Residential real estate markets have been tight for some time in terms of their demand-supply balance and are expected to remain so. A price correction due to sharp interest rate rises in the wake of the pandemic makes for an attractive entry point for investment.
Fergus Hicks, Real Estate Strategist
Strong fundamentals in the residential sector
Strong fundamentals in the residential sector
We think the long-term fundamentals of the sector are good and should drive rental growth. The sector is also developing in more countries, with new formats emerging. The amount of housing provided is determined by the interaction of demand and supply, along with government policies. Demand reflects household numbers and other socio-economic and demographic factors. Supply is driven by the availability of land, construction costs and government planning policies.
- Quality housing is essential for human wellbeing. The provision of high-quality living accommodation is essential for human welfare. It supports the smooth functioning of the economy and labor market by facilitating the movement of people between regions experiencing growth and those in decline.
- A shortage of living accommodation. This manifests itself in high sales prices, high rental values and younger generations that cannot afford to leave their family homes. Against this backdrop living accommodation can present attractive opportunities for investors and allow them to have a positive social impact.
- Growing demand in the residential sector. Growing populations have combined with shrinking household sizes to fuel growth in household numbers and demand for dwellings, be they rented or owner-occupied. In the owner-occupied market, the combination of higher debt burdens on younger generations and higher mortgage interest rates in the wake of the pandemic have put home ownership out of the reach of many, forcing them to turn to the rental sector. Moreover, for other reasons, such as more transient populations, renting can be preferable to owning.
- Supply has not caught up with demand. Growth in households has tended to outstrip supply of dwellings, generating pressures on housing markets and resulting in rises in both prices and rents. On the supply-side of the market, many countries lack available land, particularly in metropolitan areas, and tight planning policies also curb supply.
Attractive entry point for residential following price correction
Attractive entry point for residential following price correction
Along with the wider investment property market, residential property prices showed a significant correction from mid-2022 as they digested sharp rises in interest rates from central banks as they battled inflation at multi-decade highs. By 3Q23, in local currency terms global residential capital values had fallen 9% from their peak in 2Q22. Capital values have fallen across the US, UK, and other European markets.
By contrast residential capital values in Japan continued to rise, up 2.5% YoY in 3Q23. Interest rates on hold in Japan have not created the same downward pressure on residential capital values as in other markets. Moreover, Japan has also been an attractive market for foreign investors due to significant hedging gains on JPY denominated investments.
Institutional residential property expanding to new countries and formats
Institutional residential property expanding to new countries and formats
Historically, institutional investment into residential property was focused on the US, with its large so-called multi-family market. Indeed, according to MSCI data, as of end-2022 the US accounted for the bulk (62%) of the USD 2.5 trillion institutional residential investment market. Japan was the second largest market, at 8% of the total, followed Switzerland at 7% and the Netherlands at 5%.
However, institutional residential property is expanding to other markets too. These include the UK, Ireland, Spain, and Australia, amongst others. Institutional investment in the residential sector has spurred innovation and seen new specialist types of residential property emerge which meet the evolving needs of the population at large. These include student accommodation, single family rental homes, focused on the US, co-living concepts, affordable housing, retirement communities and other types of property aimed at ageing populations.
Another way for investors to access residential property is to lend against it, via development loans, bridging loans and other types of lending. Much higher interest rates in the wake of the pandemic have made debt strategies more attractive for investors, particularly as banks have tightened lending standards and retrenched.
Global institutional investing in real estate
Global institutional investing in real estate
As for all property types, investors in the residential sector can benefit from a global allocation over purely investing in their domestic market. Investing in residential property globally brings diversification benefits which can reduce risk and enhance returns. Moreover, institutional residential property investment is not available in some countries at any significant scale. For example, Italy.
Hence these investors must go abroad to access the sector. Going global opens up a much larger investment universe and allows for investment in specialist types of residential property. In addition, going global allows for tactical investment to benefit from markets which are at different stages in their cycles.
Although private investors might consider buying residential property directly themselves, apart from those with the deepest pockets, rather than diversification benefits, they will suffer from concentration risk. Moreover, they may not have the specialist knowledge, contacts and time required to enter foreign markets. They must also consider how to manage their properties.
Knowledge of regulations for real estate investing is important
Knowledge of regulations for real estate investing is important
Essentially, all forms of residential property provide housing services to people and hence inextricably linked to their welfare. As such, governments normally take a keen interest in the sector and closely monitor it. In many cases this results in regulation, whether limits on planning approvals or restrictions and caps on rental growth.
Regulations can be detrimental or supportive to investors and it is important to understand their impact. The key factor determining this is whether the regulatory and policy environment is stable or erratic. A stable and known regulatory environment means that investors can price in the impact of any regulations at purchase. For example, a 2% p.a. cap on rental growth can create more certainty over future rental income for investors and may also lead to excess demand and lower vacancy. More certainty can be beneficial to investors and priced into the purchase price. By contrast, unexpected changes in regulations which are not underwritten at the time of purchase can significantly impact achieved returns and be detrimental to investors, such as the introduction of new rental caps.
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