build to rent. But what is quite interesting is investors looking at those 100/250 units as well.
Nick: Yes, very good and we will come back to that a little bit later on. And in terms of locations and again sort of sizes of schemes throughout 2022, I think it is fair to say it was focused on the main markets, the main cities but what were your views on that and where people were looking to invest primarily?
Andrew: This is quite interesting because the majority of investors target London and then the key regional cities for their investment, but actually when you have a look at build to rent 60% of all the investment has gone into the regional cities and locations and only 40% into London. So, you get better returns being on the regional side rather than London. Also, there is a lot more supply, probably less planning regulation - easier to get planning in the regions. In other words, there is more transaction availability in the regions than in Central London. But we expect to see the kind of key regional cities continue to grow in build to rent, so that is Manchester, Birmingham, Leeds and Bristol. Those are what I call "super prime". In other words, they attract more attention than the kind of if you want the other secondary kind of regional cities.
Nick: And is that driven by a sort of a growth in market knowledge as the market matures from investors who are then more prepared and more sort of comfortable putting their money into the regions outside London? Or is it more that there is a larger amount of sort of local UK investment and therefore, will already have a good knowledge of those regional markets?
Andrew: The answer is yes to both.
Nick: Ok [laughs]
Andrew: So, what we have is that the majority of international investors prefer the first asset to be in London. That is kind of the safe haven, everybody wants that first risk effectively to be in the lowest risk capital which is London and then they will move out to Manchester, Birmingham, Leeds which are quite right. In terms of moist of the regional in other words secondary and tertiary locations most of those are UK pension funds - driven by those - or people that invest in second or tertiary product primarily. But generally speaking, out of all of the investment you have got 75% of the investment will go for London, Birmingham, Manchester, Leeds, those "super primes", and then you whittle it down to 50% or 25% of investors will look within those secondary or tertiary locations.
Nick: Yes understood. That all makes very good sense. And so, looking forward – 2023 - you said there is a bit of activity already but I think we will probably both agree that it is not exactly going at full speed at the moment and how do you see the year coming forward? What are we to expect this year do you think?
Andrew: I think it is going to be a very exciting year in terms of phases, so it is important to understand that a build to rent transaction takes about six to nine months to complete. In other words that is from the developer putting the product into the market to actually closing a deal and depending on the type of debt funding and whatever used. So, in other words, to get to financial close, it will take about six to nine months, which means that any transaction that has basically started last year will only come forward kind of this year and that is why if we had a sort of dry last quarter, in other words investment not moving, it means that those investors are not looking to tie into deals in terms of heads of terms and getting into legals. Now, when you kind of look forward it means that any deal that comes to market in this quarter will probably only close in Q3/Q4.
Nick: Yes.
Andrew: So, the deals that are actually closing in Q1 in terms of January and February, those are deals that went back into that June/July period…
Nick: Yes, that makes sense.
Andrew: So, these are development deals not stabilised assets, which obviously trail a lot faster. So, in terms of actually the four quarters of the year, I expect this first quarter we are going to see a lot of investors looking for product. Everybody wants to get a deal and to certainly close a deal by the end of the year and that is where the pressure is going to be on, to close a deal within that kind of 18 months since last year June/July. And to do that everybody needs to be finding that deal and settling into the deal now. I think Q2 will be driven by heads of terms, so those deals will be identified certainly going into heads of terms looking at how they constructed the deal best to their advantage and then instructing legals in that kind of Q2/Q3 point. In other words that then leads you into Q3 financial close or Q4 financial close and some of those may stray into Q1 of next year.
Nick: Ok, super. So, I will be taking my holiday over the next few months and getting ready for a busy second half of the year hopefully.
Andrew: That's certainly the way that I would see it. But we are going to see an influx of deals coming in, particularly in Q2 because a lot of deals were held up or held back because of the lack of investment in Q4. These are all going to start coming through, so we are going to see a flurry of deals, certainly in that Q2.
Nick: Which is good and also suggests that there is some money coming from potentially different places i.e. if the investment was not there at the end of last year, things have settled down a bit. Are we seeing some new players coming into the market or is this just some of the existing players who have tooled up particularly well and have got piles of cash to deploy?
