Market Insights: Opportunities in Residential Rent
In this edition of our briefing series, we explore the catalysts and themes underpinning housing demand in the United Kingdom and why we believe the private rented sector, in particular, is poised for growth.
Introduction
Britain’s £8.4 trillion residential market has never had it so good.1 Over twenty years of continuous population growth has supported an extraordinary increase in house prices and demand. The pace of increase has only accelerated since the Pandemic, as market dislocations have resulted in widespread goods and asset price inflation. During inflationary periods, real assets such as residential property tend to outperform as replacement costs rise and lease incomes reprice to prevailing market levels. So, as the consumer price index, a broad measure of pricing across the economy, increased by an aggregate 15% since January 2020, house prices rose at a much faster 28%, followed by a 23% pick-up in market rents for new tenancies (Chart 1).2
Rising prices have consequences for market dynamics. We believe that over the next decade, a structural deterioration in homebuyer affordability and a persistent undersupply of midmarket housing will continue to suppress homeownership rates, in turn, supporting growing demand for private rent.
Chart 1: Housing Market Price Performance
Index: 2015=100, (January 2015 – October 2022)
Source: QSix analysis, Office for National Statistics, Homelet Index of Rental Prices for New Tenancies.
UK Housing – A Growing Shortage
As a subset of the UK housing market, the outlook for residential rental property is inevitably influenced by many of the drivers affecting housing supply and demand more generally. If, as we suggest below, there is a scarcity of UK housing stock, then any imbalances in UK PRS are likely to be further exacerbated.
The UK housing market is facing a significant and growing shortage of housing. Rising demand, driven by population growth,
inward migration and changes to household formation patterns are not being offset by supply, which has been constrained by lack of new construction and restrictions on development in some areas. This supply-demand imbalance has contributed to increased competition for available properties, a sustained period of house price inflation, and a reduction in affordability. We analyse in more detail below the factors combining to create this imbalance.
Population Growth
Growing demand for housing starts with a growing population. Over the past two decades, the United Kingdom has experienced one of the highest nominal rates of population growth compared to anywhere else in Europe.
Between 2001 and 2020, the country’s population grew by 14% to 67 million, equivalent to an increase of 8 million people. In addition to the natural balance between births and deaths, the free movement of labour and resulting migration flows have substantially contributed to growth.
Recent statistics show that in the year to June 2022, long-term immigration into the United Kingdom totalled approximately 1.1 million people, an annual increase of 435 thousand. Compared to the previous year, this excess migration has resulted from a substantial increase in arrivals from outside the European Union.3
Chart 2: International Migration has Supported Population Growth
(Pre 1951-2021)
Source: QSix analysis, Office for National Statistics, Census 2021.
Positive growth is forecast to continue over the next two decades. Official projections compiled by the Office for National Statistics (ONS) estimate a further increase of 2.1 million (3.1%) by 2030, incrementally rising to 3.9 million (5.8%) people by 2045. At this point, the overall population will reach 71 million.
Chart 3: Population Growth of 6% Forecast by 2045
Millions, (1995-2045)
Source: QSix analysis, Office for National Statistics.
Household Formation
Population growth has naturally led to an increased demand for housing. Between 2001 and 2020, the number of households increased by 3.4 million, or 14%, from 24.5 million to 27.9 million.
Household formation rates are forecast to accelerate, supported by population demand and an aging society. Between 2018 and 2039, the ONS predicts a cumulative increase of 3.7 million households. This growth is equivalent to an average annual run rate of 167 thousand over 22 years and equal to the overall number of households rising from 27.8 million to 31.5 million.
Household Size
The 2021 Census reveals that the number of residents in an average household across England and Wales has remained constant at 2.4 people since 2011. Given the long-term trend toward smaller households, we would expect to see this average decline over time.
The consistency of this metric suggests the existence of a market failure to meet latent demand. Specifically, despite 62% of new homes formed between 2001 and 2020 containing fewer than two people, the average number of people per household has stayed the same. The implication is upward pressure from a growing number of people living together in larger households, either resulting from a lack of supply or reduced affordability. Both factors will have contributed to increased household density and suppressed formation rates.
