LONDON, July 12 (Reuters) - Aviva, Legal & General and M&G are ramping up investments in rental homes in Britain, betting on long-term returns in a market where housing demand far outstrips supply, even though the country's new Labour government could impose tougher regulations.

Institutional investment in Britain's rented housing sector is playing catch up, as it accounts for just 2% of the total rented stock, as opposed to more than 35% in Germany and the U.S., according to Savills.

The rented sector - which includes student housing and retirement homes - has fared better than the wider commercial property market, which is facing tough conditions after a period of soaring borrowing costs and changing working patterns.

"Investors are really keen on all these living sectors, it's a bit like the battle of the beds," said Rebecca Shafran, head of alternative residential research at BNP Paribas.

Aviva, L&G, M&G and Royal London Asset Management told Reuters they planned to increase their investments in rental homes in Britain by hundreds of millions of pounds.

Aviva Investors has channelled 750 million pounds into the sector in the last 18 months and wants to triple that within three to four years. The company said its latest deal was with housebuilder Barratt to deliver 101 rental homes in Cambridge.

Potentially stricter rental regulations are a worry but not as much as interest rates remaining higher for longer, Aviva Investors' head of real estate investment, James Stevens, told Reuters.

L&G has been amassing commitments from its insurance business and external investors to increase investment from 2025, head of residential, Dan Batterton, said. Any move towards rent controls needed to be carefully conceived to avoid deterring investors, he added.

Foreign investors are also targeting Britain, with U.S. fund giants PGIM and Blackstone recently striking big deals. Although PGIM told Reuters comparatively low returns and high construction costs posed challenges.

REFORM BILL

Investors have largely welcomed the new Labour government's pledge to "get Britain building again".

Finance minister Rachel Reeves used her first speech on Monday to promise the government would overhaul planning rules and use the private sector to deliver 1.5 million homes within five years.

But investors are also awaiting details of planned legislation to provide more protection for renters, expected early in the new parliament.

"We have still got the threat of more regulation potentially hanging over the sector, notably rent controls, which would suffocate capital coming into the market," said Rick de Blaby, CEO of build-to-rent developer Get Living.

One large foreign institutional investor, who declined to be named, said it had paused investment decisions on rental homes in London pending clarity on a rent cap policy.

Potentially stricter rental regulations are a worry but not as much as interest rates remaining higher for longer, Aviva Investors' head of real estate investment, James Stevens, told Reuters.

The UK housing ministry declined to comment.

Campaigners say there are compelling reasons for rent controls in Britain linked to inflation and wage growth.

"The market is spiralling clearly out of control, and people are suffering," said Conor O'Shea from renters' campaign group Generation Rent.

PREFERRED SECTOR

Residential was the most preferred sector for investment for European real estate funds as a whole in 2024, data from trade body INREV showed, with the share of their portfolios in homes rising more than three-fold in a decade to 23%.

Investment into Britain's build-to-rent sector hit 2.6 billion pounds in the first half of 2024, according to Knight Frank, the highest since it began tracking the market in 2016.

"The biggest fear at the moment with investors... I'll cut to the chase, is rent caps," said Andrew Screen, head of residential capital markets at BNP Paribas. "I'm a firm believer that if you want to reduce rents, increase supply," he added. (Reporting by Iain Withers in London and Aby Jose Koilparambil in Bengaluru, Editing by Tommy Reggiori Wilkes and Jane Merriman)