Real Estate

How does UK Housing perform under the lens of a Cashflow Driven Investment (CDI)?

We look at how the BMO UK Housing Fund can fit into the alternative assets portfolio of a CDI strategy.
November 2020

James Edwards

Director, Sales, UK Institutional

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Fiona Pearl

Associate, Sales, UK Institutional

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Risk Disclaimer 

The value of investments and any income from them can go down as well as up and investors may not get back the
original amount invested.

The value of directly held property reflects the opinion of valuers and is reviewed periodically. These assets can also be illiquid and significant or persistent redemptions may require the manager to sell properties at a lower market value adversely affecting the value of your investment.

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

As UK defined benefit (DB) pension schemes mature, trustees are increasingly looking towards strategies that can provide a secure long-term yield and regular cashflows, with limited downside risk. So-called Cashflow Driven Investment (CDI) strategies have become an increasingly popular approach. These strategies will usually combine credit and gilts/swaps to provide a high degree of cashflow and liability matching. Alternative sources of cashflow may also be included to increase the yield of the strategy. In this thought piece, we look at how the BMO UK Housing Fund can fit into the alternative assets portfolio of a CDI strategy, focusing on five CDI criteria in particular – contractual yield and risk, inflation linkage, investment thesis, diversification and liquidity.

Risk Disclaimer

The value of investments and any income from them can go down as well as up and investors may not get back the
original amount invested.

The value of directly held property reflects the opinion of valuers and is reviewed periodically. These assets can also be illiquid and significant or persistent redemptions may require the manager to sell properties at a lower market value adversely affecting the value of your investment.

What are the criteria for a Cashflow Driven Investment?
Contractual yield with well understood credit risk Is a significant proportion the expected yield contractual? Is the credit risk clearly understood?
Inflation linkage Does the return profile of the fund correlate to inflation?
Clear and persistent investment thesis There should be clear and intuitive rationale for the asset delivering a higher risk adjusted return than a more traditional asset.
Diversification Does the asset class give access to risk premia not readily available elsewhere: How does it compare to market cycles compared to other asset classes?
Liquidity profile Illiquidity is an acceptable characteristic providing the scheme is compensated for it and has a long enough time horizon.

Contractural yield with well understood credit risk

The fund is investing in property rather than debt instruments, so there isn’t a contractual obligation to pay coupons, rather this comes through the contractual obligation of the underlying leases. However, the fund parameters in conjunction with the imbalance of supply and demand in the UK housing market creates an income stream which typically has low volatility and low susceptibility to interruption. Even during the current pandemic residential collection levels were at 95%1. The properties within the BMO Housing Fund typically range from low density suburban houses to high density apartment blocks, both of which are generally rented by key workers, typically on low to middle income earnings. These households represent the “squeezed middle” and have consistently been faced with clear market failure within the UK housing market. The depth of demand this failure creates supports our high estimated occupancy rate.

We have performed various stress tests and cashflow modelling based on the real opportunity pipeline with deployment underway, but even looking back historically the consistency of income from residential property is clear.

Whilst a residential property investment does not necessarily rely on individual leases on single properties or bonds, the supply/demand imbalance, geographic diversification and diversification of many thousands of individual lessees should ensure an income stream that is stable over the long run.

The income yield, return and occupancy profile of the portfolio are shown below. The target yield and return compare favourably to an investment grade corporate bond portfolio, and the high occupancy rate and dynamics described above help to mitigate the downside risk of the strategy.

Target income yield (net) 4.5% per annum
Target total return 6 – 6.5% per annum
Estimated occupancy rate 96.0% per scheme

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Use our handy glossary to look up any technical terms you are unfamiliar with.

Cashflow profile2

Cashflow from the fund will be paid out quarterly after the first two years, with more detail available in the chart below.

Projected Cashflows for the BMO UK Housing Fund

chart

Source: BMO Global Asset Management, as at 28 September

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Inflation linkage

Residential rents have a strong record of tracking CPI, and all the Fund’s sites will provide leases that are linked to it. The leases range from 1 to 7 years dependent on occupier preferences in another effort to boost demand, whilst also allowing the fund to reduce void and re-letting costs.

