The case for investing in housing — at large scale.

There is 8.5 billion of us on Earth, not enough housing for everyone as it is, and, by 2040, we’ll be 9 billion. It’s no news: large cities are facing an acute affordability crisis. In New York City, public officials report that 20% of the population lives below the poverty line (Leila Bozorg at New Citie’s New Housing Solutions Conference, 2019). One third are renters and put more than 50% of their income in their home. In Paris, less than 7% of the population deems easy to find decent housing at a reasonable price (Eurostat 2015).

The need seems pretty dire, yet a majority of the European investment community remains fairly disinterested in the housing conversation. Let’s look at why, and how institutional investment could create value through new housing solutions.

Observation #1 — Existing misconception

It is commonly argued that most of the return on residential investment is in its capital growth. So large investment companies have not been incentivized to develop their residential portfolios. As a matter of fact, housing is generally seen as a capital investment, generating little to no income over time and therefore not matching investors’ expectations. But the analysis that emphasizes residential returns as a lump of cash upon the sale of the property could be mistaken in the way it assesses rents fluctuation over time.

According to Pr Michael Ball of Henley Business School, University of Reading,

“there is a clear link between capital and rental growth in residential because rents change on a frequent basis to reflect prevailing market conditions, either with tenant churn or through revisions to current tenancy terms”.

The common mistake seems to come from the underwriting process, and more particularly when one underwrites a housing deal as s/he would underwrite commercial real estate, i.e. with fixed rental terms. It leaves little room for rent increases and overlooks the fact that fixed-term rental contracts are extremely rare in housing. In fact, it is safe to assume that, when investing in most flourishing urban areas, residential rents will increase in conjunction with capital value.

Observation #2 — Investment opportunity

There is no doubt that the residential sector represents a major opportunity and remains an untapped market for real estate investors. That’s why many of us are actively working on outlining the specificities of this market — with the help of organizations like ULI or New Cities for instance.

Here are some initial conclusions…

First of all, let’s reckon that housing provides good returns over the long-term and relatively limited volatility. And residential operations are likely to provide even stronger returns in the coming years, as society continues to urbanize and cities continue to struggle at addressing the housing shortages! Much of this growth – which cannot be demonstrated of commercial properties – is largely associated with the expansion of the next generation of young, relatively affluent professionals, in need of flexible quality housing. They bring revenues and help to balance affordability levels, allowing to attract a diversity of people and thus provide economic stability to the overall area.

A second argument lies in the stability of demand for housing in relation to any other asset class. According to Pr Ball, demand rises with income and wealth, whereas firms are cost-sensitive and therefore seeking to lower rent costs whenever feasible. Even though rents and home values are closely linked, rents variations tend to be more predictable than land prices throughout real estate cycles, leading to particularly low-volatility. Some even argue that residential investments allow for income-matching strategies and can be seen as inflation hedging investment. In any event, in the long-run, demand for residential properties is much greater than for commercial ones. Besides, thanks to the huge shortage in housing and unprecedented population growth, vacancy risk is at a historic low too – and much lower than in any other asset class.

Then, throughout the life cycle of residential operations, investors can find opportunities to save costs and create value :

• Price-wise, in most large cities, residential assets are strongly upwards which is not the case for commercial property.
• During operations, new service packages offered to residents create an opportunity for increased operating income.
• Large-scale residential investment strategies can leverage economies of scale, with low defaults and regular incomes. Besides, default risk is much lower than in commercial real estate since tenants occupy small surfaces.
• On the development end, investors have the possibility to negotiate discounts by buying in bulk from developers, who face significantly higher transactions costs selling their units to individual owners.
• And residential properties depreciate less and less quickly; their refurbishment costs are also typically lower.

Observation #3 — Changing demographics and demand misalignment

Demographics have taken a strong turn since the fifties: more and more people live alone. One-third of households in the EU is comprised of single adults without children (Eurostat, 2017), and 28% of Americans now live alone. A generation or two ago, most people were married. Now a majority of us is divorced, decides to have a kid when buying their first home and lives till 80. And remaining married households shifted to single-earner to dual-earner households! Women are more likely to have a college degree than men; more people become freelancers and digital nomads; and, car ownership is going down. Those evolutions change what people want and need in housing, but the changes have not necessarily been implemented in developers’ designs.

An example of the direct consequences of this mismatch is the excess capacity in our homes :

• In the US, 54 000 spare bedrooms sit empty and unused;
• ⅓ units in the US will be headed by a person aged over 65;
• ⅓ of households in the US are single-person households.

So while most urban policies have seen homeownership as a critical element of affordability and access to housing, it may not reflect the reality of peopleʼs needs anymore. According to Fannie Mae (notes from New Citie’s New Housing Solutions Conference, 2019), this is a fair line of rationale: people’s make trade-offs when it comes to deciding on expenditure. They should be offered more diversity in their choice to determine the highest and best use of their housing solutions. Dare we hope that policy-makers start considering implementing impact- or goal-driven regulations rather than prescriptive housing definitions?

Observation #4 — Existing tools to address the housing crisis (at least partially)

The good news is that there are many great examples of successful housing innovations in the world! Entrepreneurs, designers, developers, and others around the world have developed solutions that could potentially feed acquisition strategies for investors like us.

• Modular housing is growing everywhere, whether it is prefabricated, 3D-printed or made of recycled material: Module is an example of a modular housing brand building net-zero ready rooms and/or entire homes in just two days. In Pittsburgh, where they are based, it costs $150K for a fully-furnished &-bedroom apartment. Their typical customers build an extra bedroom or unit for their aging parents. Others need complimentary revenue from Airbnb rental.
• “Sharing” is another idea. The much-talked-about co-living models or the ShareNYC initiative demonstrate the influence of the sharing economy on housing.
• Tiny houses and tech-compatible accessory dwelling units (ADU) are interesting solutions too: ADUs applications were multiplied by 30 after LA changed its regulation to allow them. They build density to help support transit and tax revenues while creating opportunities for affordable quality housing. Those small-lots optimization strategies & infill development operations allow increasing housing stock within existing urban fabrics.
• Community Land Trusts and financing vehicles allowing communities to invest in their neighborhoods are spreading all over Europe and North America. The city of Vienna has incorporated a cooperative land bank in its affordable housing plan as early as the 1920s: in order to lower home prices, local governments depressed land value through rent control and thus improved economic attractiveness throughout the city. Other cities have created neighborhood financial vehicles allowing local non-profits to acquire and redevelop rent-stabilized buildings.

All in all…

The investment community has a lot to catch up on. From modular architecture to financing options and temporary housing, city dwellers keep on developing their creativity. Will we be agile enough to seize the opportunity with them? If we want to address this evolving market effectively, we’ll need to be more responsive to demographic changes and open to experimentations.