Multifamily remains attractive in the current climate

Investment appetite for Multifamily was resilient in 2022, resulting in £4.3bn of investment, a fourth consecutive record-breaking year.

Despite current macroeconomic challenges, Multifamily is highly attractive given its inflation-matching characteristics and structural tailwinds, including increased demand, a continuing supply shortfall and challenges to home ownership.

Yields have also proven resilient relative to other real estate asset classes, supported by rental growth and strong operational performance. Forward fundings will remain the primary route to market and low-geared investors can take advantage of the current challenges in the debt market.

With the private for-sale market now weakening, Multifamily can look to increase its share of construction starts and further support housing delivery nationwide.

Sustained demand for Multifamily investment in 2022

Multifamily continues to be one of the most in-demand real estate sectors. In Savills Q3 2022 Investor Sentiment Survey, two thirds of European investors said they were likely to invest in Multifamily in the next 12 months. This follows a prolonged period of growing investor demand, with yields compressing to new lows during H1 2022.

Our analysis shows that the number of funds targeting UK residential strategies has grown considerably over the past five years, and the amount of capital raised by those funds exceeded the amount originally targeted. This shows the growing weight of capital looking to invest in the sector and the dry powder that has been raised but is yet to deploy.

We have now seen four consecutive record-breaking years for UK Multifamily investment. Of the £4.3bn invested in 2022, nearly £1bn came in the final quarter. This amount is based on actual capital allocated rather than Gross Development Values and excludes commitment/partnership announcements.

Multifamily has proven itself as an inflation hedge

One of the main attractions of Multifamily in the current economic climate is its inflation-matching characteristic. The rate of annual CPI reached 10.7% in November, compared to a 12% growth in rents over the same period. The natural churn of tenants means investors can regularly rebase rents in line with the market.

Those who were already invested in Multifamily during this period have enjoyed rising rents, high occupancy and record lease-up rates, which has more than compensated for higher costs across their businesses.

The UK rental market is characterised by consistent rental growth, underpinned by a shortage of rental homes relative to demand. This mismatch has applied upwards pressure on rents that is far in excess of initial underwriting assumptions.

During the second half of 2022 in particular, the Net Operating Income (NOI) of schemes has been boosted by the continued growth in rents, supporting the investment values for deals that are currently under negotiation.

Rental growth is protecting capital values

The uncertain environment during the second half of 2022 resulted in a slight softening of yields. However, the strong rental growth meant that this has not resulted in capital value falls, and shows that there is likely reversionary potential within operational portfolios.

The current economic and political uncertainty has resulted in a more cautious approach from investors across all real estate sectors. In Multifamily, a lack of assets being marketed during Q3 and Q4 2022 has made it challenging for investors to assess where pricing sits. As we move into 2023, they are looking to see increased liquidity in the market, which will help them firm up fair market pricing.

Investors will be keeping an eye on rental growth and what is happening to the long-term risk-free rate over the coming months. Our expectation is that rental growth will continue – we are forecasting 6.5% rental growth in 2023 – which alongside legacy deals closing and new opportunities coming to the market will result in rising investor confidence during Q1 2023.

Forward funding will remain the primary route to market

Forward funding will continue to be popular over the coming years, despite a much-changed macroeconomic outlook.

Forward funding has been an integral part of Multifamily expansion in the UK, with 75% of investment in the past five years coming via this route. Circa £1bn was deployed to forward fund developments in Q4 2022 alone.

Homes delivered through forward fundings add to UK rental stock and are vital for the continued growth of the sector, as well as helping address the widespread shortage of housing.

One of the main attractions of forward funding for investors has been the opportunity to drive value during construction. This is even more important now the spread between Multifamily yields and the risk-free rate has narrowed. The yield on a UK five-year GILT has risen to 3.3%, having been at 0.9% just 12 months ago.

