Pilot project to build 240 homes may be blueprint for other local authorities, writes Doug Morrison
Manchester is the setting for an embryonic housing initiative that could act as a model for a particular group of institutional investors to break into the private rented sector – local authority pension funds.
Greater Manchester Pension Fund has teamed up with Manchester City Council on a project to build 240 homes for rent across five sites. In principle, this pilot joint venture is a win-win project: the council secures funding for development on its land, which, while not social housing, is much-needed, new-build stock; while the open-market rents should enable the pension fund, like any institutional investor, to maximise returns, but with an undeniable feel-good factor.
“This is not a subsidised deal for social purposes,” says Paul Beardmore, Manchester Council’s director of housing. “It’s a commercial deal, but the ethos is to invest in Greater Manchester, where the pension fund originates. The intention is to use as many locally sourced contractors and professionals living and working in the greater Manchester economy as possible. But if it doesn’t work financially, it doesn’t work, and that’s the end of it.”
A “belt and braces approach to due diligence” should ensure the project does work, Beardmore adds. The joint venture has taken two years to get to the present stage of inviting tenders for the key property manager role, responsible for setting and collecting rents. Once that is settled, everyone involved will draw up more detailed plans for the housing.
There is no going back, but Beardmore will not tempt fate and disclose a timetable. Nor will he reveal the performance targets, except that the venture will need to sell as much as 30% of the housing for the pension fund to get its required returns. It has been, and will continue to be, painstaking work.
“Private-sector rents are generally said to go up broadly in line with inflation. As our liabilities are mainly linked to CPI and wage inflation, it seems a good asset match to our liabilities” Mike Taylor, LPFA
“The pension fund has not invested in residential before so is being extremely cautious. Our soft market testing had to be revisited to give further assurance that the assumptions we’ve made in modelling hold true. It’s all part of assessing the risk. It’s a huge learning curve for all of us, because the council is not hugely experienced in the private rented sector, particularly the top end.”
The property industry, however, is taking note of Manchester’s experience and the potential for local authority pension fund investment in housing.
Beardmore spoke about the joint venture at the annual British Property Federation residential conference earlier this year. Another speaker was Hearthstone Investments’ David Gibbins, fund manager of the first Financial Services Authority-regulated residential property fund.
Hearthstone leads the way with Islington
Hearthstone launched its UK Residential Property Fund fund last summer and in November secured its first big investor, Islington Borough Council, attracted by a strategy of investing in new or recently built UK private rental housing. The fund was seeded with stock from housebuilders Barratt Developments, Bovis Homes and Quintain, which attracted Islington to invest £20m, or 2.5%, of its £800m pension fund.
A long-term 3.5% net income return is expected, matching the pension fund’s requirements, with capital growth also a possibility.
Hearthstone claims that if all 89 council pension schemes in England and Wales replicated this 2.5% residential property allocation, it would amount to an investment of about £4bn – the equivalent of more than 24,000 new homes – to help ease the housing crisis (see table).
This conclusion is based on the 89 pension schemes’ combined £157bn market value – but also on some heroic assumptions, not least that all council pension funds could free up their capital for rental housing.
Hearthstone clearly wants to repeat Islington’s investment and is understood to be talking to several council pension funds.
Hearthstone chief executive Christopher Down says Islington’s “landmark” deal shows “how investment by local government pension schemes can play a role in alleviating this crisis without requiring new sources of capital at a time of austerity.”
This argument is music to the ears of politicians like London Mayor Boris Johnson. The London Pensions Fund Authority (LPFA), the capital’s largest local government pension scheme provider, whose board is appointed by the Mayor, has spent four years looking at the potential for residential investment, says chief executive Mike Taylor.
The LPFA has £170m – nearly 4% of its £4.5bn fund – invested in property globally, but it is all commercial. Taylor says a planned shift to the UK private rented sector is partly “a political aspiration” of the Mayor’s office. “But the investment case must be paramount,” he adds. “We won’t invest in something just because of a political whim. It has to stand up against all other potential investments we could be making.”
