Like all pioneers, the leaders of the UK's BTR sector have had to make several leaps of faith.

They've bet that the chronic undersupply of good quality, well-managed rented homes means the market will absorb large quantities of rental supply.

They've bet that demand for secure, long-dated income means there will be a market for stabilised rental portfolios when they’re ready to sell.

And they've bet that the income return these schemes will deliver and the prospects for rental growth will adequately compensate them for the risk of developing stock from scratch.

As the market reaches critical mass, we're going to see whether those bets pay off. The results will be key in unlocking the oft-quoted ‘wall of money’ targeting the BTR sector.

Setting the record straight

To date, evidence of professional, large scale investment in built residential assets is largely limited to a handful of mature portfolios. They're mostly owned by large landed estates and they trade infrequently.

Over the last 15 years the total return from this narrow band of residential assets has averaged 8.25 per cent per annum. This stands up well in the context of UK commercial property investments and the much larger body of residential investment evidence in Germany and the US.

But returns in UK residential property are driven by capital growth more than in other asset classes and international markets. That’s largely been a function of rising capital values in the for-sale market.

Income in focus

We predict this balance is due to shift. Investors now place greater focus on income with this making up a greater proportion of the total return.

As the sector matures and investors increasingly view it as long-dated income, there will be greater scrutiny on the premium deliverable over the risk-free rate (see Value fundamentals).

Prior to 2010, net residential income returns were lower than gilts, as capital value made up such a large proportion of total return.

But as gilt rates have fallen and capital growth eased, it has been possible for income-producing residential property to deliver a premium over gilts. In 2017, an average net income yield of 2.75 per cent on mature portfolios delivered a premium of 156bps over gilts.

Our analysis shows this figure underplays the yields available in the market for BTR stock. Between 2015 and 2017, portfolio investment deals averaged a net initial yield of 4.3 per cent, in line with multifamily deals in the US. Over this period, 18,500 units with an aggregate value of £4.1 billion changed hands. Two thirds were forward funding deals where investors fund the construction of purpose-built rental homes.

The challenge for residential property will be whether it can maintain – or even shrink – that premium as the risk-free rate rises.

Our analysis suggests that it can.