Andrew: We have got a huge supply and demand differential in this market, in other words a massive demand for rentals, both for for sell accommodation and very little supply coming forward, as well as investors that are targeting the sector. So, in last year kind of June/July, we saw a lot of funds reallocating funding to the living sectors, as opposed to kind of build to rent generally, but to that living sector and these were very serious players, players with intent of a billion pounds investment in these sectors. So, this is over and above the existing investors who are obviously trying to expand their portfolios. S,o this year we are going to see new money coming in, so we have already seen some identified and certainly coming into the sector at that sort of £200 million to a billion pounds, so we are going to see a lot more money and I think it is going to be quite interesting because we have got very little supply. In other words very little product in terms of build to rent forward funding deals and also sell pro.
Nick: Yes ok. You mentioned forward funding - one of the things that you and I have discussed - that has always been sort of a model that is what developers quite like because they can bring their product to the market and then effectively pass it on to the investor, build it out and know that if everything goes well then they get a kicker at the end, but they have also got their fees paid and all the rest of it, and they have shifted the site that they have allocated, so they have got their capital upfront. It looks like that might be something which a lot of investors are now sort of a little bit less keen to use that type of structure and are more incentivised to try and keep the developers with a bit a skin in the game. Is that something that you are seeing with some of the deals that are coming through and the structures that are being proposed?
Andrew: So this is the - just to give you a basic idea - this is a typical transaction like forward purchase, so we are going to see a lot of house builders offloading stock on a forward purchase type of deal - where they cannot sell it into the traditional markets. On the forward funding deals, the reason why these structures will change is because, there is uncertainty in the market, so there is a lot of money chasing the sector, but the problem is that there is uncertainty about how that is going to come forward. So, what is going to happen is we are going to see those structures changing. My personal view is that the yields will not shift out, so the capitalisation rates, because there is such a demand for the product. But, the issue is that a lot of investors don't know that, and so they kind of view is that deals may move out because they have moved out all of the other sectors. So, retail has moved out, industrial yields have moved out, logistics – they've moved out, they've come back in again and moved out. So, what is going to happen to build to rent and I think this is the important thing, is that you have got high rent growth rates, as well as kind of yields which I believe will remain stable, as they are at the moment. But from an investor's perspective, will those rental increases really happen and will the yields really stabilise? So, in terms of the restructuring of the deals, I think what we are going to see is a risk transfer to some extent.
Nick: And that seems sensible doesn't it? I mean up to this point, and I say this primarily as a developer's lawyer - so I probably shouldn't say things like that - clearly that means the developer taking on a bit more risk. But it is the structure that we have seen in a lot of other types of transactions, a lot of other offices for example is often the way that the developer is required to take an equity stake and to build it out and do it through a joint venture type arrangement where, you know, they do still have some skin in the game and therefore they are more incentivised to ensure that all the targets are met and so on and so forth, because they don't get anything back until a bit later on.
Andrew: I think the best thing is probably to describe it with an example. So let's just say the total development value is £100 million and that includes the developer's profit of £10 million - 10% - and includes the land value of…let's call it £10 million as well. Now, the certainty we have is that will it be worth £100 million in two or three years' time? Will that rent growth happen outside of what the normal performance is? And in other words what the investor is looking to do is say well if it does not happen, then I don't want to be paying out all that profit payment, or I don't want to be paying all the land payment. So, we are going to see deals whereby either a portion of that land payment is deferred… to the backend PC, or to stabilisation, and likewise that profit payment. In other words, once that asset is built out it will have a value but once it is leased up, it will have a certain value. And once that certain value can be determined and from my point of view is most developers aren't very pro the industry and certainly pro build to rent growth and what have you, but I think those growth rates will happen, I don't think yields will move out and because of that, I speak to developers and say you should take confidence that that product will retain that value. Because generally speaking, investors are very cautious and they will be taking a lower view on values and the kind of risk as well. So, I don't see it… I just expect to see those kind of structures coming forward and I've certainly spoken to investors who are looking to "do a deal" as they put it, which can also relate to not only deferring of land payments and profit payments, but possibly also where there is a 'pref' - a preferential return - for the investor before the profit is paid out, all of those structures are effectively the same thing. In other words, deferring that risk. But I think what's important is that the developer should understand that they should be entitled to an upside…
Nick: Yes of course.
