INSIGHT

Build-to-rent - structures for success

By Michael Graves
Build-to-rent Capital Markets Property & Development

In brief

While it is an established asset class offshore, particularly the US and UK, the build-to-rent market in Australia is in its infancy. For build-to-rent to become an established asset class in Australia, social, legal, tax and broader economic challenges need to be overcome. Recent legislative reform and a clear desire from key industry participants to grow the market show that green shoots are emerging in Australia's build-to-rent sector. Michael Graves and Tim Chislett set out how build-to-rent developments could be structured, and highlight the key differences in risk profile from other commercial developments.

Background

Australia's residential developers and investors have long favoured the build-to-sell-model, where capital is tied up for a shorter period and returns are quicker and often greater. Build-to-rent assets also have a different risk profile to other asset classes, such as commercial office buildings. These differences will influence how build-to-rent projects will be structured and who the likely players in the sector will be.

Despite the different risk profile, we expect Australian banks will be willing to lend to build-to-rent developers and investors. However, we expect that because of this risk profile, the debt-to-equity ratio will be less than for a more traditional commercial or residential development.

The appeal of a fund through model

As an alternative to bank finance, investors (such as superannuation funds and offshore funds) looking for steady returns who may be attracted to a lower yield, lower risk investment, could play a critical role in the establishment of this asset class in Australia. Such investors may be willing to fund development and enter the market using a fund through model.

cure23aug18.png

While the sector is in its infancy, to better manage their commercial risk exposure, investors may only be willing to acquire part interests, with the developer retaining the balance. This would ensure the developer takes not only development risk, but risk in the ongoing operation and ownership of the asset. In those cases, parties will need to give careful consideration to how their co-owner relationship will be regulated.

The key differences in risk profile for build-to-rent

Tenant Pre-commitments

Unlike other commercial developments such as office buildings or shopping centres, we think it is unlikely that a developer will be able to secure significant levels of tenant pre-commitment for a build-to-rent project. Investors and financiers will therefore need to rely mainly on market demand reports to determine the feasibility of the project.

To partly mitigate this risk, developers may seek to attract pre-commitment from long-term tenants by offering incentives or bespoke apartments. To attract investors, developers may be willing to provide rental guarantees for a period of time following completion.

Stability is key

Investors and financiers will also need to be comfortable that there will be a high turnover of tenants, requiring a significant level of management. Investors and financiers will need to have confidence that the building will remain attractive to tenants long term to be sure that it will be easily re-let.

Shorter leases present risks and opportunities

We expect that many tenants who would be attracted to the build-to-rent market will appreciate the flexibility of not owning a home. Such tenants will prefer to have a short lease term to ensure they maintain that flexibility.

This will not provide comfort to a financier, as the weighted average lease expiry (WALE) will, in most cases, be less than a year. As mentioned above, to partly mitigate this risk, we think developers will be able to attract long-term tenants in some circumstances. Further, in a rising rental market, a low WALE will, of course, give investors the benefit of the reversionary rental uplift.

Developers can deliver tenants greater amenity

One of the most attractive elements of a build-to-rent product for young inner-city renters will be the greater access to amenity and services such as in-house cleaning, maintenance, landscaping and on-site property and facilities management.

When structuring a fund through transaction with an investor, developers will have the opportunity to secure the management rights for the asset. Developers will be able to use the scale of their related management companies to provide exceptional services at a low cost, which will attract and retain tenants as well as generate additional sources of revenue from the asset.

Ultimately, developers and operators will seek to establish brand loyalty, where renters will follow a brand throughout their renting life.