The UK Private Rented Sector – What It Means for Investors and What to Watch Out For
A great deal of consideration has been given to the private rented sector (“PRS”) in the UK, over the last few years. PRS is a relatively new asset class for institutional investment in the UK, and is presenting itself as an increasingly compelling opportunity. This alert provides a brief examination of some of the contractual and regulatory considerations relevant to investing in PRS. We examine these matters primarily from the perspective of capital investors.
PRS currently accounts for 10 percent of the total housing stock in the UK and the sector has grown by over 10 percent in the last 10 years. Reasons for this growth include demographic shifts to urban locations, the lack of new housing supply relative to demand, and a more conservative approach by financial institutions to residential mortgage lending, requiring purchasers to provide significant deposits and to satisfy affordability tests rather than simple income multiples. Renting is becoming a longer-term (or even lifetime) housing option for many.
The returns on PRS investments have been enviable: according to IPD data, between 2000 and 2013, residential investment returns were 10.5 percent per annum, compared with a return of seven percent per annum for other commercial real estate assets. Until recently, PRS has been characterised by non-institutional supply, with private buy-to-let landlords being the most active participants. However, based on recent reports, institutional investment in PRS has increased significantly and, according to the Centre for Economics and Business Research, it is forecast to increase by 40 percent over the next 10 years.
Origination – Beware the Pitfalls
A common concern expressed by institutional investors in accessing PRS investments in the UK is the availability of appropriate stock. Historically, the non-institutional nature of the sector meant that it was not easy to locate PRS opportunities on a scale attractive to institutional investors. This may be contrasted with the USA and Germany, which have very significant stocks of multifamily assets suitable for institutional investment. However, interesting joint venture and co-investment models are developing in relation to origination of opportunities. Examples of this would be a partnership between an investor or investment manager, on the one hand, and an estate agent or developer, on the other hand. The merits of such a partnership are clear, particularly if the party responsible for origination has visibility on the assets available from housing associations (who are significant holders of residential stock in the UK) and development opportunities presented by the public sector throughout the UK.
As with any joint venture, however, careful consideration should be given to the rights and obligations of each of the parties in relation to origination of investment opportunities, especially in relation to exclusivity and rights of first offer. This is a developing area of investment activity and competition for assets can be fierce, meaning that considered negotiation and detailed documentation of a joint venture agreement is crucial in order to avoid disputes arising between the parties.
In the absence of “ready made” stock, institutional investment in scale may involve the greenfield or brownfield development of PRS assets, often with a capital investor collaborating with a developer in a joint venture. The rights and obligations of both parties should be carefully defined. If, as is often the case, a capital investor enters into a forward funding arrangement with the developer to finance the development of a PRS asset, this may pose additional structuring and documentation challenges, particularly in relation to the capital investor’s ability to step in, take over and complete the development if circumstances warrant.
Operational Hurdles, Regulatory Uncertainty
Put simply, there is no overarching regulation of PRS in the UK. Nonetheless, there are numerous regulations relevant to this sector to be aware of. Some examples of this additional layer of regulation include:
- Deposits – deposits taken from tenants must be held in a government-backed tenancy deposit scheme (“TDS”), which is compulsory for all residential assured shorthold tenancies (which are described further below). TDSs were created under the Housing Act 2004 and are intended to prevent a landlord from failing to return a tenant's deposit and to ensure that a landlord is not left out of pocket when a tenancy expires and a tenant abandons the property.
- Health and Safety – landlords must ensure that certain health and safety measures are taken in relation to the operation of PRS assets. These include ensuring that fire and carbon monoxide detection equipment is installed in appropriate places and that electrical- and gas- powered appliances are periodically checked for safety.
- Houses in Multiple Occupation (“HMO”) – if an asset is an HMO (essentially, an arrangement where more than one household occupies an asset, such as a house that has been converted into bed-sitting rooms), there will be additional regulatory considerations involving registration of the asset as an HMO with the local authority.
- Immigration Status – under the Immigration Act 2014, landlords are required to check whether tenants have appropriate immigration status before allowing them to rent premises.
- Energy Performance Certificates – a landlord must make available to a prospective tenant, free of charge, a copy of a valid energy performance certificate for the premises.
There are 50 Acts of Parliament and 70 sets of regulation that apply to PRS.
Whilst a capital investor would expect to rely on the expertise of its operating partner to ensure compliance with such matters, a prudent investor should be mindful of the relevant requirements and the consequences of a failure to comply. This is particularly important in the event of a replacement of the operating partner.
Residential Leases – Relevant Issues
Unlike commercial real estate, residential leases in UK PRS have historically been short-term in nature. Assured shorthold tenancies (“AST”) are commonly used in UK PRS. Indeed, any residential tenancy created on or after 28 February 1997 will automatically be an AST unless the landlord has served a notice on the tenant stating that the tenancy will not be an AST. This form of tenancy was created under the Housing Act 1988 and must comply with certain legislative requirements. Typically, an AST will be for a term of one year and may include, after the first six months, a right for either the landlord or the tenant to terminate the tenancy subject to a prescribed notice period.
The short-term nature of a PRS letting has an impact on the stability of the cash flow that an asset can generate. This is analogous to student housing. From a capital investor’s standpoint, it is essential that the operator has the experience to ensure that gaps in occupancy are avoided through active lettings’ management and that, if there are gaps in occupation, there are funds in place that can be used to ensure that financial obligations in respect of the asset can be met. Balanced against this, the AST regime is designed to enable a tenant to be removed from premises if he or she breaches the term of the AST and there is no ability for a tenant to remain in occupation without paying rent. The short-term nature of an AST also provides the landlord with the flexibility to obtain rental increases on expiry of the AST, subject to market demand.
