PRS Reit: buy-to-let without the bother

The removal of mortgage interest relief for buy-to-let investors and potential reform to the capital gains tax regime have made letting residential homes less attractive for individuals. Add in the greater financial strain faced by tenants following the outbreak of the pandemic, and you can see why some are considering cutting back their portfolios or exiting the market altogether. That is something a quarter of landlords surveyed by National Residential Landlords Association (NRLA) at the end of last year said they planned to do over the next 12 months.  

Yet the need for rental properties within the UK is rising rapidly. The PRS Reit (PRSR) could offer a way for investors to gain exposure to this growing demand, without the taxation or operational headache of investing directly in the buy-to-let market. The group operates a portfolio of rental houses and apartments across England, excluding London, with sites ranging from 16 to 298 units. It contracts with housebuilders, including Countryside (CSP) and Vistry (VTY), to construct the homes, which it then lets to tenants on standard short-hold assured tenancy agreements. 

The Reit was admitted to the main market in 2017 after raising an initial £250m to fund the development of private rental housing, which included an initial investment of £25m from the government's Homes and Communities Agency. The investment adviser is a subsidiary of Aim-traded private rented sector and residential development specialist Sigma Capital (SGM). 

The need for more rental stock seems clear. Around 40,000 rental properties a year have left the market since the 3 per cent stamp duty surcharge on second homes was introduced and mortgage relief began to be phased out in 2016, according to research by Savills (SVS). Research from Hometrack revealed that there was a 4 per cent contraction in the supply of homes coming to the market to rent between the end of 2017 and 2019, as non-professional landlords left the market. 

Over the longer term, the affordability constraints of getting on the housing ladder have helped push the number of households in the private rental sector up by almost two-thirds during the 10 years to 2017, according to the Office for National Statistics' latest market figures. Demand continues to grow – in 2019, enquiries and online browsing activity relating to rental properties increased by 8 per cent, according to data from Hometrack, and rose a fifth last year. Indeed, with the stamp duty holiday causing house prices to rise rapidly and the availability of mortgages at higher loan-to-value ratios still restricted, buying a home does not look as though it will get easier any time soon.

Will rental income continue to rise?

PRS has been gradually scaling up its portfolio since IPO, predominantly via new developments. The six-week closure of construction sites in the immediate wake of the pandemic cut output by an estimated 600 during the year to June. However, the Reit still managed to complete 909 homes, an increase on the 768 delivered the prior year. By the end of September, the portfolio stood at 2,634 homes, almost double the same time in 2019. By the end of December, this stood at 3,163 homes, 96 per cent of which were occupied, rising to 98 per cent after including qualified applicants that were due to move in. 

The acquisition of a fully let development of 123 homes in Greater Manchester last month meant the Reit had fully invested its £900m in funding resources, comprising £500m in equity raised and debt of £400m. Together with the 2,000 homes under development, that has put the group on track to achieve its target portfolio of 5,200 homes by the end of 2021 or early 2022. The estimated rental value of those 5,200 homes is £50m.  

Rental income has stepped up markedly as homes have been completed, more than doubling to £10.2m during the 12 months to June. Yet the pandemic has understandably sparked concern among investors that tenants being placed under greater financial pressure could cause a rise in occupiers failing to pay rent. Thus far, rent collection has remained solid, with PRS collecting 100 per cent of rent owed for the six months to December. Total arrears stood at £0.2m at the end of December, equivalent to just 1 per cent of the estimated rental value of completed homes. 

However, there is the chance that rent collection rates could falter once the government’s furlough scheme finishes at the end of April, which is shortly before unemployment is forecast to hit its post-pandemic peak. The prospects for rental rates across the market in the coming months could also be shaky. While rents in London – to which PRS has no exposure – suffered the most in the months following the outbreak of the pandemic, average annual rental growth has also slowed outside the capital. The average annual rent increased by 1.7 per cent during the three months to September, according to Zoopla, but that was down from 2.2 per cent during the previous quarter.  

How promising are dividend prospects?

In June, management announced that it would lower the target dividend for the 2020 financial year to 4p a share in light of disruption to construction during the first lockdown in March last year. For the current financial year, it is targeting a minimum payment of 4p a share; consensus forecasts are for 4.25p in 2022, which is higher than the forecast in the accompanying table. At the current price, that leaves the shares offering a potential dividend yield of 5.2 per cent, rising to 5.5 per cent the following year.  

However, dividends, which are paid on a quarterly basis, have yet to be fully covered by underlying earnings. Panmure Gordon forecasts that the Reit will have completed more than 4,000 homes by June, which it expects to boost rental income to the level that the dividend is covered around 90 per cent on an annualised basis. It forecasts subsequent dividends will be fully covered. 

Earnings per share are expected to jump during the next financial year and more than double in 2022 as the portfolio scales up. If that materialises it could enhance the security of dividend payments and help narrow the gap between the share price and the Reit’s net asset value (NAV). That stands at 19 per cent versus the last reported NAV at the end of June last year and 20 per cent compared with forecast NAV at the end of June this year. The board also this week confirmed its intention to apply for the shares to be admitted to the premium segment of the LSE early this year, which could help broaden the shareholder base and create demand. 

 Affordability constraints associated with getting on the housing ladder are likely to mean demand for rental property continues to rise, at least in the medium term. The prospect of rising unemployment this year means private landlords could face a heightened level of tenants defaulting on their rent, although PRS Reit’s performance on that score, thus far, is encouraging. The discount attached to the shares, versus the Reit’s NAV, looks attractive.

Last IC view: Buy, 88p, 25 Sep 2019