by Peter Dent
A recent case study by the writer shows how investors are reaping substantial financial benefits from the Government’s attempts to revitalise privately rented housing in inner-city areas. The benefits, however, are unlikely to revive the sector as a whole unless they can be sustained in the long term.
The history of political involvement in this sector has deceived us in the past with its cunning passages and whispering ambitions of ideological aspiration. The question is, Can this government therefore hope for success this time when the sector is, perhaps irretrievably, decayed and, as Eliot’s Gerontion “driven like an old man to a sleepy corner”?(1)
Why revive?
An examination of the reasons for this renewed interest might reveal that it is a consistent element in the Government’s overall economic strategy. It is this strategy which has had an effect on both the demand and the supply of privately rented accommodation.
There has been a shift away from direct public provision with the tightening of PSBR which has effectively stagnated council housing production. This has been further reduced in absolute terms by the right-to-buy provisions, sales of “difficult to let” estates and the growing list of uninhabitable local authority properties awaiting repair or renovation.
In addition to these there appears to have been a significant shift in the distribution of wealth in the country between the North and the South. This, with its knock-on effect in house prices, has tended to restrict mobility between regions. If the Government sees such mobility of labour as an important part of its economic strategy, then either the affordability of housing has to be addressed or alternative provisions made. If the local authority option is not available then an expansion in other areas is needed in order to provide the “right to rent”.
The Government’s proposals see this expansion coming from housing associations, newly formed “housing action trusts” and from private landlords. In each category some form of private funding is envisaged.
These proposals are, in that sense, simply an extension of the privatisation policy of the earlier 1980s. Now, with this change of economic philosophy, one might have expected a growth in the privately rented sector. But there still appears to have been an overall decline in provision of privately rented housing over the past 10 years.
While it must be accepted that, in this country, it is unlikely to return to the position of prominence that it enjoyed in the last century (few, I suspect, would wish that), it nevertheless could have a valuable role to play in the new UK economy given the opportunity.
That opportunity can materialise only if those who might invest have the confidence that the returns match the risks and the investment is a long-term prospect which outlives the present government.
Currently there is both a lack of detailed research into the financial aspects of private landlordism and insufficient analysis of the information which is available. In fact, very little analysis at all appears to have been carried out on this side of the equation. If, therefore, regeneration, at whatever rate, is to take place, an essential prerequisite is an examination of the landlord’s true position.
From the information that is available, it is apparent that some parts of the sector can prove more profitable than others. Whitehead and Kleinman, for example, suggest that acceptable returns are more likely in “areas of low demand for owner-occupation and general excess of supply”.(2)
Doling, too, has carried out extensive research in this area and highlights the regional divergences of actual returns both inside and outside rent controls.(3)
The conclusion from this is that this type of accommodation tends to be found not in the wealthier areas of the country where rental property for labour mobility is most needed but in low-value areas and more specifically in the unfashionable inner-city areas. This type of property is likely to yield a greater rental/capital ratio to their owners. Added to this, higher returns can be achieved on property which, at relatively low cost, can be converted into multiple lets.
However, even where these conditions do exist there is still the tendency towards a gradual decline in available accommodation.
Multiple occupation
So far there is little evidence of direct institutional involvement in this subsector, presumably because the perceived returns are not sufficient for the overall risks involved. On the other hand, it may simply be that the true opportunities of the situation are not readily apparent to these investors. After all, a neglected three-storey terraced house built in the urbanisation rush of the last century in a rundown area of a large city with little prosperity evident in the surrounding neighbourhoods would not appear to offer much hope of reasonable return. Add to this the political disagreements about housing provision for the disadvantaged, and any fund manager is bound to look elsewhere. After all, what effect would such investment have on the image of his portfolio?
Such a subjective view, however, may ignore some of the facts. A case study has recently been undertaken to determine whether an objective view of this investment medium could indicate returns to an investor sufficient to attract more general interest in investing in this subsector of the market.
Case study
A case study undertaken by the writer during 1985 examined a small pocket of houses in multiple occupation in a Housing Action Area in Handsworth, a deprived inner-city area in Birmingham.
Handsworth was selected because it has a history of social deprivation, racial strife and violent outburst, and has seen progressive deterioration through property fragmentation (into multi-lets), area status decline with little new investment, deterioration of basic services, and a growing immigrant population.
But, in addressing this particular problem area, the local authority have adopted a new initiative. An action team was set up “to investigate the nature of the housing problems in the area and then devise and implement a programme of action to improve physical and management conditions”. This was to be achieved through the medium of grant aid and landlord contribution.
The typical house in the survey had a vacant possession capital value in the range £18,000 to £24,000 after improvement costs of between £8,000 and £15,000. Much of the public funding was through the Inner City Partnership Programme and included damp-proofing, rewiring, repointing, roof renovation work and provision of new internal water services to comply with the regulations for multiple occupation accommodation.