This places greater emphasis on value growth. A typical Multifamily block will take between two and four years to build and stabilise. Rental growth in the wider market during this period means that the NOI can be higher than projected, driving up the yield on cost (YOC) and widening the premium over the risk-free rate. Given this, forward funds continue to be an attractive route to market.

Ungeared investors can capitalise on challenges in the debt market

The elevated cost of debt remains a challenge for investors. Relative to a year ago, the all-in cost of debt (risk-free rate + lender margin) has risen sharply – on a typical five-year horizon, it has nearly doubled. This means highly leveraged investors are unlikely to be able to generate the same cash-on-cash returns as a year ago, with some parties temporarily pausing acquisition activity as a result. This presents opportunities for less-geared investors to take advantage of reduced competition and secure the highest quality assets. To date, 80% of Multifamily investment has come from just 36 investors, many of whom are ungeared or low-geared. We estimate that nearly two thirds of this group will be able to deploy equity with low gearing in the next year.

The latest ONS data suggests that inflation peaked in November and will start to slow over the course of 2023. On 2 February, the Bank of England voted to raise the base rate by 50 bps to 4.0%. The Monetary Policy Committee’s key message was that rates are now close to – or even at – their peak. Oxford Economics expects a further 25 bps rise in March, followed by a pause in rate hikes.

This will reduce the upwards pressure on the cost of debt. The SONIA forward curve suggests it will peak at just under 4.5% in August. From this point, as the cost of debt comes down, we can expect to see transactional activity levels pick up again.

Widespread supply shortages highlight the need for Multifamily investment

The supply-demand imbalance in the rental sector shows no signs of abating, making the need for Multifamily expansion stronger than ever.

Stock in the rental market remains in very short supply – in Q4 2022, the number of properties available to rent across the UK was more than a third below the pre-pandemic average.

Buy to Let landlords continue to withdraw from the sector – we have seen over 330,000 mortgage Buy to Let redemptions since April 2016. This trend is accelerating. In the year to November 2022, there were c.73,500 mortgaged Buy to Let redemptions, up from c.28,000 in the year to November 2020.

Landlords coming to the end of their fixed-rate mortgages are now refinancing at rates much higher than they would have expected when taking out their initial mortgage. If landlords are unable to pass the added costs on to their tenants through higher rental payments, this could result in loss-making investments, particularly for the most leveraged portfolios.

Compounding the issue further, changes to Capital Gains Tax allowance in the Autumn Statement (reducing from £12,300 to £6,000 in April 2023 and to £3,000 in April 2024) means we are likely to see greater urgency to sell from those landlords who are already looking to leave the sector.

Structural tailwinds will continue to keep demand for rental properties high

Whilst rental market supply is heavily constrained, demand for rental properties remains elevated.

In the latest RICS sentiment survey, a net balance of +46% respondents reported rising tenant demand during Q4, far above the 2017-19 average (+10%). This is likely to continue, as higher mortgage rates are causing an acute affordability squeeze in the sales market. Would-be first-time buyers are being kept in the private rental sector for longer, driving greater demand over the medium term.

Particularly important for longer-term demand is that international migration has returned. The year to June saw net migration to the UK hit a record figure of more than 500,000 people.

This was partly a result of the conflicts in Ukraine and Afghanistan, but it remains the highest figure on record and indicates that any concerns of net outward migration following Brexit did not materialise.

The number of full-time students in the UK also reached a record in the academic year 2020/21, at more than 2 million students, while the number of full-time international students surpassed 500,000 for the first time as well. These two figures represent increases of 19% and 36% in the last five years, respectively. As relatively high-earning young people, graduates provide a key source of demand for Multifamily, so the growth in this demographic will further support demand for Multifamily.

Equity-rich investors can benefit from weaker buyer demand

The rising cost of mortgage debt has decreased the demand for homes for private sale, with mortgage approvals falling by -47% between September and December 2022 according to the Bank of England. With weaker buyer demand, residential development activity is likely to be subdued in 2023. However, the current downturn is projected to be short-lived in comparison to previous economic downturns.

