In 2016, Kee Gan approached Mark Landau and Rafi Lamm, the co-founders of L1 Capital, with a unique investment proposition. London based Gan had uncovered some interesting trends after making a personal investment into the U.K. residential property market.
The rental yields were very high by global standards, and I was achieving somewhere between 7% and 8% rental yield. Interest rates were very low, so I was able to borrow at a mortgage rate of about 2%. It became one of the very few developed countries where you got positive gearing.
Gan pitched the concept of investing in U.K. residential property to L1’s founders, who are best known as equity investors. Their response was emphatic, describing the opportunity as a ‘no brainer’ and immediately committing to back the idea with their own capital.
In this interview, Gan discusses the drivers behind this opportunity that L1 continues to pursue.
- How L1 Capital began investing on U.K. residential property
- Why the opportunity exists and how the market is different to Australia
- The impact of COVID on the rental market
- What makes an ideal asset?
- Solid income with the potential for capital appreciation
Click on the player to access the interview or read an edited transcript below.
Can you provide some background on L1 Capital's U.K. Property Investments?
It's probably a bit helpful just to set in context how it all started. As you mentioned, a lot of people are more familiar with our equity funds. Around three or four years ago, when I was working in London, I made a personal investment in an apartment in Birmingham, and there were several interesting themes. The rental yields were very high by global standards, and I was achieving somewhere between 7% and 8% rental yield. Interest rates were very low, so I was able to borrow at a mortgage rate of about 2%. It became one of the very few developed countries, where you got positive gearing, so a positive dividend yield on your equity versus most countries, including Australia, where you sat on negative gearing.
When I looked at where house prices were in the cycle, they were very late and slow to recover from the GFC. So, from an affordability perspective, outside of London, where about 85% of the population lives, price to income ratios were about four times, which was a lot lower than London at eight times. For comparison, Melbourne and Sydney trade between nine and eleven times, respectively.
At the time, with a bit of uncertainty around Brexit, the Sterling was also very weak. With that sort of dynamic, I thought a lot of asset classes around the world looked quite expensive. U.K. residential property offered a robust and predictable yield with some scope for capital upside.
So, I caught up with Mark Landau and Rafi Lamm from L1, and we were talking about investments and they said actually, "This is a no brainer." Their immediate response was, "We'd love to put a lot of our own money into it." Over a period of time, they said, "Actually, a lot of our clients would find this a pretty compelling opportunity." Because when you look at Australia housing, you just mainly see the opposite, low yields, negative gearing and affordability is very stretched. So, over the past three years, we have raised three funds and invested across the asset class and currently have about 250 million Australian dollars in assets under management.
What is the opportunity that exists right now?
We invest in basic blocks of apartments in the tier one cities outside of London, such as Manchester, Birmingham, Leeds, and Sheffield. What we like about these cities is one, prices have only really started to recover to the same level as they were before the GFC. So really, you've had 10 or 12 years where prices haven't moved all that much. Yields are very high, affordability very strong. When we look at a lot of these cities, they're benefiting from an outperformance of employment and population growth. For example, Deutsche Bank, Santander, NatWest have moved a lot of the middle office to Birmingham. BBC moved to Manchester, and you've got around two-thirds of the FTSE 100 who now have an office in Manchester. A lot of firms are opening up in tier one, larger cities outside of London because of affordability.
In terms of value, we think longer-term; the gentrification will support house prices in those regions. When we bring it together to say, "Well, what's the investment case?" The cities which we like the long-term outlook, there's a strong running yield where we're able to get strong, positive gearing. The funds have generated between 6% to 7% dividend yield, just purely from income. If house prices continue to remain stable or if we continue to keep repositioning the assets through refurbishment or by lifting the rents on under-managed assets, then we feel comfortable that not a lot has to go right to deliver a double-digit return.
Why does this opportunity exist?
It's very much driven by mortgage lending. In 2009 and 2010, the U.K. banks had a very different experience where they all became bought out by the U.K. government. So, Lloyds, NatWest, Santander, all became nationalised, and mortgage lending has subsequently become very conservative. The average LVR (Loan-to-value ratio) for a new mortgage, if you can actually get one, is about 60%, which means people funding that 40% deposit makes it very hard for them to make the purchase. Right now, in the U.K., 68% of all people who rent, rent because they don't have a deposit to buy a house.
So, it's not driven by affordability because if you're paying rent, which is 7% or 8% rental yield, but you can buy a home on a mortgage of now less than 2%, it's much cheaper to buy than it is to rent. It's that conservative nature of the banks that's holding back prices. We think that makes it very interesting where it's not about affordability. It's not about the location so much. It's the banks which are holding back lending.
Is that credit discipline from the banks likely to change? Is there any discussion or movement on that front?
Just before COVID, mortgage volumes started recovering and some banks started offering higher LVRs, up to 75%. I think COVID has probably put a little bit of a pause until the banks have a bit more clarity. But the long-term trends are two or three years ago, the majority of the U.K. banks had their government shareholder exit the share register. So, becoming fully publicly owned again is a differentiator. Secondly, the U.K. banks are very well capitalised and now want to grow their lending books. So, I think once there's a bit more clarity around COVID, and the longer-term focus is to regenerate housing across the U.K.