Supply Deficit
Estimates of aggregate market supply deficits are wide-ranging. A study compiled by the National Housing Federation in 20184 has suggested that a total of 380 thousand homes per annum is required over 15 years for the market to reach equilibrium. The Conservative Party, by contrast, had targeted a run rate of 300 thousand homes per annum by the mid-2020s5 (but recently dropped this target implying it is unlikely to be achieved). These supply targets compare to an actual level of 216 thousand new build completions realised in 2020/21.
Chart 4: Homebuilding Completions
(1969-2020)
Source: QSix analysis, Office for National Statistics.
Supply Challenges
Housing is a manufactured asset, and increasing supply is susceptible to prevailing market conditions. A coincidence of factors over the past year has resulted in several challenges that are likely to impact future output and pricing which include:
- The inflationary backdrop has increased the average price of delivering a new home by 12.3% in the year to June 2022.6 Although the supply chain disruptions for raw materials and inputs have begun to ease, the associated cost inflation has shown little sign of unwinding.
- Financing is more expensive. The rise in market interest rates has significantly increased the cost of capital for homebuilders, coinciding with a real-terms deterioration in the purchasing power due to inflationary pressures.
- This year also brings a step change in taxation for the industry. On top of a six percentage point increase in corporation tax, a new 4% Residential Property Developer Tax and the proposed £3 billion Building Safety Levy will additionally weigh on the housebuilding sector.
- Environmental pressures are rising. One example is the impact on housing supply from nutrient neutrality levels in Britain’s waterways. Last spring, the Homebuilders Federation found that the issue is one of the biggest challenges facing the industry and estimated that it has so far delayed the construction of approximately 120 thousand homes across 74 local authority areas.7
- Outdated planning laws which force every project to be assessed on a case-by-case basis are hindering the ability of the government to clear the current backlog of unbuilt homes. They effectively ration land for development, giving significant influence to people who, for whatever reason, want to prevent new building happening at all.
- The political complexities concerning long-term planning have not eased. In November, the Government reiterated its support for a Competition and Markets Authority study of the homebuilding sector. While in December, the Government abandoned its annual supply target. The industry believes this relaxation will reduce the incentive of local planning authorities to grant permissions for new developments.
In light of these multiple pressures, we envisage a scenario where future construction output levels are moderated, with developers refraining from any substantial increase in supply beyond a ‘guaranteed’ level of demand that satisfies price growth and net margin requirements.
According to a recent analysis published by the Home Builders Federation (HBF), the annual supply of new homes in England may drop to 111 thousand later this decade, the lowest level in more than 80 years, citing the highly restrictive planning regime, along with mortgage affordability (see below), as the two major factors.
UK Private Rent: A Structural Growth Market
With the supply-demand imbalance for UK residential property generally showing no signs of abating, we now turn our focus to the UK rental market specifically. Our conclusion is that supply is failing to match changes in demand patterns created by a combination of factors, including intergenerational tenure trends, rental market demographics, economic mobility and significant affordability constraints. Moreover, these imbalances seem likely to remain, supporting sustained growth in future UK rental values.
A Growing Market
More people in Britain are renting a home than ever before. Between 2005 and 2020, the overall share of privately rented homes increased from 12% to 19%. By contrast, homeownership rates fell from 69% to 64%, while the proportion of homes within the social sector fell from 19% to 17%.
This decline in alternative housing tenures has supported the growth of private rent. These shifts are equivalent to an attrition rate of -0.5% per annum for homeownership and -0.7% per annum for homes in the social sector. Our analysis forecasts that should these long term trends continue, the overall share of privately rented homes will increase to 23% by 2030, rising to a quarter of the market by 2035.
Rental Demand Drivers
The demand for rental property in the UK is influenced by a variety of factors, including demographic trends, economic mobility, affordability and government policies. We examine these in more detail below:
Tenure Trends
Successive generations of our society are more likely to rent a home than own one. Between 2010 and 2021, five of the six demographic cohorts (Chart 5) experienced a declining share of mortgaged home ownership, coinciding with a long-term decline in homeownership rates. By contrast, the percentage of the population privately renting a home increased across all demographics.
