Generating returns with affordably priced housing
Long-term affordability ensures predictability for tenants and a low-risk income stream that allows for inflation hedging, says Heimstaden’s Christian Fladeland.
Covid-19 and escalating energy costs have thrust the cost of living and housing affordability to the front of everyone’s mind.
As inflation accelerates to levels not seen in decades, private rental housing is becoming increasingly politicised, even in free-market economies. History shows that when rents soar, the clamour for controls or stabilisation measures often sways politicians to intervene.
It’s a tension that is very familiar in Europe. But Europe’s experience shows that institutional landlords can generate investment returns as well as provide affordable rents for tenants. It need not be a choice between the two.
These are difficult times for investors to generate returns, as equity and bond markets have fallen in tandem for the first time in decades. Institutional investors have traditionally looked to real estate for its perceived inflation hedge. The 1970s and 1980s showed real estate was one of the few asset classes to weather the kind of storm we face today – high inflation, slowing growth and the prospect of rising unemployment.
This time, institutions are being selective in how they allocate capital, as covid-19 reduced the appeal of most commercial real estate sectors. The defensive characteristics of the residential sector have come to the fore as the annual lease reviews and higher tenant turnover generally allow for a quicker inflation adjustment of income than other sectors. Our analysis of quarterly returns for the past 20 years found residential assets were the most resilient of all the real estate sectors and had the best risk-adjusted returns, as measured by the Sharpe ratio.
Record-high property prices
A number of supply-and-demand dynamics are driving rents higher, increasing the sector’s appeal. As the era of subdued inflation and low interest rates have come to a halt for now, record-high property prices and rising mortgage rates are making home ownership more inaccessible.
While wages are due to fall short of inflation in the short term, prospective tenants have limited choices, due to long-standing supply constraints. Housing starts have most recently been curbed by pandemic lockdowns and higher construction costs.
Adding to the undersupply of rental housing are the longer-term trends driving demand, namely urbanisation, ageing populations and smaller household sizes. Our research team predicts a continued scarcity of supply of housing stock in most European markets for the immediate future.
It’s a pattern replicated across the globe. In most developed economies, rents will probably continue on their upward trajectory until the supply of housing catches up with demand. In the US last year, average effective rents for Class B multifamily apartments in the largest metros rose at an annual rate of 5%, led by a 30.7% rise in West Palm Beach, Florida. Acute shortages of affordably priced housing affect, in particular, the vulnerable, young and workers who provide essential services.
Rental growth concerns
While such rental growth prospects are a boon, some institutional investors are concerned that sufficient rental growth may not materialise to compensate for the increase in interest rates. At a recent conference, one senior manager at a large global institution spoke of their concerns about the potential political responses in the US to address housing affordability.
In parallel, institutions do not want to run the reputational risk of being portrayed as profiteers from the housing crisis, given their corporate social responsibility commitments. It’s no coincidence that housing affordability was a top issue in PwC’s past three annual Emerging Trends in Real Estate surveys of Urban Land Institute members in the US and Canada.
The US multifamily market has been a favourite destination for global institutions seeking exposure at scale to positive housing trends. It is a market, after all, where only a few states and large metros regulate rents.
In Europe, the patchwork of regulated and unregulated rental markets requires local expertise for investing at scale, while Asia-Pacific’s strong culture of home ownership narrows the investment universe to Japan and, increasingly, China or Australia. As global institutions lower their US rental growth expectations to factor in rental regulation risks and ensure sustainable affordability, many are looking at Europe in a new light.
Stable rental incomes
For institutions targeting returns that match their long-term liabilities, the stable rental incomes with strong inflation protection available in Europe’s residential rental market now look attractive compared with the volatility of the US. Furthermore, since political risk is also factored in, in-place rent regulation provides a cushion as it is already priced in, whereas being invested in an unregulated market that suddenly becomes regulated presents a binary risk with material consequences.
