Authors: Stuart Cormack, Elias Stephen, Nick Lazarou, Peter Doyle, James Frixou and Brent Thompson
The Australian Build-to-Rent (BtR) market is attracting significant levels of both foreign investment (especially from established UK Build-to-Rent and US “multi-family” developers and funds that are familiar with the sector) and significant investment locally from superannuation funds and other BtR funds. Whilst Build-to-Rent projects tend to generate lower yields compared to other real estate assets such as commercial office buildings, there is growing institutional investor appetite for this asset class particularly amongst large global real estate funds who view it as sustainable long-term market.
Up until recently, tax, duty and planning law hurdles have deterred many investors (especially foreign investors) from investing in Build-to-Rent assets rather than other real estate asset classes (such as commercial, industrial or retail assets). However, some positive change is in the wings on these matters.
In a series of four articles published over the coming weeks, we consider the fast developing Build-to-Rent market in Australia and consider some of the key issues relevant to investors considering an investment in the Build-to-Rent or Build-to-Sell (BtS) market. We consider not only the growth of private rental market housing sector but also social and affordable housing and the funding sources available for such developments.
In this first article, we give an overview of the Australian Build-to-Rent Market and consider some of the key commercial issues in a Build-to-Rent project. Subsequent articles will consider the structure of a Build-to-Rent Project (including investor sources and tax aspects), construction, real estate and planning issues and financing considerations.
Rental Market Analysis in Australia
A combination of demographic and economic trends are changing attitudes towards home ownership and apartment living for many Australians.
The rental market softening in Australia from COVID-19 was short-lived as rental markets are now extremely tight across Australia’s metropolitan areas with vacancy of sub 1% in capital cities. The low vacancy environment has seen very strong rental growth with two-bedroom apartment asking rents growing by 7-17% across the major Australian capitals in 2022 and all markets having rents that exceed pre-pandemic levels. Rents are forecast to rise a further 11% in 2023 while the resumption of immigration will add further to demand. This trend is reflective of a general trend of inflation in the wider Australian economy.
Despite the growth in rental market demand, the supply pipeline of new residential dwellings has not increased at the same rate and based on project timelines of current projects, will remain under-supplied until at least 2025. Developers who might plug this gap have been squeezed significantly by rapid construction cost increases with a jump in the cost of development finance leading to relatively few large scale high density apartment projects proceeding to construction.
Other factors feeding this trend include planning and regulatory delays, and disadvantageous tax and state duty positions for global investors. As opposed to large scale high-density Build-to-Rent apartment projects, many smaller scale Build-to-Sell projects aimed at owner occupiers have proceeded to construction - demand is still strong for these more boutique projects and with shorter selling periods, there is less risk of cost escalations. However for every one of these Build-to-Sell projects in development, it means there is less land and contractor capacity to support Build-to-Rent projects.
According to a recent report from JLL, whilst there are only currently 4,340 Build-to-Rent apartments in operation nationally, there are a further 8914 Build-to-Rent apartments under construction, and 6862 apartments which have received development approval but are yet to commence development. The pipeline will continue to grow, with an additional 16,269, Build-to-Rent apartments proposed or in planning. JLL’s report indicates that as much as 59 per cent of the pipeline of future Build-to-Rent apartments was in Victoria, with 24 per cent in Queensland and only 13 per cent in NSW.
On the back of these numbers, Build-to-Rent development is set to become the biggest asset class in new property development by 2030, eclipsing offices, student accommodation and logistics. New Oxford Economics Australia research suggests that new Build-to-Rent project commencements will likely surge to $10 billion by 2030 (up from $2 billion last year).
Despite these encouraging numbers, there is still a material gap to be filled in housing availability in Australia’s major capital cities. The critically low level of rental vacancies forced the Federal Government to address the issue with housing supply being a major focus of the October 2022 budget, implementing a target of over 1 million dwellings built over the next five years (National Housing Accord Target). This was followed up by various measures in the 2023-2024 Budget which were designed to encourage investment into the sector, in which the Federal Government:
- announced that the withholding tax for Build-to-Rent developments undertaken through a managed investment trust (MIT) would be reduced and the depreciation rate for Build-to-Rent properties increased subject to certain conditions being met in relation to the relevant apartment building itself, the period of its ownership and the term of tenant leases (see below for more detail regarding these changes);
- announced the establishment of the Housing Australia Future Fund (HAFF) and the commitment of $10 billion to establish that fund (enacted by parliament on 14 September 2023 after the Federal Government agreed to invest an additional A$1 billion into the National Housing Infrastructure Facility to support the development of public and community housing); and
- amended the Investment Mandate of the National Housing Finance and Investment Corporation (NHFIC) to require NHFIC to take reasonable steps to allocate a minimum of 1,200 homes to be delivered in each state and territory within 5 years of the HAFF’s commencing operation.
