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Developers and investors: Cash in on affordable housing

20 Feb 2018

Investment is needed in the affordable housing sector. Historically, growth in this sector has been hampered by perceptions of high risk and, as a result, undervalued investments.

“If investors take the time to do their due diligence they could find South Africa’s housing shortage is also an opportunity for high investment yields,” says Private Equity Analyst at RisCura, Kiara Suttner.

Research shows that current yields for prime location residential property range from 5% to 5.5%, while affordable housing sectors are seeing yields of between 8% to 10%.

As investors struggle to achieve favourable rental returns in South Africa’s high-end property market, the affordable housing sector’s high rental yields have not gone unnoticed.

Real estate consultant, Knight Frank’s 2017 research shows that current yields for prime location residential property range from 5% to 5.5%, while affordable housing sectors are seeing yields of between 8% to 10%.

Meanwhile, according to Lightstone’s residential property report for November 2017, the low-value housing sector saw the biggest price inflation at 36% in October 2017, with luxury market prices increasing by just 1%.

Market conditions also currently favour the affordable housing sector. FNB’s Sub-Regional House Price Indices for November 2017 show that affordability in the expensive market continues to drop, leading to growth in the affordable housing sector.

Already the latter has recorded noticeable price growth of 17.5%, up from 5% in 2015. Furthermore, recent statistics show that competition for home loans among banks has increased, showing higher approval rates, up from 71.5% in 2016 to 73.6% in 2017.

The figures from Standard Bank’s affordable housing unit show that demand is so high that the affordable housing sector cannot keep up. In 2017, the unit reported a gap of between 60 000 to 70 000 units per annum in the sector, with only 6 000 units being built annually.

The figures from Standard Bank’s affordable housing unit show that demand is so high that the affordable housing sector cannot keep up.

Yet, the high cost of capital, due to the level of perceived risk in the affordable housing sector, is preventing investors from reaping high risk-adjusted returns.

“This leaves the market underserved, with lenders, investors and developers cautious to enter, despite the clear demand for this type of housing," Suttner says.

While the operating and financing risks and a lack of transparency drive up the cost of capital, the impact of these risks is likely overstated due to skewed market perceptions.

“It is important to consider the difference between the perceived high cost of capital and the actual cost of capital, as well as how it creates an opportunity for high risk adjusted returns,” says Suttner.

So, what are the perceived risks driving up the cost of capital in the affordable housing sector, and why?

“The main risk is default. There is a perception that this risk is higher in the affordable housing market due to cash-strapped tenants. However, affordable housing property, Real Estate Investment Trusts (REITs) have reported very low vacancy levels and bad debt write-offs in well-managed, affordable housing developments,” she says.

Lease strength, commonly referred to as “covenant strength”, is used to determine the quality of a tenant, and is another such risk. In the residential property sector, non-paying tenants are protected by strong eviction laws, making the lease strength lower, and creating more risk and ultimately increasing costs of capital.

Due to the risk associated with finding numerous investors to sell units to at the end of a development, REITs are a guaranteed buyer and thus provide developers with a much-needed exit path.

“Most developers build to sell and have no incentive to collect rentals, necessitating the use of rental agents or the collection of rentals by investors, which heightens the perceived unattractiveness of this market,” says Suttner.

The lack of liquidity poses a risk for developers and investors alike and raises actual costs of capital in the existing market. However, as more investors enter the market, developers will have more exit opportunities. These investors will grow the secondary market, thus resulting in a further reduction in the cost of capital.

Liquidity is also increasing as REITs aimed at affordable housing are being listed on the JSE. REITs trust’s such as Indluplace and, more recently, Balwin Properties‘ partnership with Transcend, have launched the very first funds focused on the affordable housing market.

Due to the risk associated with finding numerous investors to sell units to at the end of a development, REITs are a guaranteed buyer and thus provide developers with a much-needed exit path.

The REITs are incentivised to support efficient development of new stock as this allows them to secure a pipeline of growth in earnings for their shareholders.

“Financial risks pushing up the cost of capital in this market include difficulty in obtaining financing. Debt funding is a crucial aspect of creating sufficient returns to equity, and with stricter lending policies being implemented by the banks, it is harder for new developers to obtain funding to enter the market,” Suttner says.

The private equity industry’s appetite for affordable housing remains low due to risk. However, the industry has seen success in investing in affordable housing.

Global private equity investor, International Housing Solutions (IHS), delivered a 24.5% risk-adjusted return in its first successful South African project exit in 2013. Since then, it has seen double-digit returns in this market.

“Together, these facts and figures show that South Africa’s affordable housing sector can offer investors strong rental growth and returns,” says Suttner.

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