Meadow Partners’ J. Andrew McDaniel on the U.K. Multifamily Rental Market
"When we started executing on our strategy a decade ago, we had to build our own internal sourcing capability and lay out the framework for how to create a multifamily asset class. Today, I can say with absolute confidence that multifamily will continue to experience meaningful rental growth." says Meadow Partners' J. Andrew McDaniel
How would you describe Meadow Partners’ U.K. multifamily investment strategy?
Meadow Partners’ core markets are London and New York because we believe those cities provide particularly attractive long-term investment opportunities. Right now, both cities are bucking wider trends—they are still experiencing population growth, their rents are still rising, and their demographics and earnings potentials are strong.
Meadow Partners started evaluating opportunities to invest in U.K. residential properties in 2012. We initially focused our strategy on development because multifamily as an asset class didn’t really exist ten years ago in London. Buying multifamily buildings was not an option; rather, if you wanted to own the asset, you had to go out and build it. That build strategy shifted for Meadow Partners about five years ago – development was very challenging, and we came to the realization that there was a more attractive opportunity to buy for-sale buildings and convert them into for-rent buildings. Key to that realization and our execution of a conversion strategy going forward is that London has no zoning differences between rental and for-sale properties. So, instead of building multifamily rental properties ourselves, we replicated the asset class through the conversion of for-sale properties.
How does Meadow Partner evaluate multifamily properties in London?
In London all of our deals are direct, which differs from how we transact in New York, largely because multifamily is still a nascent asset class in the region. When we started executing on our strategy a decade ago, we had to build our own internal sourcing capability and lay out the framework for how to create a “multifamily asset class.” In terms of the types of properties we evaluate, it really comes down to finding good relative value opportunities. For some reason or another there's a value dislocation, whether it be an over-leveraged or a capital constrained seller. We've used our internal operations to source those opportunities, acquire them, and create significant value through lease-up and subsequent asset management.
Where are you seeing headwinds in the residential market?
The currency volatility resulting from Brexit and COVID, coupled with last year's unstable political environment, has certainly put a damper on capital flows into U.K. real estate. We’ve had too many leadership changes, and a lack of clarity on economic goals at a national level.
That's not helpful when you're a capital importer like the U.K. It won’t be a long-term issue, but it did have an impact on institutional capital backing U.K. real estate in 2022. Looking ahead, one of the headwinds in the 2023 residential market is land use and converting land from one use to another. The U.K. is a supply constrained country with an incredibly dense economy. While the country’s population is growing, an antiquated land use system makes it difficult for there to be enough supply of residential properties to meet the demand. This is in part due to the fact that converting a property from a low-density use to a high-density use is extremely challenging and involves a cumbersome system that relies heavily on local government involvement.
What impact did COVID have on the region’s residential market?
The pandemic exacerbated property conversion issues given local government officials were working at home and planning committees were less available for decision making. To provide some context, in order to approve new projects and building conversions in the U.K., local governments are required to run such plans by constituents in open town hall meetings. As you can imagine, these simply weren’t happening at all for an extended period of time during the pandemic. While such meetings eventually were held remotely, getting plans approved in a timely manner remained difficult and time consuming. Today, there’s still a massive backlog of planning applications that require evaluation and projects facing national appeals for approval. With such congestion across the board, we expect that residential supply is going to be even more constrained than it already is.
How are the local government and congestion issues, coupled with residential demand, influencing Meadow Partners’ investment strategy?
It really forced us to be more creative in acquiring multifamily properties. In an effort to avoid the lengthy government approval process, we made the decision to acquire completed or soon-to-be-completed units. We generally bought these assets from housing associations, which are mostly non-profit organizations that use market-rate housing to subsidize their affordable housing operations. As the world slowed down during the pandemic, there was a cash crunch at many housing associations. It was at that time that we started acquiring market-rate properties and converting them from for-sale to for-rent properties. Today, we are still finding opportunities to transact at pretty compelling prices. Eventually, it is likely we’ll have to revert to the government approval process for conversions, but we don’t anticipate that happening in the immediate term.
How has the current interest rate environment affected your valuation process and has it led to more attractive opportunities in multifamily rentals today?