The National Cabinet met on 16 August 2023 and reached a consensus, which was largely praised by industry groups, lifting the Federal Government’s National Housing Accord Target (of 1 million dwellings) to 1.2 million. This package also included $3 billion in performance bonuses available for states and territories who complete more than their per capita quota of the 200,000 additional dwellings. This additional package will help encourage the States and Territories to accelerate land release, planning and approvals processes.
The passage of the HAFF legislation, together with the commitments made as part of the National Cabinet meeting, represents a significant milestone to further facilitate investment in social and affordable housing.
Commercial issues in a Build-To-Rent Project
A number of over-arching commercial issues need to be considered when developing the strategy for a Build-to-Rent project.
Tax Landscape for Build-to-Rent Investments in Australia
Generally speaking, over the past few years, the tax and duty hurdles have deterred some investors (especially foreign investors) from investing in Build-to-Rent assets rather than other real estate asset classes (such as commercial, industrial or retail assets) due to the unfavourable tax treatment which applies in respect of residential property.
In response to industry feedback on the matter, the Federal Government, in its 2023-2024 Budget, proposed a series of changes targeted at stimulating investment in the Build-to-Rent sector including halving the withholding tax for Build-to-Rent developments undertaken through a MIT from 30% to 15% and increasing the depreciation rate for Build-to-Rent properties from 2.5% per year to 4% per year. Other Build-to-Rent tax concessions have been introduced in some states.
Challenges of Planning Laws in Affordable Housing Build-to-Rent Projects
Planning law hurdles and associated “red-tape” have stalled the development of many affordable housing Build-to-Rent projects in recent years, with local councils refusing these developments in low to medium density areas off the back of opposition from residents or community groups.
As a result of the Federal Government’s National Housing Accord Target, the NSW Labour government has recently introduced legislative reforms to both the public and private sectors which seek to address the housing crisis in NSW by encouraging the construction of affordable housing and reallocating approval powers (which would otherwise have been with local councils) to either the Minister or Independent Planning Commission. As part of these reforms, the NSW State Government has stated that 30% of new housing on public land must be affordable, social, or diverse housing. Affordable, social, and diverse housing are evolving terms which have most recently been analysed and commented on by the NSW Department of Planning and Environment.
Debt Financing Challenges in the Build-to-Rent Sector
In many ways, debt financing Build-to-Rent projects carries a similar structure and risk profile to financing of commercial developments, which is heavily influenced by market risk (including construction risk, changes to tenant demand and tenancy profile mix).
Build-to-Rent projects require a long-term debt financing solution throughout the development and construction phase which is repaid progressively during the operational phase from the project’s rental income stream. As a result, banks and financial institutions are on risk for a longer period of time and as a result, it can be difficult to obtain debt funding for the construction costs.
The Federal Government has sought to mitigate such issues by providing an additional source of long-term, low cost funding for any Build-to-Rent project which involves at least 50% affordable housing through NHFIC. As a result, banks and financial institutions are on risk for a longer period of time and so need to be convinced of the long term viability of the project post construction and into the operations phase.
Navigating the Challenges of Rising Construction Costs
Surging construction and financing costs have challenged the viability of both Build-to-Rent and Build-to-Sell projects. The risks around Build-to-Sell (which offers a developer the highest margin) in the current market relate to building costs, interest rates and the appetite of investors to buy off the plan. From this perspective, Build-to-Rent projects can be differentiated as they require only one sale to an institutional buyer, rather than many different sales to individual buyers. Operational costs tend to be higher on a Build-to-Rent development than on other asset classes, as many of the capital and repair costs and other holding costs of the asset (such as land tax) cannot be charged back to the tenants under their residential tenancy agreements. One potential mitigant for increased financing costs is to structure any proposed financing for a Build-to-Rent project as a sustainable loan.
Site selection, Amenities and management
To be successful, a large scale Build-to-Rent development generally needs to be in a major urban area, close to local amenities, have strong transport links with a good asset / property manager. Build-to-Rent investors may find themselves competing for suitable sites with Build-to-Sell developers or investors, who are able to realise their profit at an earlier stage.
Another consideration for any Build-to-Rent development is the ongoing appeal of the building to tenants through amenities and design features and whether it has the appropriate attributes to attract the target rental market. A Build-to-Rent development will need to be affordable, sustainable and community-focused while offering a high standard of on-site management services in order to encourage customers to reside in the development for longer tenancy periods.
A detailed consideration of each of the matters noted above will appear in our subsequent articles.