What is a real estate private equity investment?
The housing market is strongly influenced by the economy, interest rates, income and changes in population size. Along with these factors relating to demand, supply also plays a significant role in determining house prices. According to Statista, there are over 551,000 UK individuals who are interested in the real estate sector, and there are currently 134K active real estate businesses. As such, the sector continues to remain strong and popular. By evaluating how much income an investment will generate, one is able to equip with valuable knowledge that could help guide future investment decisions. It is estimated that the average UK rental yield is 3.63%, so any area that has a rental yield greater than this can be considered high in yield. This however, is largely because of London, which is deemed to be an extremely low-risk market, which keeps yields low – i.e. investors are willing to buy in London for very little returns on their investments.
Depending on the postcode, rental yields can vary, so it is imperative to continue researching investment locations in order to keep up with what constitutes a good rental yield in the UK. Yields in the UK are the lowest in Central London, followed by Greater London and other major cities like Manchester, Birmingham, Brighton, Cambridge, Oxford, etc., with the highest being in smaller markets with population fewer than 500,000 people, like Coventry, Peterborough, Leicester, Preston, etc. Prior to investing, one should be familiar with two terms (1) yields and (2) cap rate. Both are usually the same number, but yield is what one earns from an investment while cap rate is the multiple in % one is willing to pay for an asset based on its income.
If an investment of £500K generates an income of £25K, Yield is 25K / 500K, i.e. 5%
If an asset generates £25K and the investor expects to earn 5%, the investor will offer an asset price equal to Income / Cap Rate, i.e. 25K / 5%, i.e. £500K.
What is Yield Investing
As a percentage, yield represents the earnings generated and realized by an investment annually. Most yields are calculated on an annual basis, although some yields are computed on a quarterly and monthly basis as well. A yield should not be confused with a total return, which is a more comprehensive measure of the return on an investment. The market price, invested capital, or the security's face value determines the percentage. The yield is comprised of the interest earned or dividends received over the course of holding a particular security. Nevertheless, it does not take into account, capital gains. In the case of stocks, a 3% yield for example, would mean that you would receive 3% of your total investment as income every year. Together with capital growth, it is one of two ways to earn a profit from investing. A dividend stream - which is the share of profits you receive may be provided by shares of stock.
The behavior of yields under various market conditions?
Market conditions refer to the attractiveness or lack thereof of an industry in which a business operates. There is a tendency for market conditions to influence all businesses in an industry, although the extent to which they are able to take advantage of or respond to changes in market conditions varies. Understanding the different types of market conditions begins by distinguishing what is favourable and unfavourable conditions - favourable conditions facilitate the creation of new companies, company growth, investment returns, and job stability, whereas unfavourable conditions make markets more competitive and difficult. A real change in market conditions influences yield, changing the way yield operates in each of them, and it is vital for an investor looking into the property market to understand these changes. For example, bond yields shoot up in difficult situations.
Some Market Conditions that affect yields
In industries that experience a rollercoaster of economic changes, demand can exceed supply by a wide margin (or vice versa). As firms add capacity, supply increases. There may be shortages in high demand spots such as bars & restaurants and nightclubs in a city like London, for example. As a result, more investors are likely to enter the business to cater to unfulfilled demand, or compete with existing businesses, thus pushing down yields by offering cheaper options.
As a reminder, interest rates are the percentages charged by lenders for loans, which in turn is affected by base interest rates dictated by a country’s central bank from time to time. An investor's return on investment (ROI) is influenced by this fundamental type of market condition. Like in the current environment caused by the after-effects of Covid-19 and conflict in Europe, interest rates have gone up significantly. In such a situation, the interest expense of the business goes up thereby pushing down profits. If an investor is invested in this business at this time, their yield is likely to go down because of the profits going down. This illustrates the volatility of yields in this market.
In a highly competitive market, profits will be lower. New competitors will be able to enter the market more easily if the market is contestable. The competitive environment is greatly influenced by the promotional strategies, pricing, location, and quality of the product, and not all companies are capable of ticking all the boxes. It is revealed by Simplybusiness that Bristol is one of the most desirable BTL areas in the UK due to its long-term property growth (annual average of 5.1%), the lowest number of long-term vacancies (0.6%), and over a quarter (27%) of residents renting privately.
