The residential investment market is undoubtedly changing. Over the past 12 months there has been an influx of overseas capital including from Canada, Sweden and UK residential property institutional investment into the sector. however, as an asset class residential property is regarded as being relatively immature.

Because investors are unfamiliar with its granularity and perceive difficulties in building and effectively managing a residential portfolio of scale, they are typically partnering or setting up joint ventures with existing developers and operators in the residential sector. This is to be expected in the early stages of the development of the sector. It is an important part in marrying up the available investment capital and existing market expertise needed to access the housing stock and generate competitive returns from it.

The generation of competitive returns is critical. According to recent research there are some 46 funds or institutions with available funds of £26 billon with an interest in residential investment and UK investment opportunities. However, UK residential investment is in competition with a range of other global real estate opportunities and it is important to understand the strength and weaknesses of the UK residential investment proposition.

UK market returns

Over the past 20 years, UK residential property has outperformed commercial property and other mainstream asset classes on the basis of total returns. Residential returned an annualised average total return of 12.3% whilst the average annualised return from IPD All Commercial Property was 9.1%. The residential returns were therefore 30% higher and also less volatile than commercial property.

However, low income yields have frequently been cited as a major barrier to wide scale institutional investment. Over the same period (1992-2011), 75% of the total return from commercial property has come from income returns (6.8%), while income has accounted for 52% of the total return from UK residential (6.5%).

Despite the inclusion of residential property in the main IPD index this year, the lack of publicly available information on the market is a significant barrier to its ability to expand through institutional investment. The fact that there is no information available on portfolio deals, prices achieved and gross initial yields prevents large institutions from being able to make rational investment decisions in the residential sector.

To counteract this, Savills has established a proprietary database to track the progress of investment deals across the UK. The database holds information on 108 deals that have taken place during the course of the last 18 months and provides detailed information on
the 40 or so investments that are currently being marketed throughout the UK.

The average gross initial yield of these transactions was 6.6% and the average discount was 20% but this varies from 5.5% in London (where medium term capital growth prospects are strongest), to 9.2% in the North West (where income returns are expected to make up the majority of the total return in the next 5 to 10 years) - see table 2.

This indicates the current residential investment market, is already distinguishing between investment and owner-occupier value. However, the degree to which these two differ is dependent upon whether investors see different types of residential property as a predominantly income or capital play.

Whatever the capital growth prospects and projected internal rates of return, we expect investors to require a minimum income return. But we do not expect them to ignore capital growth entirely, as we know that this is one of the major attractions of the sector.

International context

The most appropriate way of setting London residential in the context of other residential real estate markets is to compare its risk and return profile. Using 10 year annualised returns and assessing the volatility of these returns shows that there is a group of Northern European countries (Switzerland, Germany, Austria and the Netherlands) where annualised total returns are modest (average 5.5% p.a.) and the returns have been very stable (low levels of volatility) - see graph 1.

The UK and London have had higher annualised total returns (average 10% p.a.) which have been more volatile than the very stable returns evidenced in many northern European countries but substantially less volatile than the US REIT market. This is interesting given the US Residential REIT market is the largest in the world with a market cap of $70 billion (£44 billion). Clearly, the returns have been higher than UK residential but the falls have also been much deeper which has created the volatility in the market. The fact US REITs are volatile may explain why it is largely a vehicle for retail investors rather than an institutional investment instrument.

Developing the sector

The development of a much larger scale investment market in UK residential property, one that builds on the emerging demand from funds and institutions, requires a more detailed understanding of the investment market and greater availability of market information to allow the emergence of a more liquid and efficient market.

Taken from
Spotlight: Rental Britain as an Asset Class