Build to Rent Zones

Build to Rent Zones

In this article David Lawrenson, founder of landlord advisors, www.LettingFocus.com, looks at why a big growth in big scale build to let may only happen if specific areas or zones are set aside for this asset class.

How big will big build to let grow?

When I talk about build to rent, in this article, I’m referring to big scale developments of lots of flats in blocks that are dedicated to all be rented out, mainly for market-rate private rent. I’m not talking here about smaller developments of say less than 20 units in a block.

The big problem for big scale build to rent, (apart from their high rent to operating cost ratios, when compared to buy to let landlords – see Note), is that most developers will find it far more profitable to build to sell than to build to rent.

It works like this. A developer of a non-build to rent site will get financing to construct a project. This will eventually be paid out from sales of units in the development, allowing a developer to hopefully bank a profit, pay off the loans for construction and get cash out for the next development project.

With build to rent it is a bit different because there will be a stream of rental income instead. After the build has been completed, fresh finance will have to be sought, based on that rental income, which will certainly mean quite a lot of equity remains stuck in the development. And these days there will more equity stuck than in the past, because the banks who are loaning the money are these days, quite stringently stress-tested by the Bank of England. So, inevitably lower loan to values (LTVs) have to be accepted.

Build to Rent Compared to Build to Sell

Contrast this with a developer whose aim is to develop and sell. They will be straight on to the next project having banked a typical 25% to 35% profit margin after taking account of all their costs. That looks very good compared with the build to rent alternative, where they not only have to leave a load of equity in the development, but also accept net rental yields of at best 8%. The maths implicit in these figures will always constrain a big growth in big scale build to rent.

Of course, build to rent is very much happening today in the UK – in the right niche, and / or, for the right owner. Today, the two areas where it works are in purpose built student blocks and / or where the end investor is an institution.

For student accommodation, it works in the right places, because of scale economies – think big developments! – but also because no single individual is able to (or will want to) buy a single unit for a student to live in or own, within these blocks.

Building at scale also works where the backer / owner is an institution, such as a pension company. Again, common features including the fixtures and fittings, shared amenities and dedicated management means that operating costs can be driven down (though not as low as with Mom and Pop buy to let). The pension funds (and also some overseas sovereign wealth funds) like the flows of rental income because it can closely match their liabilities for pension pay outs etc.

Note too that most will badge the development with a separate brand, possibly because they are aware of all the bad press landlords get. You won’t see a development with Legal & General’s name plastered all over it!

Build to Rent Zones and Economics

But outside of these two areas of business, (student accommodation and pensions / wealth funds), it simply does not pay the developer to go down the build to rent route as the economics are so much worse than buy to sell.

In the longer term, though, there are some ways that build to rent could really expand. Firstly, there are subsidies from the state. Naturally, the likes of the British Property Federation, key tub thumpers for build to rent, are pretty keen on this. Central government has already set aside and could continue to set aside more hard cash or soft loans to encourage developers to build to rent instead of building to sell.

The other way is to set aside zones in towns and cities where the only type of development allowed is build to rent.

This is common in places like the USA where areas are zoned in this way. Here, on such developments, no one can sell a unit, it’s just not allowed within the permitted development options.

So, when an owner of such a build to rent block wants to sell, they would have to sell all the units as one freehold, with all the tenants in place. The value of the property is thus linked to the ongoing rental income. The lower the void levels and the higher the market rents, the higher the value of the block. Lenders and other providers will only lend or give equity finance based on the cash flow. And with no owner occupied premium, no developer ever pays more than the current cash flow would demand.

Build to Rent Zones in the UK?

Naturally, the big build to rent cheerleaders would the UK to copy America and mandate zones where the only development allowed is build to rent.

Tailpiece

The new affordable housing targets in the draft London Plan requires even small developments of less than ten homes to meet an affordable housing target. Previously they were exempt.  The low or even negative returns on affordable housing are likely to mean small developers will not be able to make these developments work. So, yet more power to the big housebuilders!

Note: I first highlighted the very high operating cost in build to let, compared to buy to let in my blog “Build to Rent – Hype or Fact” back in October 2014 at my blog. http://www.lettingfocus.com/blogs/2014/10/build-to-let-hype-or-fact/

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