Build to Let And Why New Institutional Investments in Private Rent Is Risky

In this article, David Lawrenson of LettingFocus.com looks at where the big new entrants could get it wrong with their investments in the private rented sector.

The big new players (big pension funds like M&G, Prudential, Legal & General and various foreign real estate investors) who are now already in or about to come into the private rented sector could make a lot of money in the private rented sector. But they could also get things badly wrong if they are not careful.

Demography

In order to reap the available economies of scale, most new “build to let” entrants have to either build units in big developments and / or build them high to make the figures add up.

This tends to mean fairly dense developments and smaller units – one or two bedroom flats usually. (The numbers also work better in London or in south east of England towns where transport connections are good).

The problem is that one and two bed units in dense developments tend to appeal most to single people and young couples. Fortunately, right now, this type of tenant is a key constituent of the private rented sector.

But these types of units will appeal less to those same people when they are starting a family.

So, thinking ahead, in future years, there could well be significantly less demand for the types of units on offer. If this happens, who will the one and two bed flats be let to then?

If today’s “generation rent” tenants in the future are scarce, the impact for the institutional investors, especially the pension funds (who will occasionally need to liquidate some assets to meet liabilities) could be very serious.

Of course, demographic changes are hard to predict.

Faced with a changing demographic a “Mom and Pop” buy to let landlord would simply sell up and buy something else that lets better and has better capital growth prospects. The pension funds, potentially stuck with a lot of non performing units, would be in a tighter spot.

Shorter Tenancies and Buy to Let Landlords

One of the great misunderstandings about buy to let landlords is around the issue of why they prefer initial short tenancies of just 6 or 12 months.

The media and some housing charities like Shelter think it is because:

1) their mortgage lenders will not allow them to issue longer tenancies …

and/ or

2) their letting agents tend to force them to keep agreements short so they can earn more fees on renewal from them …

and /or

3) because private landlords are just either plain mean or stupid or possibly both.

Actually, though these three reasons (especially the first two) do partly explain it; two other reasons are actually far more important. These are:

1) A technical reason to do with the slowness of recoveries under Section 8.  Simply put, if a landlord issues a shorter term tenancy it is far easier to recover a property from a tenant using the “no fault” Section 21 at the end of the fixed term. Issue a longer tenancy and the same landlord can be stuck with a tenant who is a pain for as long as the fixed term. And unless the tenant turns the property into a brothel or a cannabis farm or worse, the landlords only chance to recover the property is if there has been 2 months arrears of rent – and even then, the process is much slower than under Section 21.

And there is a more simple reason…

2) Lots of tenants don’t want longer term tenancies anyway. (Indeed, at LettingFocus, we think that where demand for longer tenancies does exist it is limited to certain types of families).

Lack of Demand for Longer Term Tenancies

One of the supposed benefits of big institutional investment in private rent is that by offering longer term tenancies they will tap into a great well of demand.

But though this makes good PR and longer term tenancies is a benefit that’s still worth flagging (and flogging), our consultancy is not convinced it is really a key benefit to many of the tenants who tend to fill the one and two bedroom flats, which is so often the staple of the institutional investor.

We think that single people with few roots (other than a local job) and young couples who may soon want to start a family and buy their own place (perhaps taking advantage of occasional bouts of government largesse such as the “Help to Buy” scheme) will probably not want to sign up to long tenancies anyway.

And more transient tenants obviously move more frequently. And this matters because frequent changes of tenants will lead to higher new-tenant recruitment / referencing costs, added inventory management costs and more general admin costs for the operators. It also tends to increase maintenance costs as new tenants will want everything working just right when they move in.

Higher costs of this nature, as any buy to let landlord knows, go straight to the bottom line and can quickly shift investments into the red.

Promotion

If new players don’t get the promotional offer right – especially in the online space – they will have to work very hard indeed and incur more costs.

So, if their advertising / promotion and PR push fails to reach the tenant market then they may have to fall back on finding tenants the more traditional way, via letting agents.

Using letting agents hugely increases costs, and the letting agents, once they have forged a connection with the tenants, will be very active in trying to entice those tenants away in the future – leading to yet more void periods and associated costs for the operators in build to let.

People

People who run the private rent ventures (and their advisors) need real experience of letting to tenants at market rent. The demands of private market rent tenants are often fundamentally different from the demands of affordable and social rent tenants – but many operators do not see this difference as significant or important.

Making private rents work is about more than just finding the right site and getting the funding in place. It requires an understanding of the real metrics in private renting – and getting this right, time and again.

The Private Rented Sector Initiative has come a long way already but new players in the private rented sector need to tread very carefully.

LettingFocus advises on how to make private rental investments work.