Chart 5: Private Rent is Growing Across the Demographic Spectrum
Age cohort in tenure, (2010-2021)
Source: QSix analysis, Office for National Statistics, Department for Work and Pensions. Note: Chart excludes Social Rented tenure, so cohorts illustrated will not sum to 100%.
Rental Market Demographics
Demand for private rent is highly polarised. The highest absorption rates are unsurprisingly amongst younger adults aged 34 or under. Between 2000 and 2021 the proportion of 20-34 year olds living at home with their parents has increased from 20% to 28%, equivalent to 3.6 million people. This cohort is more likely to rent a home than own one, not least because of rising affordability constraints.
On the basis that the substantive increase in the share is attributable to people who have been suppressed from forming a new household – as opposed to those making a positive decision to remain at home with their parents – this is indicative of an unrealised demand pool of approximately 1 million people, comparable to over four years of new housing supply.
At the other end of the spectrum, demand from mature adults aged 35 and over is overwhelmingly led by the population of aging millennials who are now entering the family formation phase.
Economic Mobility
When it comes to housing, fewer of us are buying our own homes, not only because affordability has reduced but also because economic mobility has increased. Our society is also now more skilled, as millennials and the generations below them are more likely to have benefitted from a university education.
As people move up the social ladder and seek to improve their economic and social status, they are more likely than ever before to seek new areas for better job opportunities or to access better amenities, such as good schools, cultural venues or leisure facilities. This inevitably leads to an increase in demand for rental properties that allow a higher degree of flexibility and greater freedom of movement versus the alternative of home ownership.
Affordability Constraints
An extended period of above-trend population growth, combined with secular shifts in socio-demographics, has led to deep sector imbalances. The resulting disequilibrium has sustained an increase in average house prices, which have grown faster than the broader economy over the long term.
The consequence of this price appreciation has been a deterioration in homebuyer affordability. In just over twenty years across England and Wales, average house prices have risen by over three and a half times, equivalent to a nominal increase of £201,000, from an average of £79,000 in 2000 to £280,000 in 2021. By contrast, average earnings over the same period rose by just £12,000 (1.6x). This divergence has increased the multiple of annual earnings required to purchase a home from 4.1x to 8.9x, a record high.
Chart 6: House Price Inflation has Outpaced Earnings Growth
Index 2000=100, England and Wales, (2000-2021)
A general deterioration in homebuyer affordability followed the 2008-9 financial crisis, firstly as the gap between house prices and earnings expanded and secondly as mortgage lending markets tightened.
Renting Now Cheaper Than Owning
With the average two and year fixed rate mortgages now exceeding five percent, the cost of home ownership for first time buyers has more than doubled during the past 12 months. Our analysis (see chart 7) shows that for all regions in England outside London, renting is now cheaper than the average annual outlay on a 75% loan-to-value mortgage.
Chart 7: UK Rent Versus Buy Cost Analysis
Sources: ONS, Rightmove, Halifax Mortgage rates 06-Feb-2023, CACI, Nationwide, QSix Analysis
Deposit Affordability
In addition to higher mortgage servicing costs, deposit affordability represents a major barrier to entry for those seeking to gain a foothold in the UK housing market. Chart 8 below shows the number of years it takes to save a deposit using average household income for each region in England, with the left-hand extremity of each bar denoting the time to accumulate a 10% deposit and right hand extremity denoting the time required to accumulate a 25% deposit. For London, where house prices are highest it now takes 10 years to accumulate even a 10% deposit and 25 years to accumulate a 25% deposit.
Chart 8: Deposit Affordability
Sources: ONS, Rightmove, Halifax Mortgage rates 06-Feb-2023, CACI, Nationwide, QSix Analysis
The Withdrawal of Help-to-Buy
The widening gap between house prices and earnings has inhibited homeownership. This theme has worsened in the years following the financial crisis, as average mortgage loanto- value ratios have fallen, leading to an increase in the level of homebuyer equity required to fund a purchase.
