* Young professionals rent in co-living developments
* Microflats can earn higher rents than traditional properties
* Planning restrictions may hold back growth
Aug 23 (Reuters) - Millennials priced out of London's traditional housing market are opting to rent tiny apartments in so-called "co-living" developments, a fast-growing area that private investors and venture capital are eager to tap into.
Investors have put more than 1 billion pounds ($1.28 billion) into "microflats," where residents share facilities such as dining areas, lounges, work spaces, laundry rooms and gyms, and the investors are looking to do more.
The Collective, a property company founded in 2010, is one of London's major co-living developers. Its Old Oak co-living apartment building in west London is the world's largest, with 546 people living across 10 floors, according to its website.
Reza Merchant, chief executive of The Collective, said: "There's a complete lack of affordable and good quality accommodation for young working people."
Merchant said The Collective was looking to secure more sites across London as well as in other major global cities.
Microflats - which typically range from 200 square feet (about 20 square meters) to 350 square feet for a studio apartment - are already being built across the world, from Hong Kong to New York.
The Collective says tenants at Old Oak have a median age of 28 and a median income of 32,000 pounds per year. They pay 230 pounds to 360 pounds per week, including bills.
"For people at certain stages of their career ... it definitely makes a lot of sense," Ivan Soto-Wright, a 27-year-old resident of The Collective Old Oak, told Reuters.
The co-living microflats market now accounts for 5 to 10 percent of Britain's 25 billion pound build-to-rent private rental sector, made up of institutionally-backed blocks of flats built for families to rent, James Mannix, head of residential capital markets at property group Knight Frank, said.
Investors say the micro-units create more attractive income streams as the more efficient use of space means the rent per square foot in each flat is 10-15 percent more than for traditional rentals.
"This strategy will provide us with an investment that has long-term, defensive characteristics," said Arron Taggart of hedge fund Cheyne Capital Management, which has invested in one of The Collective's schemes.
Although investors say they expect demand for microflats to grow, planning restrictions could become an issue because specific local authority permission is needed for new builds.
Native Finance, backed by venture capital firm Passion Capital, is seeking to get London's local authorities on board. Native's co-founder Prasanna Kannan said by working with local authorities it can be possible to build more of these innovative schemes.
But large property investors in Britain's private rental market have tended to focus instead on developing more traditional apartment blocks designed for families to rent.
And others in the industry see limits to co-living developments as an investment class.
"While it is hugely socially encompassing, it does have its drawbacks from an operational perspective. You might have high voids, it costs a lot to run," Toby Nicholson, a director in property company Colliers' private rental sector team, said.
"It is going to be relevant, but it's not going to overtake or outweigh the traditional approach to residential in terms of studios, one and two bedroom regular flats," Nicholson said.
In central London, small apartments now make up a big chunk of the rental market. In the year to July 31, 42 percent of the flats let in prime central London have been studios and one bedroom units, as single people and couples opt for location over size, property investment fund London Central Portfolio said.
Residents like Soto-Wright said the benefits of micro-flats outweighed any drawbacks.
"The spaces are definitely small ... (but) as an entrepreneur you really want to bootstrap and be smart around your expenses."
But size remains an issue.
"On the micro-sites ... people are starting to rethink how small should they be going," Roger Southam, a director in Savills' property management team, said. People do not want to stay in another format of student accommodation when they are starting their journey into business life, he added.
The Collective's new schemes will have slightly bigger apartments. "I think slightly larger units is driven by the fact that we want to create more longevity in our product," Merchant said.
And in the market for residential sales, small size can be a drawback in terms of sale prices.
A survey published this month by consumer group Which? found that in terms of sale prices, smaller residential properties did not perform as well as larger ones.
Price growth for apartments smaller than 37 square meters was 6.9 percent, while larger properties achieved growth of 8.7 percent, the Which? survey said. Britain's minimum standard size for a studio apartment is 37 square meters.
In terms of yield, microflats have a net initial yield of 50-100 basis points above a traditional build-to-rent private rental sector project, Adam Challis, head of UK residential research at property consultant JLL, said.
Property group Savills said a traditional build-to-rent private development in London has a 3.5-4 percent net yield. Knight Frank puts comparable prime central London yields at 3-3.25 percent.
A microflats project being developed at London Bridge in central London by property group Spaces is expected to have 172 units and be worth about 80 million pounds, delivering a net yield of 4-4.5 percent, Jatin Ondhia, CEO of Shojin Property Partners, which has invested in the project, said.
Shojin and its investors have provided most of the equity for the Spaces' project and Ondhia said they were keen to fund other projects and will launch an online crowd-funding platform on Sept. 1.
Spaces, which has previously used private investors and some senior debt to fund developments, is now in "advanced discussions" with a few large institutional backers.
"They're willing to back us from a strategic perspective so we've got the ability to deploy capital quite aggressively and quite quickly and bid effectively on land opportunities," Spaces Development Partner Zafar Bhunnoo said.
A litmus test of institutional interest will come with the outcome of the sale of The Collective's Old Oak scheme, property consultants said. The development was put on the market earlier this year.
($1 = 0.7797 pounds) (Reporting by Esha Vaish in Bengaluru; editing by Alexander Smith and Jane Merriman)