Private Equity investing
In a low-yield environment, a private equity fund offers stable returns to investors, both institutional as well as individual. However, most Private Equity investment firms require 7-figure minimums, thereby leaving a large part of the investing population unable to participate. While the Coronavirus pandemic has caused widespread disruption in markets around the world over the past few months, private equity investing remained a high-performing investment option.
When we look back at the 2008 financial crisis, public market issuance had become stagnant, giving way to an unprecedented decade for private investments, as investors sought better returns and took advantage of companies staying private for longer periods of time. Despite the British economy experiencing multiple swings of change in recent years, private equity investments continue to improve and be well utilized. Real Estate is the at the forefront of UK Private Equity. According to Statista, the total value of private equity investments in UK portfolio companies in 2020 is £25.1 billion. In that year, the majority of investments were made in buyouts, which include purchasing majority or controlling stakes in companies. A few economic freezes aside, this proves what a great investment private equity can be, proving UK has shown itself to be Europe's most forward-thinking country in the private equity sector.
Private Equity derisking
The purpose of private equity is to provide long-term, committed share capital to assist unlisted companies in growing and succeeding. Private Equity is usually best suited for otherwise illiquid assets – real estate being the most illiquid. However, real estate is also viewed as the safest asset class. For this reason, many investors believe that private equity is the future of the economy. In spite of this, Shareholders who are considering the sale of their business, or an event which provides them with capital to derisk their personal financial exposure will be wondering if such an event is feasible over the next year, and if the time is right.
According to BVCA research, the following types of PE risks can be reduced:
Funding risk: In the absence of predictable cash flows, investors are exposed to funding risks. Private equity partnership interests are lost if payments are not made in accordance with contractual obligations. Default risk is also commonly referred to as this type of risk.
How to reduce funding risk: Through the use of cash flow simulations and cautious planning, investors can reduce the risk associated with their future commitments. The over-commitment and self-funding strategy should be avoided by investors with limited external capital available or significant allocations to illiquid assets. When considering such a strategy, investors should consider possible extreme scenarios and how much cash would be needed and how it might be obtained. In order to address these extreme cases effectively, a strategic plan as well as a plan for portfolio construction are essential.
Liquidity risk: Investors are exposed to asset liquidity risk when sold at a discount to reported NAV in the secondary market due to the illiquidity of private equity partnership interests.
How to reduce liquidity risk: Despite being difficult to reduce, liquidity risk in private equity is easier to manage for investors in an overall asset allocation strategy. A private equity investor who is solely focused on private equity assets and who needs to sell in difficult market conditions cannot avoid the liquidity risk. Private equity, on the other hand, can be traded if it is only part of a well-diversified asset allocation, as is the case with many insurance companies, pension funds, and banks. Generally, banks or insurance companies use the secondary market more often when prices are high to sell their assets rather than in distressed markets when prices are low.
Market risk: This occurs when you own an asset that can be traded on a secondary market and whose value fluctuates over time. Through the purchase of stocks, one can acquire equity in listed companies. Private equity is often incorporated into this framework as well because market risk measures are the main risks for public equity.
How to reduce market risks: As the change in net asset value reflects a short-term risk measure, market risk is also affected by the short-term movement of public and foreign exchange risks. It is therefore possible to minimize the volatility of the portfolio by diversifying it across a variety of geographies, markets, and industries.
Capital risk: Private equity investments are subject to capital risks, which can include (but are not limited to) the quality of the fund manager, equity market exposure, interest rates, and foreign exchange rates.
How to reduce capital risk: There is a close relationship between market risk and capital risk for investors. Private equity portfolios carry a high degree of capital risk for investors, defined as the possibility of losing capital over the life of the portfolio. A realised loss would be recorded in the investor's portfolio, whereas market risk is based on unrealised values would usually not. In the same manner as market risk, capital risk is influenced by both internal and external aspects.
The realm of real estate investment in the UK intertwines with the ever-shifting dynamics of market conditions and the strategic prowess of private equity. As investors navigate the intricate balance between yields, risk management, and long-term growth, the private equity sector, notably within real estate, stands out as a resilient and forward-looking avenue. With the ability to derisk and provide committed capital, private equity plays a vital role in supporting the growth of unlisted companies, particularly in the traditionally illiquid landscape of real estate. Amidst the evolving investment landscape, fractional ownership emerges as a progressive concept, opening doors for a wider investor base to participate in the real estate market. In the face of economic fluctuations, these multifaceted approaches underscore the adaptability and strength of the UK real estate sector and its integration with private equity strategies.