The experience in Australia has been that rents have fallen during the COVID period, has that been consistent in the U.K.?
The U.K. has been a little bit different. Rental prices have remained resilient. Looking at July, outside of London, rental prices are up 3.4% versus last year. In London, they're down 1%. So hence, one of the reasons we focus less on London. London is driven more by international tourism, a lot more Airbnb service accommodation. With a fall of that foot traffic, they're focused on the private rents, so there is a lot more supply in London. Outside of London, which are places where people live, rents have continued to move up.
When we look at how rents have performed over the past 70 years, what we've seen is it just consistently grows at around between 2% and 4% in line with inflation and the worst year, which there was a decline, it only fell 0.8%. So, it's a very stable product.
The other aspect that we did look at is whether people continued paying their rents, particularly during a period of uncertainty around people's employment and jobs. The residential sector for the year to date and including the most recent months have averaged around 97% collection rate. So, 97 cents of every dollar that's meant to be due, people have paid. In the worst month, which was in April, that only dropped to 95%. People have continued paying just given relative affordability, and that's been much more robust than other sectors, such as commercial, where, unfortunately, the collection rates have been much lower, closer to 60% or 70%.
I also understand part of the fund invests in student accommodation, and there are some higher yields on offer in that part of the market. Can you tell me about that opportunity and if the returns are more attractive why isn't it a more significant part of the portfolio?
They do come with higher risk. We allocate somewhere between 15% to 20% of each fund into student accommodation. One that allows us to be very selective and two, it allows us to really pick the best one or two assets in each year in the student market. Each fund that we've raised to date, we invest two student assets, and each of them has generated attractive yields.
Can you provide an overview of the typical asset you would invest in and the process for managing these assets?
The typical asset that we would invest in would be a block of flats in one of the larger city centres in the U.K. So, it would be somewhere in Manchester, Sheffield, Leeds, Birmingham. What we're looking for is not something that's perfectly run, but a building which we might find is a little bit under rented, or the prior owner hadn't spent a lot of money on it, and we could do a light touch refurbishment. Or it might be sometimes it's run quite well, but the prior owner hasn't recognised, "it's in a great location, and if we just put a bit more premium furniture or change the sub-agent, we could reposition the rents quite materially."
So, the ideal investment number one is a strong city, an excellent location within the city, and then we build a typical three or four year business plan the two or three things that we can do differently.
We get comfort that as a starting point, it is fully income-generating day one. So, we know that there's a robust running yield that can start being returned to investors from the outset. If we execute these two or three initiatives, that's where we can generate a bit more capital growth over the three or four-year plan. Then when we deliver that business plan, we look to exit, and we have several options.
From time to time, each building is broken up one by one, and each flat is sold at retail value. When you buy a building in bulk, you typically buy it at a discount. When you sell at the retail value that crystallises a premium, if that's not possible given its location, sometimes it's marketed as a bulk deal as well. So that's typically the process from start to finish.
Risks, it's a lot more around building quality, fire safety, and changes in regulations. I think one chance that has become a lot more pronounced, which is significant to the fund, has been around fire safety. So now our process is much more focused around the building materials, getting the right certification for our engineer to review it because the cost of getting that wrong and having remedial action to fix it under our ownership can be quite expensive. So, I think risks around building quality, carrying out the right surveys are critical, and they need to be managed.
What has been the experience for investors in those earlier funds, and what are you seeking to achieve with your current offering?
In the first two funds, which have a longer track record, the distributions have exceeded our investment objective of 6% to 7%. Both funds are paying 7% or more and that's coming primarily from the rental income. A yield like that is sustainable, it's coming from income, and it's quite attractive in a low-interest-rate environment. In terms of a total return, our investment objective is 10%. Both funds have exceeded those investment objectives because when you have a robust income yield, there's not a lot that we have to believe to outperform that investment objective. From a capital growth perspective, both funds have outperformed the underlying investment objective. I think going forward, as we look to Fund IV, I think the asset class and the opportunity largely remains the same. What's changed? I believe, within our team, it is about the experience and how we improve assets and how we can learn from some of the things that we might not have done so well in the prior funds.
Mark and Raf put their money in the early rounds, are the managers continuing to invest in these opportunities?
Consistent with all our funds, all senior L1 staff do co-invest alongside investors on identical terms in each fund. I think, across all the prior funds, the L1 team is probably the single largest investor, so very heavily invested in the strategy. We will be investing in Fund IV and perhaps not in similar amounts, but the conviction remains the same, and we'll continue to invest, so the full alignment of interest.
Thanks for taking the time to jump on the call, appreciate the insights into what's happening in the U.K., and in telling us a bit about your fund.
Thanks, James. Appreciate it. Thank you for your time.
Defensive income yield and capital growth
The L1 Capital U.K. Residential Property Fund invests in high-yielding residential assets that can deliver strong and growing income, along with significant capital appreciation. Click the 'CONTACT' button below to find out more.