Secure income strategies: How secure is secure?

In recent years, there has been growing interest in the UK in secure-income assets (SIA) as a solution for the liability-matching requirements of pension funds. According to Stuart Hitchcock, head of portfolio management, private credit at LGIM, it is a broad “landscape, consisting of corporate, alternative, infrastructure and real estate debt asset classes”.

Douglas Crawshaw, global head of real estate manager research at WTW, says: “The long-term trends for this sector continue to be very strong. Most UK schemes are moving towards a liability-matching solution… which inevitably results in further interest in secure-income assets.”

Boris Mikhailov, head of client strategies at Alpha Real Capital, agrees, pointing out that 87% of UK defined-benefit schemes are now closed. “Pension schemes generally are becoming increasingly cash-flow negative,” he says. “[They] will continue allocating to income-generating assets as they de-risk in preparation for their endgame of self-sufficiency or buyout. As corporate bonds offer increasingly poor value, so investors have turned to secure-income assets that provide higher yields and inflation protection.”

Additional support, as Crawshaw observes, comes from the fact that “secured income has proved itself” during the pandemic. “In general, rental payments have been broadly more consistent for secure-income assets than in the wider market,” he says.

“COVID provided a real test of secure-income resilience,” says Mikhailov. “What we found is that secure income did exactly what it said on the tin.”

In fact, the main concern for Crawshaw is a growing number of players “crowding into the same space and prices are going up”. He says: “I therefore like to see differentiated products. Differentiating between investment managers and strategies is very much what we are looking to do.”

What could that differentiation look like? Many fund managers point to their scale. Hitchcock says LGIM’s scale “affords us an unparalleled network of relationships to tap into”. He continues: “The platform’s reach and relationships with key stakeholders such as governments, agencies and local authorities, allow us to unlock a pipeline of opportunities not available to all.”

Hugo James, who left Alpha Real Capital more than a year ago to join Macquarie Asset Management as divisional director of private credit, says: “Scale is a distinct advantage for our team. We are able to pursue larger transactions thanks to our large client base and ability to bring in co-investment.”

John Harding, head of product strategy at BlackRock, says: “The key differentiator for BlackRock is the advantage we have as a large asset manager with considerable resources. This means we are able to source excellent deal flow, have good risk-management systems in place, and advanced use of big data.”

Renos Booth, head of long income real estate at Aviva Investors, takes a different tack. “Our [unique selling point] is a focus on stronger credit,” he says. “A focus on stronger counterparty credit provides not only greater income security but also greater capital stability.”

For Philip Rose, CEO of Alpha Real Capital, “our capability in origination is a key differentiator”. He says: “We originate over 80% of all our investments – a very important competitive advantage.” 

ESG opportunities

“We’re in a different market cycle now,” says Harding. “Two major themes are the impact of inflation and the ever-increasing importance of sustainability.”

According to Rose, ESG has always been central to secure income, with 43% of Alpha Real Capital’s assets “related either to environmental investments like renewable energy or to social infrastructure that encompasses not just social housing but also healthcare and education assets”. The company has more than £800m (€956m) invested in wind and solar. “In future we are likely to invest much more in this area and we have a specialist wind fund for investors,” Rose says.

He continues: “There is definitely growing investor appetite for secure income from social infrastructure. The sector is going to get an awful lot bigger. It is estimated in the UK £50bn of additional investment will be needed in the next 10 years, especially with an ageing population.”

Crawshaw agrees: “For me, the most interesting strategies at the moment are in the healthcare sector and the senior-living sector, especially given the growing and ageing population.”

But ESG also poses challenges. Crawshaw raises the question of stranded assets as real estate transitions to net zero. “The key for secure-income real estate is just how secure that long-term income stream is,” he says. “How reliable is the receipt of income in the future going to be and what exactly will be the future of the asset at the end of the lease?

“We believe that managers need to put more emphasis on environmental and social impact to make sure that their end assets have a sustainable long-term future. There is a very real risk of stranded assets in the secure-income sector from a net-zero perspective, given the long-term nature of the leases. An asset labelled as secure income may not, in reality, be as secure as it’s perceived to be.”

Harding says secure-income investors should “always have an eye on the future of the asset”. He says: “Could you sell an asset on? We are constantly reviewing the danger of stranded assets in our portfolios and attempting to predict 20 years out.”

Crawshaw is clear on what is required: “Engage, engage, engage – investment managers need to remember that there is always something that can be done through tenant engagement.” 

Harding says: “Fortunately, there is an ever-increasing willingness amongst tenants to cooperate with the provision of information as we move towards net zero.”

The impact of higher inflation

Transition risk is not the only danger. “If inflation gets too high, stranded assets would be an issue,” Harding says. “When leases have a collar, a cap and a floor, there is a danger that the upside is missed. The question we must increasingly be asking ourselves is, how sustainable is this lease in a high-inflation environment? What appeared to be a great long-term contract originally may lead to unsustainable rents in the future.

“We’ve seen in Spain how, what appeared to be safe, contracted cash flow backed by the government for solar PV energy, was not as bulletproof as was first thought.”

James says the danger in real estate is “the rental cap may be below inflation”. He says: “This is particularly prevalent in the sale-and-leaseback market. For some investors who think they bought inflation protection, they may discover they are not going to achieve what they had assumed.”

Crawshaw agrees: “There may be some issue with cap and floors in leases if the period of high inflation is maintained for longer than we think. But even then it is likely to have limited impact [from real estate assets in isolation] when those that are impacted are considered in a whole-portfolio context.”

He adds: “Overall, we are not particularly concerned about inflation, as our clients have matching liabilities. Most commentators believe that the current high-level inflation will be relatively short-lived.”

Rose is even more positive. “In many ways this inflation-focused investment environment is the optimum market for secure-income investments,” he says. “After all, you can now be looking at an [internal rate of return] of 7.5% to 8%. As inflation picks up, assets which offer some inflation protection are increasingly a focus.”

Will Europe follow the UK path?

“Growth across secure-income opportunities is expected to be significant over the coming years,” says Mikhailov. Alpha Real Capital estimates the size of the three markets it focuses on in the UK – commercial ground rents, renewable infrastructure and social infrastructure – to be about £35bn, £90bn and more than £100bn, respectively – or about £225bn in total.

“Over the next decade we expect that there will be £15bn of new opportunities in commercial ground rents, £40bn in renewables and £50bn in social infrastructure,” Mikhailov says. “This means that £105bn-plus or around 50% growth across these three markets alone.”

There is also the question of whether there is an even bigger pool of opportunities if continental Europe is to be included. “The European market is perhaps behind that seen in the UK for investment into secure-income assets in general,” says Crawshaw. “This is partly due to where European pensions schemes are in terms of their evolution – partly resulting from local differences in how real asset SIAs are considered within portfolios, partly due to lease lengths in some countries, and partly due to existing holdings.”

WTW has expanded its offering to include a euro-zone secure-income fund. “We see appetite for secure-income assets in the EU as growing and compellingly supported by the prevailing gap between local yields for high-quality defensive long-income assets and bond yields,” says Crawshaw.

Alpha Real Capital and LGIM have also launched secure-income funds targeting continental Europe. Rose says continental Europe “has huge potential for secure-income strategies”. Booth adds: “Our belief is that we will see some similar patterns in the secure-income market in Europe as we have seen in the UK.”UK pension funds have been piling into secure-income funds. But challenges around ESG and inflation are on the horizon. Christopher Walker reports