The local authority’s aim was the provision of adequate housing, and the partnership built up in this exercise with the existing landlords was simply an effort to fulfil that role. It was not the authority’s intention to provide rejuvenated housing through these private means, or indeed to boost the returns to the landlords concerned. An examination of the relative financial position of the landlords does, however, reveal some interesting conclusions. These are not put forward as universally valid and applicable to every similar situation. But they may indicate that this subsector of the market may be worth a second look by investors, particularly when the risks of short-term volatilities in other sectors of the investment market are currently being reassessed.
Investment rationale
If the subsector is to appear viable as an investment opportunity it must fulfil certain minimum criteria and, as part of this case study, an attempt was made to assess the potential of the properties in a manner which might be adopted by an investment analyst.
It was estimated that investors would be looking for an internal rate of return of around 16.5% (11.6% net of tax) on such investments. From the small sample analysed it was apparent that prior to any involvement by the local authority most returns fell far short of this target rate (ranging from 2.09% to 15.4%).
On the other hand, after work had been completed, rates in excess of these minimum requirements were being achieved. The range here was from 15.87% to 20.16%. These results were based on expectations regarding projected income growth. Essentially, this involved putting these projections (based on adjusted past performance) into a DCF program over a realistic time-horizon for the properties concerned.
On the basis of return on initial income the respective figures were 1.48% to 7.91% (unimproved), 8.67% to 12.93% (improved).
Several factors contribute to the level of returns being achieved. These include lower void rates on improved properties and minimal uninhabitable space on improved properties. From this it is apparent that while the improved properties are still owned and managed by the same individual landlords, it has been possible to secure a higher let ratio through local authority involvement. Also, it is clear that although in some cases the number of units has been reduced by the scheme, rents subsequently registered do appear to be in the landlord’s favour.
There are many questions which could be raised here relating to the possibilities for the future of this type of property as an investment medium and the manner in which acceptable returns can be achieved and maintained. Nevertheless, what seems to be clear is that if the assumptions made from the trends in this localised market-place are realistic then a scheme such as this can increase returns significantly. Obviously, any institutional investor would look at alternative scenarios and test the sensitivity of their results against changes of input assumptions and, to date, no detailed analysis of this type has been completed.
However, as a simple test on a sample of the properties, a reduced income growth rate was applied. This was intended to assess the impact of a change in the expectations at a fairly superficial level. Results indicated that, while rates of return were reduced, the tendency was still to produce levels on improved properties above the minimum acceptable.
Need for more research
A cynic would say that the free market only works once government has put in the initial (or in this case, intermediary) costs. But that view is perhaps too unproductive. The local authority scheme highlighted here is helping to regenerate an inner-city area. It is doing it partly through central funds, partly through local funds, but also through private means (ie the landlord’s contribution). It is a partnership arrangement which, in the circumstances of the case, is meeting the objectives of the parties involved.
There are alternative models to this which might be more appropriate for wider application. For example, an institution/housing association partnership where a financial institution would own the properties and fund the regeneration and housing associations would manage the properties. There are also opportunities for the newly formed urban development corporations.
From discussions with the local authority, the landlords, and local banks and building societies, it was apparent that there was little indirect support, in terms of loan capital, from institutions to this particular venture owing to, it is presumed, their perceived risk thresholds. But whatever the arrangements of any particular partnership, the risks to the investor can surely be mitigated to add to the attractiveness of the opportunity. The properties, themselves, will, of course, offer some of that security in capital terms, but it is also apparent that income is safeguarded by government. Here the safety net of housing benefit can provide affordability in the market-place.
So the analysis in the case study does indicate that a direct involvement from such institutions may produce more than they may initially expect. It must, certainly, be an avenue which should be explored in more detail and one in which more extensive research could profitably be undertaken.
If the results prove to be a true reflection of a general situation this could benefit both the private sector, who would be able to extend their range of investment opportunities, and the public sector by providing a means of addressing the twin problems of homelessness and labour immobility, although this latter problem may be more difficult to resolve, given the tendency of lower returns in high-value areas evident from earlier studies. Nevertheless, these would be tackled through the medium of a joint-venture project with ultimate responsibility remaining in private hands.
The Government proposals are to be welcomed as a platform from which to launch a new air of confidence in the sector. It should understand that it is not a cheap solution and it should realise the full subsidy implications if its proposals are to succeed. Either that or, returning to Eliot’s Gerontion, the White Paper will simply be the thoughts of a dry brain in a dry season.
Peter Dent is a senior lecturer in the Department of Construction and Surveying at Birmingham Polytechnic.
(1) T S Eliot — The Waste Land and Other Poems (Faber & Faber).
(2) C Whitehead & M Kleinman — Private Rented Housing in the 1980s and 1990s (Dept of Land Economy, Cambridge University, Occasional Paper 17, 1986)
(3) J Doling — Estates Gazette March 23 1985 p 1186 and April 18 1987 p 319