In April 2013, the government introduced its Help-to-Buy scheme to support demand and stimulate new supply.8 The original programme ran until December 2021 and provided buyers with effective leverage, bridging the gap between mortgage loan-to-values, equity deposits, and the price of a new home.
The original scheme supported over £99 billion of new build demand and enabled the completion of over 355,000 transactions. In 2022, the scheme closed to new applications leaving the market with a sizable demand and supply-side gap. In the absence of a replacement, we believe the withdrawal of the scheme will lead to a substitution effect in favour of private rent.
Mortgage Market
A tighter credit cycle following the financial crisis brought about changes to mortgage loan origination. Most notably, these included a reduction in average loan-to-value ratios, an end to interest-only borrowing, and a decrease in the proportion of mortgage advances relative to incomes. These factors constrained homeownership rates by increasing the hurdles of equity and income required to fund a home purchase.
In subsequent years, mitigation arrived in the form of falling interest rates and extending mortgage term durations, which combined to counterbalance the impact of higher property prices. So, despite house prices and mortgage principal values at origination rising to all time highs, repayment affordability as a percentage of household income dropped meaningfully and remained within a relatively tight range for most of the past decade (Chart 9).
Chart 9: Residential Capital Stack
Average First-Time Buyer House Prices (£), (2000-2021)
Source: QSix analysis, Office for National Statistics, UK Finance.
Interest Rates
If the 2008 financial crisis represented one market inflection point, the past year has represented another. A rapid acceleration in general price inflation has reduced the purchasing power of money, creating additional pressures on household finances. The Bank of England’s decision to reverse its accommodative monetary policy has translated into a sharp increase in market interest rates, further exacerbating
cost-of-living pressures.
Rising rates principally increase the term cost of borrowing, reducing ongoing mortgage repayment affordability. For new homebuyers, the immediate consequence of this has been an increase in the average income required to obtain a mortgage. For example, the latest mortgage origination statistics show that in the third quarter of last year, the average income of first time buyers stood at £60,000 per annum, an increase of 17% year-on-year and well above the rate of wage inflation.9
Chart 10: Significant Increase in Mortgage Interest Rates
(1999-2022)
Source: QSix analysis, Building Societies Association.
The significance of rising rates is that a higher proportion of prospective homebuyers on average incomes cannot obtain a mortgage with house prices at current levels. Moreover, with many fixed rate mortgages struck pre-2022 now “rolling off,” affordability, or rather the lack of it, is likely to have a major influence on potential homebuyer decision making. Put simply, more potential new buyers will be forced to remain within the rental system for longer and homeownership is shifting toward households with higher incomes.
Supply Constraints
Supply has remained static. Despite the many drivers supporting demand, the aggregate supply of rental stock has been curtailed in recent years. A series of Government fiscal and regulatory interventions have resulted in the net balance of rental homes within the market remaining broadly static since 2016. These policy interventions have contributed to the growing imbalance between supply and demand of rental property in the UK.
Chart 11: Supply of Rental Stock has been Curtailed Since 2016
Dwellings by Tenure, United Kingdom (2001 – 2020)
Source: QSix analysis, Office for National Statistics.
Buy-to-let Landlords are Exiting
According to the National Landlords Association, one third of landlords are currently planning to sell some or all of their properties during the coming year, the highest level of planned divestment in more than six years.
Further Restrictions are a Deterrent
Data from the English private Landlord Survey indicates that changes to legislation are the most common reason for landlords choosing to decrease their portfolio size. In this respect, proposed changes to EPC requirements for rental properties will represent a significant challenge for some landlords, potentially leading to further capacity withdrawal from the PRS market.
Outlook for rental market regulation
Unsurprisingly, significant recent rent inflation having occurred against the backdrop of cost-of-living pressures, has led to increased political discourse about rent regulation. In October 2022, a six-month ban on PRS rent increases was introduced in Scotland (along with a ban on evictions). It was recently announced that as from April annual rent increases of up to 3% pa will be allowed.