Another very significant difference between PRS lettings and lettings of other commercial real estate assets is the absence of any service charge or insurance costs payable by the tenants in PRS lettings. There is also, typically, an inability to charge the tenant for any dilapidation-related costs when the tenant leaves the premises. For these reasons, the landlord must ensure that the rental income alone is sufficient to cover all maintenance-, dilapidation- and insurance-related costs. Otherwise, the landlord must be prepared to fund refurbishment work that is required in respect of the asset itself either during the term of an AST or after a tenant departs. The greater the “spec” of a PRS asset, the greater these costs are likely to be.
It is worth noting that the Scottish Parliament is considering new legislation, applicable only in Scotland, which seeks to adopt a more interventionist approach to the regulation of PRS assets in Scotland. This is contained in the Private Housing (Tenancies) Bill. While a review of this proposed legislation is beyond the scope of this alert, one of the most interesting provisions from an investment perspective is a power, given to local authorities, to introduce rent controls under certain circumstances so that the ability of a landlord to increase rent at the end of an AST will be regulated.
Finally, it should be recognised that PRS is a politically sensitive area, given that the end users of the product are individuals. Indeed, given the structural shift to longer-term or lifetime renting, it is quite possible that PRS accommodation increasingly will be used by families. Capital investors should take care to ensure that the management of assets is undertaken with sensitivity to the nature of the tenant mix, in order to avoid adverse publicity (as has occurred in the care home sector in the UK).
In theory, PRS assets generate rental income over a long duration provided they are appropriately managed and maintained. From a financier’s perspective, there are a number of differences to conventional commercial real estate assets, which include:
- Short-Term Cash Flow – as a result of the short duration of ASTs, as described above, it is difficult for “normal” forward-looking interest cover tests to be applied without bespoke amendments. Such tests typically work on a 12-month look-forward basis but do not give credit for rental income arising after a “break date” which, in the context of ASTs, could occur after six months and which would reduce every month after an AST commenced. A typical forward-looking interest cover test may not be appropriate, and what may be more practical is a backward-looking interest cover test, coupled with a minimum in-place rental income test or a maximum vacancy test.
- Capex Reserves and Business Plan – a prudent financier should make sure there are reserves in place for maintaining and refurbishing the asset. These should be put in place either upon draw down, or accumulated over time, or by some combination of the two. This recognises that PRS assets, which are by definition occupied on a 24-hour-a-day, 7-days-a-week basis, may be subject to greater wear and tear than the generality of commercial real estate assets, and so will need more maintenance and refurbishment spend.
- Replacement Manager – a lender should insist on rights to remove the incumbent manager and engage a replacement, for instance, if anything were to happen to the original manager or if it were to default. Such rights are crucial to ensure that the assets are properly managed and to mitigate the risk of cash flow disruptions. As described above, the importance of management in the context of PRS is driven by the short-term nature of the lettings, the regulatory framework and the maintenance requirement.
While both the bank and alternative lending markets are fairly liquid at this point, it is interesting to note that securitisation has been used to finance PRS assets in the US. These transactions involve a securitisation of the rental payments made by tenants (as opposed to a loan secured on commercial real estate, which is the essence of a typical CMBS transaction). It may be that the capital markets could provide a means of accessing term financing for stabilised PRS assets.
Tax Changes Affecting PRS
Various measures have been introduced by the UK Government in recent budgets that have materially changed the tax landscape for investors in UK real estate. In particular, measures announced as part of Budget 2016 in March have increased the cost of acquisition for PRS investors. In the last few years, major changes have been made to the way in which SDLT is calculated on residential property, most recently for acquisitions of additional residential properties by individuals; and, importantly, for acquisitions of any residential property by companies and other non-natural persons there will be a surcharge to the headline rate of SDLT of three percent for each charging band. Notably, despite significant lobbying efforts, the Government decided against including an exemption for large-scale property investors from the three percent SDLT surcharge.
The UK Government is also continuing its charge at the forefront of OECD BEPS implementation and announced the introduction of measures to limit interest deductibility from April 2017. A consultation on this measure is to take place during the course of 2016, with legislation to follow. The introduction of a fixed-ratio rule limiting corporation tax deductions for net interest expense to 30 percent of a group’s UK EBITDA will significantly restrict interest deductions—though it is at least some comfort that the proposed cap of 30 percent is at the top of the range proposed by the OECD.
Finally, provisions are to be introduced to bring into the charge to UK corporation tax non-UK resident companies realising trading profit from trading in or developing UK land (even where such development is carried out without a UK permanent establishment). There will also be a charge for disguised trading (i.e., holding the property in an investment entity, in order for the non-resident to avoid what would otherwise be a trading profit if there had been a sale of the land instead of the entity holding the land). These new measures are being supported by the creation of a new task force with a remit to improve taxpayer compliance in the sector.
It would be misleading to say that PRS, as an asset class, differs entirely from mainstream commercial real estate assets. However, there are key differences to warrant an analytical and an informed approach by capital investors as well as financers, and an appreciation that there are similarities to assets such as student housing.
The Real Estate Investments & Transactions Group at Ropes & Gray has up-to-date experience of PRS transactions as well as a significant track record in joint ventures, acquisitions, investments and financings.