Europe, therefore, offers investors the opportunity to diversify portfolios across the stable regulated and the more dynamic unregulated markets.
Heimstaden’s portfolio of some 155,000 homes, for example, is currently a 60:40 mix between regulated and unregulated rents across nine European countries. It allowed us to generate a blended running valuation yield of 3.1% in 2021, while our average cost of debt ended the year at 1%. Rents grew on a like-for-like basis by an annual 5.2% in the second quarter of this year, up from 2.1% in the same quarter of 2021.
The European model
Each European market differs, so “affordable housing” means very different things. The continent’s political heritage has shaped residential rental markets around a post-World War II compact which accepts political intervention if landlords are perceived to abuse the system.
An example of this was when Denmark introduced tightened legislation in 2020 in response to aggressive behaviour by landlords to modernise and renovate properties before ratcheting up rents. In some jurisdictions, rental regulations serve other political objectives, notably in the field of sustainability. The Dutch operate a points-system framework for setting rents, where landlords may lift rents by more than normally permitted if they improve the property’s energy performance and meet other sustainability metrics.
Irrespective of each country’s approach to social housing and the frameworks for setting regulated rents, the for-profit private rental housing sector has played an important role in Europe’s residential markets since the liberalisation of many national housing markets in the 1970s.
‘While initial cash yields may be more modest than in the US, the regulated European markets offer greater affordability and less volatility.’
Christian Fladeland, Heimstaden
The European model shows regulation is no barrier to institutions seeking consistent risk-adjusted returns to match their liabilities. While initial cash yields may be more modest than in the US, the regulated European markets offer greater affordability and less volatility. What it requires is a longer-term perspective for returns and a professionally managed platform with the expertise to navigate the complexities of country-specific legislation.
The authorities in Berlin, the Netherlands and Denmark have responded to speculative investors with short-term investment horizons seeking outsized returns in housing markets characterised by material housing shortages. While the remedy to the housing crisis lies in stimulating and boosting supply, this will take time.
Beyond the rentier mindset
Tightened legislation targeted to existing housing stock as a response to the housing crisis may be quick to implement. However, it may reduce investments supporting increased supply and exacerbate the very housing affordability issues it was designed to address. Housing is a basic human need, so when the short-term profit motive is pursued too aggressively, it will inevitably spark a political response.
The general takeaway is that a socially viable and sustainable rental housing business is not compatible with investors incentivised to generate short-term profits.
Aside from taking a longer-term approach to their investments, landlords must act responsibly in unregulated rental markets. One of the lessons of covid-19 is that property owners must be more customer-focused and establish a connection with their tenants. They must take responsibility for their tenants beyond providing a roof and four walls.
Today, too many institutional landlords in the residential rental sector continue to have this rentier mindset, treating tenants as a source of commoditised cash flow. This cannot continue in the current housing market. It means doing the right thing for tenants, so improving the quality of homes may not be motivated solely by the short-term goal of increasing profits. Our current €700 million investment programme to improve the sustainability of our properties is as much about future-proofing buildings and helping tenants reduce their energy bills as the income growth it will unlock down the line.
Fundamental to this long-term outlook is the principle that housing affordability is in the interests of tenants and landlord alike. This is something that we have integrated into how we underwrite our investments as an evergreen investor. We have built our portfolio with due consideration of the long-term affordability of the markets in which we operate to ensure predictability and surety for our tenants, as well as an income stream with low risk that allows for a high degree of inflation hedging.
Accordingly, we monitor tenant affordability closely, alongside the data on supply and demand trends, occupier sentiment, consistency in housing policy and political risk. Since Heimstaden began investing in residential real estate in the 1990s, it has always run its business to ensure it is socially viable and attuned to the needs of its tenants.
This distinct European business model, shaped by our own Nordic heritage, offers a way forward for institutions to generate attractive risk-adjusted returns from the residential rental sector as the housing shortage is due to persist and calls for rent controls get shriller.
Christian Fladeland is Chief Investment Officer of Heimstaden