Five pension funds agreed last year to commit £100m to a fund aimed at building and managing housing in the private rented sector. Room151 reveals how it came about.
The Hearthstone Residential Fund 1 (HRF1), a ten-year closed end fund, had its first close with a £100m in committed capital from five Local Government Pension Schemes (LGPS of Staffordshire, Nottinghamshire, West Midlands, Derbyshire and Teesside) in December 2017.
The fund announced its first acquisition in January this year: a portfolio of four almost fully-let low-rise blocks of flats in Birmingham, Manchester and Nottingham from the Hermes Countrywide Vista Fund.
The HRF1 focuses on private rented sector (PRS) primarily new-build clusters of housing and low-rise blocks of flats in suburban locations through forward purchase deals with builders.
The objective is to generate an acceptable investment return from a well-diversified, institutional quality portfolio.
When there is an opportunity to enhance returns HRF1 will consider acquiring standing stock, provided it conforms to HRF1’s stated objectives in terms of location with good local employment and social infrastructure which reinforces sustainable rental demand.
HRF1 invests nationally, with assets allocated across six broad regions benchmarked against ONS property market weights to avoid over-concentration. A built-in margin is provided to give some flexibility to the managers.
As has been the case for other emerging property sectors, residential property is expected to become a mainstream segment for UK pension funds, with investment portfolios increasingly traded as the sector matures (a good example of a maturing sector is student housing).
Drivers
The Hearthstone partners took three years to bring HRF1 to life, focusing almost exclusively on LGPS as potential investors. The initial engagement began with a series of regional group presentations followed up by a long series of individual meetings across the UK.
The principal drivers for that focus were the growing interest from LGPS in diversifying further into property, away from historically dominant strategic asset allocations to equities, and the search for a satisfactory level of indexed income in a world of low interest rates.
Indeed, asked why they invested, first close investors said: “PRS offers a steady real income-generating investment at a time when traditional equity and bond markets are looking expensive and offering relatively low income returns.
“As LGPS investors, we focus on long-term rising and compounding income streams which can provide a match for our index-linked pension liabilities.”
HRF1 targets distributed income net of all costs of 4%+ and a total return over the life of the fund of over 9%. This is through a combination of indexed income, a gradual increase in capital values over the life of the fund and the benefits of a disciplined process at the point of acquisition.
As has been the case for other emerging property sectors, residential property is expected to become a mainstream segment for UK pension funds, with investment portfolios increasingly traded as the sector matures (a good example of a maturing sector is student housing).
Residential property offers the benefit of steady yields and lower volatility through economic cycles compared with commercial property.
UK institutions, unlike their peers across the industrialised world, have traditionally avoided the sector despite its size and low volatility of income returns.
This gives rise to potential benefits from scale and competent management where the interests of residents, communities, and investors are aligned.
The current structure of the UK PRS market is very fragmented, with over 90% of the stock held by landlords holding less than five units. The result of this fragmentation is that the market is dominated by rental stock that is well past its “sell by” date, in general of lamentable quality, badly maintained and expensive.
By bringing scale and good management, institutions can quite quickly set the benchmark for housing quality by offering a well built and well maintained, fairly priced competitive product where tenants are valued and treated as customers.
The presence of institutional investors can assist in the acceleration of housing projects, both new build and regeneration, leading to an increase in the housing stock and its quality, as well as acting as a spur to the improvement or creation of vital social infrastructure.
This is the reason why managers are increasingly engaging with councils and combined authorities as a means to identify projects, initiatives and their drivers early.
Governance
A further characteristic of HRF1 is its governance structure, in part tailored towards the specifics of the LGPS. The advisory board of HRF1 is currently chaired by Melanie Stokes, head of treasury and pensions from the Staffordshire Pension Fund.
The investment committee (IC) has one of two independent seats formally reserved for a representative of LGPS investors over the life of the fund.
This is not a superficial detail, as the IC has veto power over potential acquisitions. Currently the position is held by Brian Bailey, non-executive chairman of PIRC and formerly head of pensions at the West Midlands Pension Fund. In an earlier career Brian was assistant director of a large council’s housing department.
There was early recognition by the partners of Hearthstone that potential sustainability issues and reputational concerns were an especially sensitive area for LGPS investment activity. The project evaluation process ensures that due consideration is given to responsible investment issues throughout.
HRF1 has a final close target of £200m, and it is currently capital raising. It has identified a number of opportunities across the UK, including both new build projects and standing stock generating immediate income.
Recognising that a lengthy lead time is unattractive, the fund terms stipulate a two-year investment period from commitment. Buying into standing stock and the house builders’ existing delivery pipelines helps to accelerate the receipt of income.
Fortunately, preparatory work during the pre-launch phase and ongoing discussions housebuilders show those objectives to be realistic and achievable.
This article was produced in cooperation between the five LGPS funds and Hearthstone Investment Mangement.
