Executive Summary

• The UK residential investment market is facing headwinds in the form of an ongoing adjustment of yields to higher interest rates, falling private house prices and risks of weaker growth or recession affecting household balance sheets.
• However, rental housing demand remains strong as high mortgage rates are discouraging ownership and rising incomes are feeding through into rental growth.
• Returns are set to trough in 2024 as yields adjust further, but the outlook from 2025 onwards is for headline prime returns to settle into a 7-9% range driven by higher going-in yields and sustained rental growth (Exhibit 1).

1. The Residential Yield Adjustment Process Has a Little Further to Go

UK residential investment yields are rising, but market pricing has been slow to react to a shift in long-term interest rates so far (Exhibit 2). The UK 10-year government bond yield is up by more than 250 basis points since end-2021, but indicative prime/grade A residential investment yields have only risen by about 75 basis points.
Several factors have limited yield shift so far, including

• strong current rental growth,
• low leverage among key investor groups in the sector,
• reversionary potential on existing leases and
• upward revisions to future inflation and rental growth expectations.

Our view is that some further adjustment will be required as interest rates settle at much higher levels than in the recent past.

Since 1Q22, the shift in UK residential yields has been mild compared to other major core European markets (Exhibit 3). In Amsterdam, Munich, Paris and Stockholm, residential investment yields have risen by 125 basis points, impacting values significantly.

For the UK, the difference is mostly due to

• an absence of significant rent controls, boosting UK rental growth relative to continental peers,
• pricing not being as steep as core continental markets, where yields hit 2% and below, and
• the UK didn't have the same yield-driven ramp up in values as in core continental markets.

Our internal modeling -which factors in expectations about long-term interest rates, inflation, rental growth and risk premiums -suggests that UK yields need to rise another 50 basis points in 2024.

For an indicative, fully let, stabilized for-rent residential asset in a major regional UK city, this means we see yields rising from about 4.5% today to somewhere in the range of 4.75%-5.25%. This would represent an attractive long-term buying opportunity for a stabilized multifamily asset, including affordable living projects (Exhibit 4).

Based on historic data, yields on single family portfolios -an important part of the rental housing market -tend to trade at or slightly below benchmark apartment levels, and we expect this to continue.

Rapid rental growth means that we will likely see transactions at entry yields below these levels due to the high degree of reversionary potential.

2. Affordability Pressures Are Driving Rental Demand

Affordability pressures continue to be a key driver of demand for rental housing. The dominance of longer-dated, partially fixed-rate mortgages means that the effect of higher interest rates on households is feeding through slowly.

Pressures are growing as more households come off existing mortgage deals, and the burden on households is expected to rise further in the coming years (Exhibit 5).

Difficulties in refinancing and challenging conditions for new buyers mean that many more households are set to move into the rental sector in the coming years, driving demand for affordable housing options.

3. Limited Supply Is Supporting the Rental Growth Outlook, But Ultimately it Is Income Growth That Counts

In recent years, additions to stock have been overstated by the breaking up of existing properties into multiple dwellings rather than new completions (Exhibit 6). Rising second home ownership and a legacy of poor quality housing in the private rental sector are further reducing availability.

On the other side of the ledger, household formation has likely been held back by limited availability. In today's market, developers are grappling with higher building costs and falling exit values on the back of higher yields. Supply is set to remain constrained in the next few years.

There are signs that these supply issues are starting to push rents higher. Our breakdown of portfolio rental growth for UK excluding London of just under 8% in 2023 shows that non-income factors, which include supply, made a positive contribution for the first time since 2012 (Exhibit 7).

Headline rents for new lets are growing rapidly, suggesting an even stronger supply effect than implied by institutional portfolios, especially in major cities including Birmingham, Edinburgh, London and Manchester, where annual rental growth has been above 10% since 2021.

Over time, these short-term supply and demand effects will balance out -household incomes ultimately dictate ability to pay, determine affordability and drive rent levels (Exhibit 8).

Household incomes are set to grow at about 3.2% per year over the next decade, reflecting weaker real growth than in the past, but higher inflation. Past experience suggests that typical rents in the market will broadly keep pace with this growth over time, giving an NOI growth-driven boost to expected returns across the spectrum of residential investments in the UK.