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Why we’re approaching big cities with caution

August 24, 2018Article by Paul Avery

The evolution of the UK property market over the last few years demands a re-think of where and how we should be investing in the buy-to-let sector. We believe that the best opportunities are now arising in undersupplied regional cities with staunch economies and ambitious regeneration plans. But we are often asked why that means holding off on the big cities that first spring to many investors’ minds: Manchester, Liverpool, Birmingham, and so on.

In fact, we’d never dismiss those places out of hand: they have made a lot of investors a lot of money in the past, and are bound to harbour a few great opportunities still. But there is a case to be made for approaching them with caution.

A matter of timing

With Brexit around the corner and price stagnation rippling out from London, capital growth can no longer be counted on as a matter of course across the UK. But more specifically, many of the big cities appear to be far advanced on their growth cycles, with rampant appreciation over the last five years beginning to peter out just as (or because) a gut of new supply is arriving on the market.

Manchester, for example, is projected to experience the highest city centre price growth across the North of England over the next five years, but at 4.2%, its projected annual growth rate is subdued by the standard of its recent performance (JLL).

Probably not coincidentally, Manchester also has more residential units currently under construction than were built in the last eleven years combined (11,135 compared with 10,870 delivered since the start of 2007), according to Deloitte’s 2018 Crane Survey.

(Housing supply on this scale is almost totally absent in less popular regional markets, many of which require large quantities of new stock and are not receiving it. The unaffordability of major cities is also likely to benefit demand in their commuter towns like Rochdale and Heywood, which are targeted for regeneration and serve investors well with low entry points.)

Of course, calling time on price appreciation is just as futile as predicting it will accelerate. But we can all agree it is not guaranteed, and any sensible investor will think of capital growth as a happy bonus rather than a prerequisite. So rental yield remains the crux of the matter, and the problem is that the strong recent growth cycle has compressed the excellent yields that have traditionally been these cities’ strong suit.

Yield compression

The most common yield quoted for off-plan investments in these places is 7% net – sometimes predicted and often assured. But that figure has remained more or less fixed throughout the current growth curve, and that is simply unrealistic.

In Manchester in 2017, house prices rose by 10%, and rents rose by 3% (JLL). Both are excellent rates of increase and very good news for investors who bought early in the present cycle. But for anyone looking to buy now, the holy grail of 7% net must be getting further and further out of reach.

If, simplistically, a £100,000 property generated a 7% yield of £7000 at the start of 2017, by 2018 an identical unit would cost £110,000 to buy and generate £7,210 in rental income – a 6.5% yield. JLL’s equivalent growth figures for 2016 were an even more impressive 15% (prices) and 6.9% (rents). So, a £100,000 property generating 7% in 2016 would now cost £126,500 to buy and bring in £7707.50 per year – a yield of 6.1%.

Though not always dropping by half a percentage point per year, as long as capital growth has been stronger than rental growth, yield compression will take effect. So advertised yields – whether 7% net or any other number magically staying constant over the years – require closer scrutiny. Many of them may be entirely justified, but investors must seek proof.

(One caveat is the fact that 3%+ rental growth will lift yields higher over time, but if an advertised yield is not justified, the period of fixed returns had better last a good long while for the actual yield to catch up in this way.)

Serviced apartments

However, there certainly are still ways to achieve high and sustainable yields in the UK’s major cities. One particular area in which they show considerable potential is in the serviced apartments sector. This booming industry tends to run counter-cyclical to movements in the national housing market, and has performed especially well with the devaluation of the pound making inbound travel more appealing.

An industry report released this week states that, although ‘corporate adoption has perhaps reached a temporary ceiling’ in demand, and supply has grown by 19% in just one year globally, 63.4% of operators still experienced higher occupancy rates in 2017 than 2016, and 39.21% did so with higher nightly rents (GSAIR 2018/19).

The UK is among the world’s most mature markets, boasting stable average occupancy of 81.7%, with nightly rates rising by 5.4% in 2017 (STR / ASAP). With figures like that, serviced apartments can be an extremely profitable alternative to buy-to-let in areas where yields are being squeezed. And big cities make by far the most sense on that model, as it requires a substantial demand stream from business and tourism.

Yet in similar tendencies are already beginning to creep into this sphere. Manchester’s large volume of new serviced units actually caused occupancy to decrease by 6.3% in 2017, although it was previously the city with the highest occupancy rate in the country and remains strong at 80.5% (STR/ASAP). Edinburgh, without a huge injection of new stock, saw occupancy stabilise at 84.4% and nightly rates rise by 7.3% in the year (STR/ASAP).

We don’t mean to pick on Manchester, but it is the clearest example of this trend in both the residential and serviced apartment sectors, with plenty of data reported, and also happens to enjoy an extremely favourable reputation among potential investors – which, again, should not be discounted, but could benefit from a little moderation.

The heaps of investment shovelled into Manchester, Birmingham, and their peers, have served those cities and investors extremely well, and their property markets have plenty of life in them yet. However, at this point in time it pays to question conventional wisdom. We are convinced that the reasons to pause before pouncing on mainstream investment locations can be avoided altogether in other, less obvious locations.


Paul Avery

Paul joined us in 2016 to lead our in-house research efforts, producing reports and guidance for clients as well as the strategic market analysis behind our new project launches. His background is in sustainability in the construction sector, and he is currently being trained in property valuation to further bulk up his investment creds.
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