In England and Wales there is currently a government white paper proposing the abolition of section 21 “no fault” evictions as part of the Renter’s Reform Bill. It is also proposing to limit rent increases to once per year, and the minimum notice landlords must provide of any change in rent will be increased to two months.
The prospect of further rent regulation in England and Wales can never be ruled out, but as seen in other countries where they have been tried, rent controls simply serve to limit the construction and supply of rental accommodation; and as we have shown earlier in this report, there is already a significant shortage in the UK. With government finances stretched, policy makers will be acutely aware that they need to keep the private sector engaged and incentivised in order to avoid the current shortages reaching crisis levels. To the extent further rent regulations are introduced at some point in the future we believe they will take their lead from what has been introduced in other countries such as Germany and focus on major metropolitan areas (and hence multi-family properties) where affordability constraints are most acute, with more affluent, suburban areas (and hence single family homes) less affected.
Conclusion: UK PRS Poised for Sustained Growth
The structural decline in homeownership, entrenched market imbalances, demographic changes and affordability constraints have all combined to create a higher incidence of demand for private rent. An analysis of rental stock inventories10 showed that in October 2022, demand for rental homes was 46% above the five-year average, while aggregate supply was 38% lower.
This imbalance has supported a 12% annual increase in market rents (asking prices) in the year to October, 2022 equivalent to more than double the average rate of rent inflation experienced over the previous three years.
Looking ahead, it is difficult to envisage any meaningful reversal of the trends that have created such scarcity of supply for UK residential property, particularly in the rental segment. Current rental values and future rental growth would appear to be well supported.
Chart 12: Market Rent Inflation Accelerated in 2022
Advertised Residential Rents, (October 2022)
Source: QSix analysis, Building Societies Association.
Summary
Private rent in Britain is a fast-growing and attractive institutional investment class. We believe the sector is poised to outperform as a favourable combination of fundamentals gathers pace these include:
- A structural decline in homeownership supported by a sustained appreciation of house prices relative to incomes.
- Existing pockets of suppressed demand combined with a persistent supply-side disequilibrium.
- Favourable population dynamics underpinned by international migration and long-term demographics.
- A historic compression in homebuyer affordability that is unlikely to abate in the near term, as wage growth and mortgage market constraints work to inhibit a broad increase in homeownership participation rates.
- The withdrawal of Help-to-Buy is significant; in the absence of a substitute, we expect it to result in a demand substitution effect in favour of private rent.
- Rising interest rates mean that people on average incomes across much of the country are increasingly crowded out from homeownership.
- A series of Government policy interventions have curtailed private rental market supply, exacerbating existing imbalances and supporting sustained rental price inflation.
- The Renters Reform Bill covering PRS in England and Wales has been published recently. To the extent further reforms happen in the future they are likely to focus on major metropolitan areas where affordability constraints are most acute.
About QSix in the United Kingdom
QSix has been managing portfolios and advising investment funds in the European residential market since 2006. Our seasoned investment team has invested over £300 million in the UK residential asset class in recent years. We have an outstanding track record and understanding of the market and operating environment.
Our investment teams are based in London, Berlin, and Amsterdam. We would be delighted to discuss how we might work together with you.
ENDNOTES
1. Savills Global Research, UK Housing Value Breaks £8 trillion Barrier, January 2022.
2. Office for National Statistics and Homelet Index of Rental Prices for New Tenancies: Calculation
period between January 2020 and October 2022.
3. Office for National Statistics, Long Term International Migration, November 2022.
4. Crisis for the National Housing Federation, Housing Supply Requirements Across Great Britain,
November 2018.
5. Conservative Party, Election Manifesto, 2019.
6. Centre for Economics and Business Research for the National Housing Federation, August
2022.
7. Homebuilders Federation, Achieving Nutrient Neutrality for New Housing Development, March
2022.
8. UK Government, Help to Buy Statistics: Completion period between April 2013 and December
2021, May 2022.
9. UK Finance, Household Finance Review: Q3 2022, December 2022.
10. Zoopla, UK Rental Market Report, December 2022.
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