In London, given that the planning process is the same for both for-sale and for-rent properties, valuations are driven by the for-sale market; multifamily rental properties are generally appraised to a per square foot value tied to the for-sale market. That said, in general, we seek to buy whole blocks at significant discounts to those for-sale numbers. That hasn’t changed. As interest rates go up, more people are transitioning to the rental market daily. We're still driving considerable rent growth year-over-year, due to a supply shortage, demand, and income growth in London. Real-time data shows that rents are increasing by double-digits as are the earnings of the underlying occupants. The for-sale market is just difficult, especially with high transfer taxes for buyers. When you combine those taxes with rather high interest rates, it makes it even more compelling to be a renter in the near term, even if you're not a renter by necessity. There are plenty of compelling reasons to be a renter by choice, and we are continuing to find attractive opportunities to invest in the growing U.K. multifamily rental market.
How is the undersupply of housing impacting new construction?
Simply put, construction starts are way down. London’s affordable housing policies were likely not sustainable before the world changed during the pandemic, as they were too expensive to deliver with the level of affordable housing that was required. Today, with construction costs going up, we’re seeing even more challenges emerge, and expect new construction starts to continue to slow in the medium term. This slowdown creates even more pressure to raise rents. It also feeds into why we are trying to buy housing that is already completed, convert it to rental use, stabilize it, and operate it through this supply-constrained period. As a result of the lack of new supply, coupled with rising demand fueled by growing employment in London, we are continuing to see real rental growth even with high inflation rates.
How do you expect demand to evolve over the near, medium, and longer term?
As compared to other regions across Europe, the U.K. is unique – and London is particularly unique – because it is still experiencing population growth. That growth puts continued pressure on the limited and increasingly expensive supply of housing, so it goes without saying that I expect multifamily to remain one of the healthiest asset classes. People need beds to sleep in. That will not change. That's why we continue to focus on maximizing our exposure to multifamily rental. Our strategy is meant to capitalize on the near-term opportunity, as there's really no way of developing properties quickly enough.
Without question, multifamily continues to outperform other property types. For example, industrial has repriced significantly as interest rates have come up, and office and retail are no different. Sure, interest rates remain an issue for multifamily too, depending on how long the current rates sustain, but the necessity of housing creates a floor. That's why we're still driving revenue growth right now while other asset classes are struggling to grow. I can say with absolute confidence that multifamily will continue to experience meaningful rental growth, so we're getting the benefit of that inflation plus the benefit of further shortages.
Beyond the demand factor, what steps are you taking to increase property value?
The U.K. multifamily asset class is not as established as the asset class in the US, so there are significant opportunities to increase value via operational improvements. There aren't off-the-shelf providers of property management or leasing services at economic rates that help to drive net operating income (NOI). As such, as I noted earlier, we’ve internalized various operational components of property management, leading to a reduction in operational expenses and an increase in NOI margins. It’s a really great way to add value. On the leasing side, we've internalized a lot of the functions, especially renewals. Finally, in some markets where we own a property and there's also a third-party owner with a third-party service provider, we’re adding value by significantly outperforming on rental rates achieved and lease up velocity.
Given market dynamics, are you seeing more real estate investors enter the multifamily market?
There are fewer new entrants because many investors are baffled by the complex processes required to develop multifamily properties in London. In my opinion, the supply shortage will only worsen unless the process is simplified. London is a great city and has recovered well in a post-COVID world, particularly with respect to employment. However, everyone who lives here or has migrated here knows we're short of housing. There's an obvious opportunity in the residential space that we’re capitalizing on, but it’s hard for investors who are less familiar with the space, particularly given the challenges of new development.
A specific area of opportunity for increased investment into the U.K. residential market is with REITs. In the US, REITs own large multifamily portfolios, while in the U.K., private capital and institutions are the long-term holders of the asset class. There’s a real opportunity to develop a more active U.K. REIT market, which would provide the opportunity for a wider group of investors to gain exposure to the asset class on a liquid and cost-effective basis.
Finally, there's a real lack of government agency financing for most multifamily products in the U.K. that is commonly available in the US. I could see a similar product being developed in the U.K. in the future, or a beneficially enhanced financing pool to help increase housing supply. That’s also really needed. By and large, there’s a really tremendous investment opportunity ahead, you just need the market expertise, relationships, and creative thinking to drive value.