September 10, 2019
Build to can’t sell. Let’s be honest.
This article examines the existing conditions in the build-to-rent market and highlights:
Financing constraints on the debt and equity side that are hindering investment in the segment;
Lack of tax concession for investors (MIT withholding tax/lack of GST Credits) significantly impacting project returns; and
Pointers we can take from overseas with their further advanced build-to-rent markets.
We continue to see the concept of “build to rent” occupy prime space in local press and are struggling to understand why? To us it reads “can’t sell so rent”.
Build to rent is a concept that we see having little application in the private development market. Our view stems from two challenges facing this segment constraints on finance (of both the construction and hold period of the asset) and unfavourable tax structures cutting into margins.
Whilst it is widely reported that major banks are pulling back from construction finance, they do still
remain by far the largest providers of debt capital to the property market. Construction finance is typically progressively released to the developer meaning a construction loan remains at peak for a short period whilst the commitment is provided from commencement. Carrying such contingent liability requires a robust balance sheet. Additionally, when procuring this debt from a major bank without pre-sale or leasing commitment (save where leverage is low), developers must settle for a higher equity contribution. This equity contribution is significantly higher compared to a regular build to sell development with an acceptable level of pre-sales.
In relation to the hold portion of the asset, facility size is typically based on the assets interest cover ratio (ICR) – that is the cost divided by the net rental income. With banks typically wanting two times interest cover, an investor would do well to get beyond 50% LVR for an asset valued on a 4% cap. This continues to see equity tied into developments and would deter use of higher leverage non-bank construction finance where the repayment strategy upon completion of construction is uncertain.
Tax disadvantages for foreign investors
This requirement for greater equity is made more difficult when sourcing capital from foreign institutions due to tax policy surrounding Managed Investments Trusts (MITs). MITs are highly popular investment vehicles for institutional investors into the property market due to their concessional tax rate of 15%. In last year’s budget, a positive change was made to this vehicle which allows local investors to own residential property through this structure and access the 15% tax rate. Unfortunately, this concession was not granted to foreign investors (foreign pension funds/sovereign wealth funds etc.) who are still taxed at 30% for returns on residential assets they hold in MITs. This significantly deters foreign investment into the residential space, especially when considering foreign investors can access the concessional tax rate (15%) for commercial, retail, industrial, and leisure assets.
Pairing these constraints from the debt side with further constraints from the equity side, one can see the difficulty in financing build to rent projects – particularly in comparison to regular build and sell developments. Thus, we currently see this market being dominated by local institutional capital.
Tax disadvantages – during/post development
Tax settings around build to rent assets also play a large factor in deterring entrants into this segment due to their negative impact upon margins. In particular, the inability of build to rent developers to claim GST credits on their construction expenses is extremely costly, equating to roughly an extra 9% on costs they are unable to reclaim. Contrastingly, a build to sell developer would be able to fully recover these GST costs through construction – making build to rent significantly less attractive for developer’s margins.
What could change look like? Looking to the UK for insights
Looking to the UK, greater flexibility in funding options for both the construction and hold period of build to rent assets has allowed for the segment to flourish into the second largest form of tenure behind owner-occupied residencies. Looser financial covenants such as typical LVRs of 65-70% and Debt Yields (annual rental income as a percentage of the total facility) of 7.5%-8% have given developers greater accessibility to funds and allowed for expansion of this segment.
Additionally, the UK’s focus on housing policy that gives concessions to all the build to rent industry, not just affordable housing developers, has shown great success. In the UK, the proportions of affordable housing required in build to rent developments varies from project to project. This approach is likely to deliver a better outcome than the “one size fits all” one which has characterised Australian policy. If the Federal government were to take direction from the UK, then the industry is likely to develop significantly.
However, for the moment, we see build to rent being a game for local institutional developers with balance sheet and surplus staffing capacity in a declining residential market. The majority of developers will continue to build and sell as this model is less equity intensive, reaps greater tax concessions and has higher margins.
So back to our original point… after looking at all the impediments in this segment, sounds more like “build to can’t sell” to us.