New homes are where the debut Hearthstone fund is

New residential specialist believes defensive qualities of housing sector and demand from small retail investors will help its FSA-authorised OEIC fund grow in value to £1bn, reports Jane Roberts

Investors looking for a way into the private rented residential sector now have a new option: an authorised fund launched over the summer by Hearthstone Investments.

The TM Hearthstone UK Residential Property Fund is the first Financial Services Authority-approved, authorised residential property fund – and Hearthstone’s debut vehicle. Structured as an ungeared, open- ended investment company (OEIC), it allows small investors to invest from only £1,000 and get daily liquidity. Before, their only options would have been tracking indices or to invest directly through geared (probably) buy-to-let investments.

But is it a good time to be going into the residential market? With little or no prospect of capital growth for the foreseeable future and housing’s infamously low income yields, investors might reasonably expect to get better returns from commercial property, or other asset classes.

The latest house price indices show that the UK market remains flat: average house prices have fallen again, according to the Halifax, which says they are 1.2% lower than in September 2011. According to the LSL/Acadametrics UK House Price Index, which is the Hearth-stone fund’s benchmark, house prices drifted down 0.1% in September on the back of “the distraction of the Olympics in August”, although they were up 2.2% on an annual basis.

Christopher Down, Hearthstone’s founder and chief executive, doesn’t disagree that the story is mainly about income, for the time being. He says the fund is expected  to produce a gross income return of about 5.5%. So, assuming no capital growth, after deduction of property management and maintenance costs and fund management fees, he says that would net retail investors a 2.75% return, and 3.5% for institutional investors, whose fees are lower. “We should outperform our benchmark,” Down says.

Offering investors a defensive play

He believes that some retail investors may view the fund as a purely defensive play for the time being. “An investor might want to use the fund to hedge the cost of paying for student accommodation in the future, for example. Others might say that it will make their portfolio more stable.”

Although initially, most of the return will be income, Down believes the ratio will be closer to 50:50 income and capital growth in the longer term.

“We wouldn’t be doing this if we felt there was a long-term problem [with UK housing values],” he says. “It is true that the credit situation reduces transaction activity and pushes prices down, but the shortage of stock is holding things in balance.”

Down and his team, which includes distribution director Mark Forman, will find out very soon if investors agree. They are the distributor as well as investment manager.

In August, they opened the fund with a ounder offer allowing retail investors to buy institutional share classes at a reduced minimum of £20,000 – at the lower 0.75% annual management charge. All investors, from £1,000 up, can also take up a launch offer that waives the initial charge, up to a 4.75% saving “We have been running at £250,000 a week, implying £2m approximately in the first couple of months and we expect that to pick up,” Down says. “Launches take six months to build, or even 12 months, and some investors will wait for the first 12 months’ performance before deciding whether to invest. We are very pleased by the initial results.”

As one of only a handful of new, tax- efficient Property Authorised Investment Funds (PAIFs), the Hearthstone fund is tax efficient and can be included in Individual Savings Accounts (ISAs) and Self-Invested Personal Pensions (SIPPs).

Wide doorway for financial advisers

The fund is on “about 12” of the ‘wrap’ platforms, such as Transact, Nucleus and Novia, which independent financial advisers use to advise clients on products. “So we are almost there in terms of widening the doorway that people can walk through and most IFAs can invest via some entrance point,” Down says.

Hearthstone’s target for the fund is £250m in the first two years and potentially £1bn by year five, as support for the new residential funds industry grows.

Unlike most of the current strategies for investing in private rented housing, this model is very different to the usual focus on prime central London postcodes. As befits an index-tracking fund, Hearthstone is building a diversified portfolio to reflect  the existing geographical distribution of housing stock, including flats and houses.

Fund manager David Gibbins has worked in this sector for 20 years, including managing residential funds for Goodman and Morley, while assistant fund manager Lucy Hawkins had a stint at listed residential landlord Grainger.

Down, an accountant by training who worked for six years at Alderson Consulting before setting up Hearthstone in 2009, is also an advocate for the positive contribu-tion he thinks funds such as Hearthstone’s can make to the wider housing industry, at a time when investment in new housing is at a low ebb.

He points out that unlike individual buyers, who are constrained by mortgage criteria, demand from investment funds is less volatile throughout economic cycles. In addition, funds will often invest early on  in the development process, potentially forward financing thousands of homes and reducing development risk.

The seed deals for Hearthstone’s fund are sale and leasebacks of housebuilders’ existing show homes (see above).

Hearthstone has additional contacts and access to potential stock, plus operational resources, via Skipton Building Society-owned Connells, the UK estate agent with 481 branches, which took a 25% stake in Down’s business for £2m in February.

Jeff Pulsford, former chief executive  of Arlington Securities and Goodman’s European business, is also a shareholder, and chairman.

Hearthstone is talking to one local authority pension fund that has shortlisted the fund for possible investment. In terms of considering a residential investment strategy, Down says some local authorities have a secondary objective of wishing to help stimulate housing supply.

Institutional investors will have a three- month redemption period. Down argues that residential investment has less of a potential mismatch between a fund’s liquidity, and lack of liquidity in the underlying assets, than commercial bricks and mortar does.

Residential suits open-ended funds

“In the commercial sector there is only one set of people to sell to, people who buy big commercial buildings,” he says. “It’s the reverse picture in residential and therefore it is more suited to open-ended funds. Faced with redemptions in a fund, you can select a few assets to sell and can sell gradually, rather than in big jumps.”

The fund will hold 10% in cash and 5% in liquid instruments, such as housebuilder shares “and maybe derivatives”. The FSA has authorised the fund as an ‘umbrella’, “so rather than the two years it has taken to put the first together we could hang new funds off it and launch a second in two months”, says Down, commenting on what lies ahead for Hearthstone.

Other ideas the company is already considering include entering higher-yielding specialist residential sectors, such as student or sheltered housing, or a build-to-let strategy, recycling development profits into a fund. In the shorter term, Forman expects to be targeting overseas money for the maiden fund next year. However, Hearthstone will always stick to the residential sector. “We aim to be the primary source for residential fund products for the UK,” Down sums up.