Andrew: On those returns, because they're effectively deferring a profit, which in their view they shouldn't be deferring their profit.
Nick: And so on to that end, you know - there is a potential for making, you know - if prices and yields remain at the right levels, we are going to have more profit, which means there will be more money for everybody and the developer will get to share in a bit of that as well.
Andrew: I think we have got two kind of worlds that we are living in at the moment. We have got huge news headlines - "house prices are falling" - they are going to fall during this year, which I agree they will, not by a huge amount and I think they will bounce back fairly quickly. But you have also got rents going up as well as capitalisation rates not moving out, so that means that actually on a rental product, your value is going to increase, whereas on the sale product you are seeing a decrease. Surprisingly, you have now got this gap in the market and you have to convince an investor that this gap is there and does actually exist but the for sale prices will come back.
Nick: Yes of course.
Andrew: So I think this is the slight problem that everybody is going "well the build to rent must then be falling in price", and that is not the case.
Nick: No indeed, indeed. And you mentioned that rents are increasing and they are at the moment and don't want to get down too much of a rabbit hole, but rent caps are something that do come up in conversation and what might be just some of the sort of high level impacts of if we did see rent caps being imposed, either nationally or over specific markets like London?
Andrew: I think there is a lot of talk about affordability. You know we have got a huge demand for rented product, very little supply of rented product, which means rents are going up, they went up 12% last year, London up 17%, and so there is obviously a lot of people concerned about rent increases.
I firmly believe that if you want to reduce rentals or control rentals, you should increase supply. Let's go back to basic economics, supply and demand. So build more homes of all types and basically rents will not go up as quickly, and that is quite simple. But I think the issue is that this is seen as a kind of 'stop gap' position, in other words, if we put a rent cap on that will be fine it will become more affordable for everybody, but I think it is a short term kind of provision because you still do not address the underlying problem, which is there is a lack of supply, which comes back to planning and back to regulations and that is why you get the supply demand indifference, which you don't usually see in the US for instance, where the planning is much more efficient. But in terms of rent caps is that one of the fundamental problems that I have with rent caps is that because it's not consistent. If you are an investor underwriting a return and you want to know that that return or effectively rent increases are linked to some kind of CPI index or RPI index or HBI index for that matter. But if you have got a local authority or Government that can suddenly just turn around and say your rent cap was 4% but now it is 2% or that it is now capped at a level or basically that you have now removed it or brought it back in. It is that inconsistency which is difficult to underwrite from an investment perspective.
Nick: Yes of course. So we've been talking about new structures. We have been talking about various different ways in which the pricing, construction pricing, investment returns impact on the product. We've also got, and we've also seen already, quite a lot of regulatory changes. There are more regulatory changes coming down the line, some of them we know about, some of them we don't. We touched on rent caps just a minute ago, which is something that people might start to look at and some interesting thoughts from Andrew on what the impact of that might be, but we have also got some changes along the lines of EPCs with more stringent requirements coming in. What do you think the impact of that is going to be first up?
Andrew: I think on EPC, we have already seen something like 300,000 buy-to-let landlords move out of the sector in the last five years and this is largely down to taxation but also regulation as well.
Nick: The individual is being squeezed out.
Andrew: Exactly. And so, as that EPC starts to bite, which will be kind of 2025 and 2028, particularly 2028, which is the effectively the 'drop dead' deadline, so 2025 is for all new build property and 2028 is for any property on the rental. Now, will all of these… will we see a mass exodus of landlords in this space? Well the way the legislation is written, yes we will. Whether it is actually practical to implement that I am not quite sure. But what it really means as you put it are those sort of buy-to-let landlords being squeezed out and certainly they are. Does this mean we are going to get more institutional funding coming into that space? I think we will certainly get new product, because that is the only way to basically satisfy the EPC and a lot of the other regulations like number of staircases, fire regulations that are coming into the sector as well. So institutional investment coming to the sector that is a good thing.
