What is the direction of travel for buy-to-let? With all the regulatory changes coming to the private rented sector (PRS) it’s go bigger or get out.
It’s well known that demand for rental accommodation is very strong in the UK, and this demand is not likely to go away in the foreseeable future. This situation is strengthened by the Government’s attack on buy-to-let landlords, the constant threats of tighter regulation and more taxation. The consequence is many small-scale landlords are leaving the sector.
Enter a new class of small-scale landlord, the SME landlord. These are individual sole traders or companies acting as professional property landlords falling under the Small and Medium-sized Enterprise (SME) category.
These landlords typically own and manage a portfolio of rental properties rather than just single lets or a couple of homes. These are professional landlords operating their property interests as a business rather than a sideline investment. They often operate as a limited company and manage their properties with a focus on business growth, professional management and compliance. These are their distinguishing features from the small, less formal, "amateur" landlord.
Their scale of operations means that unlike the small-scale buy-to-let landlord with just one or two properties, they are less concerned about new laws that give tenants more security. And they operate in a corporate structure which at scale gives them some tax advantages.
Most people in the property industry conceive Build to Rent (BtR) with images of gleaming new towers, like the apartment buildings going up in Manchester, Leeds, or London’s Docklands. These are run by pension funds and global investors. It’s a sector dominated by the institutions: Legal & General, Grainger, M&G, and the like.
But beneath the surface there’s another story: it is one that should be of keen interest to professional SME landlords. Recent research by development finance specialist Rangewell, using Valuation Office Agency council tax records cross-checked with Land Registry data, reveals a surprising volume of small-scale BtR projects happening across the UK.
We’re not talking here about the 200-unit mega schemes you see reported in the property press, or the physical high rise tower blocks dominating city landscapes. Instead, these are smaller new builds, infill schemes, converted shops and offices, and modest apartment blocks being developed by entrepreneurial local landlords and developers.
In today’s economic climate, with demand for rental housing booming, and traditional buy-to-let looking less attractive, this “hidden” gem of the BtR market may be the most compelling opportunity in a long time for landlords who are prepared to think bigger than single lets.
The UK’s rental market is under intense pressure. Latest ONS data shows private rents are rising at their fastest pace on record, with demand outstripping supply in almost every region. At the same time, thousands of small buy-to-let landlords are leaving the sector, squeezed by tax changes, rising mortgage rates, the imminent Renter’s Rights Bill, looming EPC deadlines and more recently, the rumours floated by the treasury that landlords could have to pay National Insurance (NI) on their rental income.
This landlord exodus is leaving a gap in the market which is crying out to be filled. Tenants still need homes, while more and more people resort to renting long-term when they find mortgages are so out of reach for them, and local authorities still face a housing crisis with growing homelessness and mounting housing waiting lists.
Into this gap can step Build-to-Rent. While the institutions and large-scale developers focus on prime city centres, the smaller SME landlords can operate in the towns, suburbs and the regional hubs where demand is just as strong, if not even stronger.
For landlords willing to move beyond single-unit buy-to-lets, small-scale BtR offers some serious advantages:
Rangewell’s analysis of Valuation Office Agency’s council tax data, which they cross-checked with Land Registry completions, reveals the extent of this hidden BtR development. Their figures show that Leeds had an estimated 7,780 potential BtR units, Birmingham 6,730, Salford 6,470 and Manchester 5,570. There’s also activity outside of the big cities, for example Cornwall alone had 5,590 new BtR homes.
The overall regional figures amounted to: South East (85,420 dwellings), London (73,370), the North West (57,230) and the West Midlands (46,600), North East (19,540) and Wales (17,330). Not all these completions will enter the rental (BtR) market, but the predominance of apartments, the configuration most likely to be retained by SME developers, is an indication of a significant additional supply to the rental market in those regions.
There are several ways SME landlords can get involved:
Break new ground for small new builds. Not every BtR project must be a skyscraper. Smaller housebuilders and landlords are increasingly developing small infill sites of family homes and blocks of flats on a small scale, perhaps from 5 or 5 up to 20 flats in small clusters of rental houses, in-town brownfield and edge-of-town sites, or redundant land of all types.
Commercial-to-residential conversions have become very popular since the introduction of permitted development rights (PDRs). Since this came along it’s been possible to convert many in-town shops, banks, pubs, and offices into residential units without the need for full planning approvals.
This route has become a major driver for small-scale BtR activity and one open to existing owners of commercial premises that are not commercially viable for upgrading as shops, offices or industrial buildings, to meet the latest MEES environmental standards - it’s a logical repositioning strategy.
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Commercial MEES Standards (England & Wales)
April 1, 2018: All new tenancies in non-domestic (commercial) properties needed an EPC rating of E or higher.
April 1, 2023: This requirement was extended to apply to all privately rented non-domestic properties, including existing leases, even if there wasn't a change in tenancy.
April 2027: The standard increases to a minimum EPC rating of C.
April 2030: The standard increases again to a minimum EPC rating of B.
Residential MEES Standards (England & Wales)
From April 1, 2018, private residential landlords could only grant a new tenancy or renew an existing one if the property had an EPC rating of E or above.
There is no separate, future, stricter MEES requirement for residential properties beyond this E rating, although future government policies could change this
Refurbishing existing multi-occupation rental stock is another entry point. As existing landlords rush for the exit opportunities arise for the enterprising SME to pick up bargains, older and smaller blocks of rental buildings, run-down HMOs, or under-utilised buildings that can be upgraded into modern BtR schemes.
Refurbishing these older properties may be less appealing to some than a ground-up new development schemes; in many ways these refurbs have a smaller impact on the environment, and their returns (yields and capital appreciation) can be very strong. Plus, these developments are swimming with the tide of government policy approval and demand for the finished product is there in spades.
