LGPS funds strive to make an impact with build to rent

Initiatives include impact investing on social projects and UK residential property initiatives. Funds often venture into this market through private equity partners. With Brexit's stormy seas in prospect on the horizon, will these changes in direction pay dividends for them?

The Merseyside Pension Fund and the Tyne and Wear Pension Fund are typical of the new breed of local authority investors turning to residential property.

They have joined five existing local authorities: the Derbyshire Pension Fund, Nottinghamshire Pension Fund, Staffordshire Pension Fund, Teesside Pension Fund, and the West Midlands Pension Fund as limited partners with Hearthstone Investment Management Limited, an institutional investment manager specialising in the UK private rented sector.

On 25 February it announced the final close of its 10 year closed-ended private equity fund, Hearthstone Residential Fund 1, with just over £200m.

Positive impacts are experienced in the communities that local authorities serve and can have multiplier effects that result in financial benefits to those local authorities

Owen Thorne, Merseyside Pension Fund

The fund aims for a high yield, and this dictates the locations it invests in. Cristoforo Rocco di Torrepadula, partner and director of investor relations, Hearthstone Investment Management, says: “Where our yield targets are not met, the fund won’t invest. For the time being, the fund is not investing in Greater London and only very selectively in the South East. The target return net of all costs is north of 4 per cent per annum distributed income to investors.”

Cllr Paul Doughty, chair of Merseyside Pension Fund enthuses:  “Since achieving its first close in December 2017 with assets of just over £100 million, HRF1 has consistently delivered on its investment strategy, focused primarily on new-build housing and low-rise blocks of flats.”

While Hearthstone emphasises that the fund is not a social impact fund, the investments’ role in the UK’s housing crisis could explain its popularity with LGPS member funds.

It has invested in the Midlands, the North West, the North East Region, Southern England and Wales, aiming to build and manage to a high standard a portfolio of mainstream rental properties with the interests of tenants, their communities and institutional investors aligned. Cllr Doughty explains: “This is consistent with our objective to support needed housing development in the region.”

Owen Thorne, portfolio manager, monitoring and responsible investment, Merseyside Pension Fund, says in addition to a regulatory nudge, local authorities are drawn towards social impact investments because “positive impacts are experienced in the communities that local authorities serve and can have multiplier effects that result in financial benefits to those local authorities”.

He continues: “The Hearthstone opportunity is a good example of that, given the range of issues that arise for local authorities having to deal with inadequate supply in their local housing market.”

For the Tyne and Wear Pension Fund, it is simpler. A spokesperson said: “This investment has been made as part of a long-term strategic allocation to UK residential property. The decision to invest has been taken on purely investment grounds.”

Homes and profits?

Impact investing is often seen as being driven by ethics, but evidence is mounting that social initiatives can benefit portfolios.

“For local authorities, there is increasing recognition that as well as delivering a social benefit, social impact investments offer a very good diversifier from traditional assets,” says Vishal Makkar, principal and senior consulting actuary and head of retirement consulting at Buck.

He adds: “On a larger scale, social investing by pension funds offers access to lower-cost capital for social enterprises. We saw this to some extent historically with infrastructure investments.”

 “First and foremost, the driver has to be financial return,” explains David O’Hara, partner, investment advisory, tax and pensions, KPMG. “If this is aligned with economic growth, job creation, environmental change and social good then these investments can deliver much more.”

Generation rent

David O'Hara, partner, investment advisory, tax & pensions, KPMG, says this sector is worthy of consideration: “The rise of generation rent provides an attractive opportunity for pension schemes to access financial returns for members through the private rented property market.” 

A recent KPMG report highlights four advantages. The risk/return profile and strong income focus of the private rented sector make it a suitable building block for cash-driven investment, while the diversification benefits provided by PRS, combined with the muted outlook for balanced commercial property, make it an attractive substitute for traditional property exposure.

Some funds have a strong social focus, which provides alignment with clients looking for investments with a positive environmental, social and governance impact. With asset prices relatively high by historical standards, PRS could also be a risk reduction trade if investors can afford the illiquidity.

Social housing in particular has potential for pension investors too, as Pete Smith, associate at Barnett Waddingham, explains: “The demand for new homes at affordable/social levels of rent, or for homes to address the homelessness issue in the UK, far outstrips the current supply. This demand is expected to continue into the future, even if there is a material increase in supply. 

“This combined with income streams that have a large element of government backing, and hence security, produces investment returns that are attractive in absolute and comparative terms.

Will Brexit blues dampen the market?

Will the UK residential sector collapse in the event of a disorderly Brexit? The shuddering 2016 market after the referendum shows that anything is possible.

Mr Rocco di Torrepadula enthuses: “Brexit or no Brexit, families, professionals and key workers need the availability of good-quality, and well-managed rental accommodation in areas where they want to live and work.”

A spokesperson for  M&G (which runs the M&G UK Residential Property Fund, in which 13 UK pension funds, including 10 UK local government pension schemes and one foreign pension scheme invests), states: “The PRS sector continues to be polarised by location. Brexit uncertainty and ongoing development have continued to restrain rents in the central London market but the rest of London is proving more resilient.”

The spokesperson points to Manchester (which provides the UK’s second-highest commitment to the construction of new rental properties, after London, according to BPF data) as “one of the UK’s most successful locations for large-scale private rented sector projects”.

However, the spokesperson sounds a note of caution: “With increased interest from investors in the build to rent market in regional areas, there is a risk that some cities will see significant levels of development in the next few years, which could temper growth in some locations in the medium term.”

“General trends affecting the UK property market such as high street retail woes and the rise of online retail are likely to have a more immediate impact than Brexit,” says Makkar.  

He forecasts: “In a no deal scenario, UK property may withstand the shock. However, it could be severely hit if inflows from foreign investors decline” but cataclysmic outcomes for the property market have been avoided. So far, so good."

He advises pension schemes “to analyse their UK property exposure to ensure resilience from these effects”.

His final word of advice for long-term investors: “Avoid knee-jerk reactions.”