Nick: Yes.
Andrew: But the reduction of overall rental supply or stock is a bad thing.
Nick: Of course.
Andrew: Because obviously if you take out the rental stock, prices go up again. You get less supply into the market.
Nick: Exactly, and it is one of these things that it is difficult for institutions to buy individual, or even small, portfolios because for them for the product to work they need numbers, they need to aggregate and obviously dealing with it in a very granular way is very complicated and not something that they have really been able to achieve. On the difference between institutional landlords and private landlords, is it often a lot of discussion about the good points and the bad points but actually it does seem that on the whole, an institutional landlord is going to be much better for the renter than the private landlord. I think that is a fair assessment. Would you agree or is that giving too much credence to the advantage of our big pension funds?
Andrew: I think it goes down to two things: one, economies a scale. In other words the institutional landlord can get more properties, therefore more efficiently manage those properties for a cost, or a cost base, in other words is the gross to net or operational costs. Also, they can build up bigger schemes compared to the smaller kind of buy-to-let kind of landlord. The interesting thing is though that I think we need all types of product because the institutional landlord will not go and invest at scale in a lot of locations, particularly for example Cornwall where there is still a demand for rented accommodation but does not necessarily attract institutional landlords, mainly because we come back to scale again. I think it is quite interesting what is happening in the market is some of those institutional landlords are now looking at smaller scale build to rent or PRS blocks, that 100 to 200 kind of units as opposed to 350 units plus. So across the whole spectrum, I think we need to encourage landlords as much as possible, but evidently most residents will prefer a fully amenitised unit.
Nick: Yes, that of course as you say for those smaller schemes - the amenities - it does not support the same level of, or does not support the need for the same level of amenities, cannot get the space to be able to provide more than perhaps you know a gym or a few communal areas. Ok, and then just looking wider at the increase in investment into single family housing and how that is sort of coming together within the market as a separate BTR or distinct BTR product. Where do you see that coming forward over the next year or how do you see that coming over the next year and what are some of the advantages to investing into that type of product?
Andrew: Well we saw a couple of portfolios trade in the last few years in single family but one of the biggest problems about institutional investment into single family is being able to aggregate. In other words, being able to get to scale. Because if we're buying ten units at a time it is very difficult to transact half a billion pounds worth of stock.
Nick: Of course.
Andrew: So that is why the single housing investors are typically been targeting 50 units or 100/150 units. What is quite interesting is that we are going to see house-builders offloading stock where they cannot sell into the normal for sale market, looking at those institutional buyers. So, this is an opportunity for institutional investors to get into that single family housing, or a rural housing for a better word, at scale. So, I think you are going to see that institutional investment grow into that sector over the next two years as they can get to scale a lot more quickly.
Nick: Absolutely, and of course being precipitated by things like interest rate hikes, which has made mortgages more difficult to get which have meant that the individual has found it more difficult to buy, of course Help to Buy coming to an end as well another one of the sort of big products that has been of great advantage to the house builders and purchasers of course, but it does seem that that has created an opening for institutional investors to come and talk to the house builders and say actually don't sell this whole section to individuals we'll buy that. And of course once you are into that type of cycle the house builders realise that this is a more efficient way, it might not necessarily be as profitable as it is by selling them on an individual basis but they are getting the cash in on a much more efficient basis.
Andrew: Single family is quite interesting because, if you invest in let's say build to rent, you're investing £150/£200 million in one building. Which means you have got a three to four year construction period, so you add a risk from the development phase for three or four years. And single family housing, do not forget these houses are built over a period of months.
Nick: Yes.
Andrew: So, you can have, and at any point in the cycle you can just stop the construction and not all that anymore, or not invest in it anymore, so you are also getting a lot more units completed and stabilised on a phased basis, so you are getting income in during actually your overall construction bit so that is the advantage, they are a lot easier to manage because you are not actually providing all of those amenities. There are some schools of thought that single family housing should come with amenity levels. There are other schools of thought that basically that they are not, they are clearly just a landlord – if you want resident relationship. But either way it is a slightly different product from your build to rent but it is more akin to rural accommodation, which build to rent does not really work for.