He adds: “We’re attracted to infrastructure as an asset class and see housing development as infrastructure. The private rented sector is the area where we think the best returns are for pension funds. We’re not too interested in social housing, because we don’t think the returns are good and there’s potential for government interference.”
The authority would prefer build-to-let projects or to invest in existing blocks built purely for rent. Either way, it wants housing to generate 4-5% net yield on the rent, preferably with a demonstrable inflation link.
“Private-sector rents are generally said to go up broadly in line with wage inflation,” says Taylor. “Given that our liabilities are predominantly linked to CPI and wage inflation, it seems like a good asset match to our liabilities. We’d also want the potential to increase capital values, although as a long-term investor, our liabilities are long term.”
Having looked at the sector for four years, the LPFA has yet to seal a deal, largely because of a dearth of suitable opportunities, until now. Taylor says the LPFA is talking to asset managers and evaluating their products. It is also “a long way down the road” on joint ventures with prospective co-investors.
A new board, chaired by private equity entrepreneur Edmund Truell, was appointed to the LPFA in January. The extent of the LPFA’s housing investment is unlikely to be rubber-stamped until the board completes a review of the authority’s asset allocation strategy in the next few months. But Taylor says the LPFA is likely to invest £50m- £100m “in some form of housing scheme” by this time next year.
Truell has also added his voice to the calls for government to pave the way for a merger of all 32 London boroughs’ pension fund assets, to create a pan-London fund with assets of £40bn. This plan is backed by the Mayor and Communities Secretary Eric Pickles, and could have ramifications for other council pension schemes.
Council pension funds find Catalyst for investment
Catalyst For Homes, a ‘community interest company’ formed in 2009, is in advanced talks with five local authority pension funds to raise £152m for its first three developments.
Lloyds Banking Group is backing Catalyst, which will develop 676 homes on two London sites and one in Bristol.
Catalyst founder Clive Bird says he has agreed deals with the respective landowners subject to the fund raising.
Each site has planning permission and construction on all three is due to start this year. Bird, a former Taylor Woodrow executive, says his target is 27 sites and 6,000 homes in three years.
The government introduced community interest companies in 2005 as a corporate vehicle for socially minded entrepreneurs to use their profits for the public good.
Catalyst’s business plan involves using part of the pension fund money as a bond-type loan to registered providers to build and manage 338 social homes on the three sites. Catalyst will develop the private homes, with debt from Lloyds, then sell or rent them at open-market rates. The pension funds may make total returns of up to 10%, while Bird promises to reinvest a £37.5m ‘developer’s profit’ in the local communities.
Hearts and minds to be won over
“It could create much bigger funding for asset classes like infrastructure and housing,” says Taylor. But he admits “an awful lot of hearts and minds have to be won over” for such a merger to happen: local government minister Brandon Lewis is unlikely to decide on this proposal until later this year, after which it would still require legislation.
Meanwhile, local authority pension funds must make best use of their money, which for the LPFA means investing in rental property in the relatively buoyant London and south east. “We have to look at long-term asset classes that can produce returns correlated more with inflation than the way the market moves,” says Taylor.
Outside London and the south east, the income yield from private rented housing looks far less certain, as Beardmore concedes. “The early movers will be in markets where people feel very secure about prospective levels of return,” he says. “Outside London and the south east, that will be in places like Manchester, where there is confidence in the employment base and prosperity of the city and its wider environs.
“We are in a fairly privileged position in having that strength. But if you tried to make this work in somewhere like Stoke – no disrespect – but I don’t think the values in those areas and the scale at which you’d need to do this would hold up.”
If Manchester’s pilot project goes to plan, the intention is to add further city council land to the joint venture. Sites outside the city could lead to separate joint ventures with Greater Manchester Pension Fund.
“The intention is for this to become a Greater Manchester proposition,” says Beardmore, “so there will be other districts engaged in developing opportunities in their areas and we’ve already set the ground work for that in terms of identifying sites.”
He adds: “Once the floodgates open and we see investors going in, I think you’ll see this happening in quite a wide area. Other centres, such as Leeds and Liverpool, will start to look attractive propositions.”