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The big institutional investors in BtR are targeting the big cities at scale: London, Manchester, Manchester, Leeds, Bristol, Edinburgh, Glasgow. But that leaves plenty of opportunities and scope for smaller developments outside of these major centres. The secondary towns and smaller cities also have chronic shortages of rental accommodation.
People like to live in university towns and there’s demand for student lets here. The UK is also blessed with many tourist attractions like in Oxford, Cambridge, York and Bath, all desirable places to rent and work. There are also many suburban commuter belts where renters are priced out of the major cities and are still looking for quality rental housing.
Regional hubs are also growing and providing good employment, some of them benefiting from Government grants and “Levelling Up” investment. Milton Keynes, Warrington, Hull are good examples.
Small-scale entrepreneurial landlords with local market knowledge are well placed to search out opportunities in locations such as these. Yes, there is much planning and red tape to be contended with, and negotiations aplenty, but that’s the case with any development taking place in the UK – it’s part of the challenge.
A West Midlands family landlord with a portfolio of single lets redeveloped a disused garage site into eight two-bedroom rental houses. Demand for these rentals was so strong that all were pre-let before completion, with yields comfortably exceeding local buy-to-let norms.
In a North Yorkshire market town, another small landlord acquired a vacant high street bank branch. Using PDRs to convert it into 12 rental flats, the scheme revitalised an otherwise empty building and street, it provided much needed homes and delivered a strong return on investment the landlord’s investment.
A landlord in Bristol refurbished a tired 1960s block of six flats, upgraded them to modern energy-efficiency standards and facilities and within a very short time of relaunch, all the units were let at a high premium to the previous rents. The tenants cited the quality of the finish and amenities as a deciding factor.
There are multiple regulatory challenges for both investors and developers embarking on their BtR journey. These are ultimately residential assets which are caught within the general residential lettings tax rules, and planning and building regulations as well as all the environmental surveys are now required for developments.
Environmental surveys are often required as part of the development process, particularly with the implementation of the Biodiversity Net Gain (BNG) legislation in England, which mandates a net increase in habitat value for most new developments.
Planning authorities now require ecological assessments to protect protected species and habitats. Developers must submit ecological surveys, often including a Phase 1 Preliminary Ecological Assessment, with their planning applications to indicate the potential impact and achieve a positive outcome for the environment.
Taxation on stamp duty, rental income, capital gains and corporation tax in practice are fairly complex issues which result in increased tax and adviser costs and the need to carefully manage taxation regulatory risk. Though there are tax advantages when operating as a true business as opposed to an investment sideline.
Building homes to sell can be carried out on a Value Added Tax (VAT) efficient basis through the availability of zero-rating on both the construction costs and onward sale. Construction rules apply to BtR developments, but the exempt end-use creates some complexity around recovering VAT on professional and land costs.
There are also commercial structures that can be used for BtR development assets which may also mitigate VAT. Disposing of land at the so-called “golden brick” stage of construction - the point at which construction of the dwelling reaches above foundation level - creates a very valuable zero-rated supply.
However, despite these advantages, operating a business of any size will usually create a VAT cost. The VAT cost usually sits with the end-consumer, while in some cases, VAT may have a negligible impact on rent depending on the chain of under-lettings.
However, in BtR arrangements, the VAT cost stays with the landlord as it makes the last supply in the chain as an exempt letting to tenants. This VAT is irrecoverable and must be factored into decisions about rent setting and acceptable level of returns.
Determining whether residential units are dwellings for VAT purposes and restrictions in planning and other documents need careful analysis and investors need to determine if ancillary facilities, such as gyms or common areas etc. are part of the dwellings.
Other issues to be straightened out are, among other things, how are the services categorised? When could the property be classed as a hotel for instance? Can services be split from rents?
All these regulatory issues are complex and require expert advice before making decisions and embarking on developments.
Despite its many advantages, Build-to-Rent for the SME landlords is not an easy option. Operating as a buy-to-let landlord as opposed to a professional portfolio landlord is not the same thing, there are higher barriers to entry with the latter.
Finance for development funding is far more complex than a simple buy-to-let mortgage or even a commercial loan for a HMO, it requires a completely different skill set when negotiating with lenders.
Planning & compliance rules can be a time consuming and an expensive process – even with permitted development rights prior approval is usually needed. Design standards, building regulations and environmental issues must be complied with.
Developments entail risk. Bad weather as well as ground issues can lead to construction delays, materials cost inflation and sourcing problems, health and safety and site management issues, meeting stringent planning, building and environmental standards, are all realities of property developments.
BtR tenants generally have higher quality expectations of the sorts of accommodation generally associated with BtR. They warrant better amenities, higher energy efficiency, and excellent management service.
Professional landlords operating at scale, especially those with HMO experience will generally have the sort of skills and systems ready to make the transition to small-scale build-to-rent developments.
Looking to the future, there’s a tailwind behind BtR. Government policy favours the professionalisation of the private rented sector (PRS), it’s looking to landlords with the sort of operation capable of providing quality accommodation for singles, couples and families while complying with all the regulations.
Central and local governments are under severe pressure to house more people, and by increasing rental supply they have a solution. The government has expanded permitted development rights for this purpose, and although institutional investors building at scale will remain a primary focus, nevertheless local gaps in supply filled with small-scale SMS, BtR developers, will be equally valued.
Demand for quality rental homes is not going to go away any time soon – in fact just the opposite. For those landlords who aim to future-proof their businesses, moving away from the traditional concept of buy-to-let, BtR is that hidden gem of an opportunity to be taken very seriously.
As Rangewell’s analysis has highlighted the opportunity is ready to be seized by more professional landlords.
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