Nick: No precisely. And just going back to our investors again and just thinking about what they are looking for, where are we in terms of returns and numbers and the such like, what are you seeing at the moment in terms of the expectations, of investors coming in and looking for product?
Andrew: Well we have had in the past the target kind of returns from most investors in build to rent was kind of a 16 to 18% RR, over roughly at about a five to seven year hold period, and that is on a levelled basis of about 65% debt funding.
Now obviously with an increase in debt funding costs, which have almost doubled, some of the total debt funding costs for construction roughly works at about 11%, of the target taken the debt funding, hedging costs, the arrangement fees, all the other fees.
Nick: So if you can get the funding in the first place. [laughs]
Andrew: And because of the construction cost increases and interest rate rises, you cannot get to a 16 or 18% RR.
Nick: No.
Andrew: What is interesting is most of the new money coming in is at about a 10 to 12% RR, or should I say that is the new expectation certainly from a developer's point of view. And so, that lower cost of funding if you were are about 10 or 11% RR on equity, pure equity investment. That does not make any difference whether it is unlevered or levered…
Nick: Yeah ok.
Andrew: It'd cost you the same. In other words, debts are a lot like creatine to those target developments. So, a lot of interesting points coming forward here is that we are going to see quite a lot of investors just funding 100% equity, no debt finance during construction and then there will be finding out later once rates have improved or the hedging costs are not so expensive.
Nick: Exactly and once you have got a stabilised product that you can take to a funder and who can analyse a lot more clearly I think this is one of the issues that I have seen with a number of putative loans is not being able to get a fixed and a proper feel as to the exact construction costs. If you can't get a feel for the construction costs, you don't what your overall input is and that causes huge problems from an underwriting perspective. It is maybe not quite that bad all the time but if you are a conservative lender, then you are going to struggle to get comfortable with the position at the moment.
Andrew: One of the interesting things is that you have got because of the rent increases in build to rent, rents will go up 5 to 7% this year again and possibly again next year. It means you have got a play on both the capital asset value of those that yield and partial rent increases given your total return, which is not something you see frequently in other asset classes. So, this is an opportunity but it is a case of investors being cautious to underwrite a more sensible rent inflation versus what will probably actually be achieved. So it is a very interesting play at the moment from an investment point of view, across the whole of the living sectors not just build to rent.
Nick: Yes. Understood. Understood. OK so I think it sounds like we are going to see an interesting year. It sounds like it is going to be busier towards the end of the year. We are hopefully going to get all of those heads of terms in circulation over the next three to four months maybe, with as you say, with the deals coming forward Q3/Q4 and I think it is, and certainly sounds like it should be, a good bet for investment in terms of returns and everything else. Just whether or not there is enough product on the market to satisfy everybody's appetites. Andrew, anything further from you, anything we have not covered that you would like to say right now?
Andrew: Sure, it is going to be interesting to see the types of transactions we are going to be seeing this year as well. I think we are going to see a lot of purchase of block, in other words PRS blocks, 50 units/100 units going up to what some people are terming build to rent at 150 units. We are going to see that whole spectrum of the smaller scale as investors look to get into the market, so that is either stabilised product or to be built product. We are also going to see the standard 400/500 units kind of product coming forward as well, as we have seen in the past but I think this year we are going to see mergers, acquisitions coming forward as wel,l so there will be a couple of corporate transactions and this is because we are seeing a lot of those players who are interested in investing £500 million into the sector fairly quickly, so I think it will be the first year we see those big transactions coming forward and certainly that will probably continue over this year and next as that huge amount of equity gets to come into the sector and pay at the later scale.
Nick: Something very exciting and something to look forward to.
Andrew: It most certainly will be.
Nick: Andrew, thank you very much indeed for your time.
Andrew: Thank you very much Nick, it has been a pleasure.
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