Equity-rich investors are well-placed to mop-up any slack in construction capacity during the coming year. Developers' balance sheets are strong but private for-sale development will offer less opportunity to maintain and/or increase output due to falling sales rates. Developers will therefore need to seek other routes to maintain delivery rates, which is likely to include Multifamily and Single Family Rental.

Investor-developer partnerships likely to rise

For developers, the wider economic context has made partnering with an investor more attractive. Firstly, using forward funding arrangements to access development funding avoids the use of expensive debt to finance projects. Forward funding can make projects viable where debt is no longer accretive. And secondly, the weakening sales market should increase the value of certainty. Multifamily investors can offer developers a guaranteed exit on completion, at a price which is agreed before construction begins.

The appetite of developers to take on Multifamily projects is likely to increase, given the security of partnering with an investor and the lack of alternative development opportunities. Multifamily investors should therefore gain access to a wider choice of development partners. Investor-developer partnerships will allow both parties to secure their development pipeline over the next year.

Multifamily increasing its share of construction starts

We can expect Multifamily schemes to make up a greater share of housing starts in 2023, given that developers are now looking at alternative exit strategies to maintain sales rates and de-risk their pipelines.

Nearly 20,000 Multifamily apartments started in the year to Q1 2022 across England. Since 2014-15, Multifamily has grown its share of permanent dwelling starts from 4.4% to 11.2%. With rental demand forecast to remain more robust than sales demand, we are likely to see this share increase.

Multifamily provides an additional source of demand for completed homes and can accelerate delivery

A recognised benefit of Multifamily is that it can accelerate housing delivery, especially on large, multi-phased sites. It allows developers to continue to sell homes to individual buyers whilst also delivering homes in bulk to large-scale investors.

On large sites, Multifamily can facilitate an increase in delivery rates, over and above the normal annual target for open market sales. This is because the delivery of Multifamily is complementary to open market sale by diversifying the occupier base, allowing both tenures to be delivered on the same site at the same time.

The pace of absorption of rental homes is also much faster than sales, particularly when rental supply is constrained, as has been the case throughout 2022. At Portland’s Place, Stratford, Get Living let 368 apartments in just three months. The acceleration benefits of partnering with an investor can help developers maintain profit margins as sales demand weakens.

For developments completing imminently, a bulk deal to an investor may be more beneficial than pursuing individual unit sales. This provides developers with a quick exit and allows them to move their supply chain (sales, marketing, construction) to a new site.

UK Build to Rent Investment

Almost £4.3bn was invested in 2022, with c. £1bn in the final quarter.

A landmark transaction in Q4 2022 was PIC’s forward funding agreement for One Eastside in Birmingham. The £200m investment will fund construction of 667 Multifamily apartments in what will be the tallest BTR tower outside London. This demonstrates the continued confidence in city centre investment and shows the ambition of investors to scale their UK Multifamily platforms quickly.

At the same time, momentum for Single Family Rental investment is growing at pace. Two forward funding agreements were agreed in Q4 2022 with UK housebuilders. As the sales market slows, we are likely to see more housebuilders and developers seeking alternative exit strategies and there will be opportunities for investors remaining active in the market.

UK Build to Rent Development

The UK’s Build to Rent (BTR) stock now stands at 78,700 completed homes, with a further 50,500 homes under construction. The future pipeline currently stands at 113,400 homes, including those in the pre-application stage. This brings the total size of the sector to 242,500 homes completed or in the potential pipeline.

The latest quarter’s data shows that BTR delivery has begun to slow down, suggesting Multifamily is not immune to the headwinds facing the wider construction sector.

Annualised starts have fallen around a quarter during the year to Q4, albeit this follows a very strong 2021 and mirrors the trend seen in the wider residential development market. There has been a greater decline in completions, meaning the construction pipeline is in a healthy position in both London (14,700 homes) and the regions (35,750 homes).

For more information, get in contact with our Operational Capital Markets (OCM) team here.

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