The key benefit of this linkage with CPI, is that in doing so it enables occupiers to project their future outgoings, which we then expect to further bolster demand and reduce occupier turnover as an additional benefit.

Clear and persistent investment thesis

Even before the pandemic, there was an overreaching demand for more residential housing in the UK. According to a calculation by Savills, the net annual housing requirement of the UK is currently over 300,000 per annum3. The aim of this fund is to address a distinct gap in the UK housing market by offering high quality, sustainable, community based rental property, targeted at low to middle income households whose needs are not currently being met and where a large scale opportunity exists, whilst targeting the aforementioned returns.

The events of 2020 further underpin the fundamental investment case for build to rent investment:

 

  • Unemployment is forecast to rise from 4% to 7% by the end of the year, creating a weaker labour market, in turn reducing wage growth and subsequently reducing the ability for low to middle income earners to buy.
  • Household savings are declining, as people are forced to use them during the current crisis, resulting in a higher chance of having to rent for longer.
  • Consumer confidence is currently low4, with first time buyer demand slowing5.
  • 90% LTV mortgage products significantly reduced, with overall finance products less than half of what was on offer pre-pandemic.

 

The Fund’s investments will be in purpose built, quality housing stock that improves the options to rent for working households and complements existing market participants (operators launching premium rental accommodation and social housing provided by Registered Providers and Local Authorities).

ESG – underpinning sustainability of income

A sophisticated ESG approach provides superior risk management when considered in the context of a cashflow driven investment, particularly when building and operating long term rental residential property. Regulatory, Climate, Environmental and Reputational risk can all be positively managed and used to support the generation of low volatility income.

Investors in the Fund are contributing to the development of modern buildings that are fully aligned to future regulatory targets such as Net Zero Carbon. This too also adds to a demand increase, with a large proportion of the occupier market desiring to live in energy-efficient, sustainable homes.

It hopefully goes without saying that an investment in affordable housing has a strong social focus too. Through the provision of high-quality rental accommodation to those most in need and not served through either social housing or existing premium rental accommodation, build to rent can have an impact on the UK’s housing crisis.

Diversification

Residential housing can be considered a diversifier to traditional property and other real asset investments through several different means:

 

  • Geographic diversity through where the developments are built.
  • Economic diversification driven in part through its location near large, different employers around the country (such as hospitals or universities).
  • Income diversification through the large number of underlying leases for each development.

 

In addition to the diversification points above, it is widely recognised that the direction of travel for UK DB schemes is towards a “low dependency” portfolio, that typically have a heavy reliance on credit since the characteristics align well with pension scheme liabilities. The market for inflation-linked corporate bonds is small and relatively concentrated, so many pension schemes have sought to enhance income and diversify risk through allocations to real assets such as long lease property or infrastructure. Build to rent offers something that sits between these two types of assets: the develop to hold model requires long-term investment and the underlying rents linked to CPI offer inflation-linkage. Ownership of the underlying buildings means the pension scheme’s money is secured in a real asset which can help diversify the default risk present in corporate bonds.

Liquidity

The Fund has a 9 to 12-year time horizon, including two years of construction ahead of income stabilisation. For pension schemes with a long-term investment horizon, we believe the Fund can provide an effective enhancement to low volatility inflation linked income streams within a CDI portfolio.

Summary

Both historically and presently, inflation linked income streams from the UK residential rental market have remained resilient during periods of volatility. There is a significant supply and demand imbalance in the UK, which we are boosting further by capping rental rates for our sites in line with CPI. In addition to this, the targeting of the UK rental market residents of low to middle income earners, provides us with a deep occupier base. It is after considering all of these points, that we believe the BMO UK Housing Fund can create a long-term low volatility income stream for schemes and be an effective enhancement to a scheme’s CDI portfolio. 

1Knight Frank, Remit Consulting, June 2020

2Indicative only, BMO REP, Home Group, July 2020

3Savills, calculating housing need, September 2020

4CBRE Indicators of Recovery of the Residential Market, September 2020

5Zoopla House Price Index, September 2020

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