Investment returns are broadly split into two categories: capital appreciation and income. When investing in stocks, capital appreciation occurs when stock prices go up, and you profit after the stock is sold. That same stock may also offer an income in the form of a dividend, a regular cash payment from the profits of the company.

In the bonds market there is no capital appreciation per se, there is only income through the regular coupon payments. That said, bonds that are bought at a discount to their face value can be redeemed at maturity for the full amount, thus simulating a defined rate of capital appreciation.

Investing in property can be seen as a hybrid of the two assets, though it has more in common with bonds, and investors often include real estate investments in optimised portfolios as long-term hedges against inflation or long-term income streams. Whilst there is no hard and fast rule for real estate allocations within typical portfolios, some studies have shown a typical allocation of 10 percent, and, at least on an individual level, the proportion of investment value tied up in real estate increases from that point to over 30 percent.

Given the potential for capital appreciation to net out the relatively high transaction costs on a long enough time scale, the only key differentiator between an income stream from a large PRS asset and an income stream from a similar bond is the standardisation and inherent marketability of those assets. But the PRS (Private Rented Sector) residential market may be considerably underpriced relative to its characteristics.

In order to price real estate more accurately, it crucial to understand the flaws of the current model. Currently, in the residential property market, the most common method to price a property is to go above or below the sell prices of comparable properties in the area, adjusting for current market trends. But this method tends to create a level of autocorrelation in the property market, as higher or lower prices feed back into even higher or lower prices.

Meanwhile, in the commercial property sector, it is common to derive the value of the property based on the rental yield. The price can be calculated by dividing the rental income (gross or net) by the yield, which is usually determined through the use of comparables. Although this method of pricing is derived from the financial sector, yield in the bonds and securities markets are treated differently: they factor in the final repayment of the initial investment and make assumptions about the ability to re-invest returns. Current pricing calculations for residential property tend to only account for the current year rent/cost, rather than using an IRR (internal rate of return) calculation for income streams, and therefore underestimate its the investment potential of residential real estate by not accounting for reinvestment. Using IRR more frequently in residential investment would standardises the approach and can give investors a certain metric from which to determine investability.

It is also worth noting that the typical monthly payments from real estate tenants, in contrast to bi-annual bond payments, confer additional advantages. In the time a bond holder receives one payment, a property owner could have already received six monthly payments. When it’s possible to re-invest the proceeds, the marginally earlier repayments from the property asset also gain an additional small compounding benefit. The second advantage is more conceptual.

In the absence of a market or other forms of analysis and information, the only information available to an investor is his current income stream. By this logic, the more frequent the payments, the more updated information the investor has, and the better he may be able to react. More simplistically, the loss of one period of rent (yield x 1/12) is not as bad as the loss of one period of bond coupon payments (coupon x ½).

The competitive advantages of residential real estate are derived from its natural inflation-hedging characteristics and its potential to appreciate over the long-term. Considering all of our calculations, we believe the PRS investment is currently undervalued by the market. Our comparisons show that the yields on professionally-managed residential portfolios should fall in line with other investments over time.

At present there is still the potential for significantly higher returns on investment in real estate than in comparative debt securities. This will be welcome vindication for those already in the market in what was once an uncertain asset class. For those looking to enter the market, take this as data-backed encouragement.

Over the course of the research and conceptualization of this white paper, we have seen continued yield compression on residential real estate in the UK, in line with our expectations as outlined in this whitepaper. We expect to see that compression continue until large scale PRS investment is aligned with other asset classes.

For more details on how we came to this valuation for the PRS market, download our white paper here:

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'REalyse (Treex Ltd) does not provide any form of investment advice or property advice or any other regulated function. Note that any information or opinions, presented or referred to in this article are for information purposes only. Any actions taken by a reader are done entirely at their own discretion, you are responsible for your own investment decisions and hold Treex Ltd harmless from the results of any such decisions'. Whilst every effort has been made to ensure the accuracy of the information herein some inaccuracies may remain.'