As the outlook for rental growth from commercial UK real estate weakens so the income component of investors' portfolio return increases in importance, as Malcolm Frodsham explains
The downswing in occupier markets has increased the importance for investors of the income component of portfolio total return. Over the long term the income component has often comprised a high share of market total return: varying from 5.9% pa on a rolling 10-year basis to 7.7% pa since 1981. This compares with capital growth, which peaked at a lower level, 6.6% pa in the 10 years to 2006, and in the 10 years from 1989 to 1999 actually detracted from market total return over the period by -0.4% pa.
The choice between income and growth portfolio strategies in a downturn is not a simple one. High-yielding assets will tend to offer less secure income (shorter lease terms and weaker covenants) with the higher yield potentially short lived if a unit falls vacant or if the rent that can be achieved at lease renewal is lower than the current rent. So to ensure long-term performance, the investor must weigh up the relative value of assets offering a secure long-term income stream against assets with an income secured only for much shorter periods.
Existing leases generate a more certain income return in the short term and the value of this income stream is considerably enhanced by the ‘upwards only' rent review. This is still the norm in the UK and prevents rent from falling below its current level at rent review even if current rental values are below this level.
We can show the protection afforded by leasing contracts by comparing rental value change and portfolio net income growth in the last major downturn from 1990 to 1994. Over this period, investor cash flows overall continued to grow despite rental values falling by a third.
Net income growth remained positive during this period due to the capture at rent review (typically every five years in the UK) of the increase in rental values during the preceding strong upswing. In this cycle, the level of ‘reversion' from market rental growth in the UK that has yet to feed through to rent is 13.5%.
The protection to an asset's cash flow afforded by a lease ensures that as rental values fall, assets with longer unexpired lease terms will deliver capital protection to investor portfolios as well as delivering an income return.However, the reliance on long unexpired lease terms and the protection of the ‘upwards only' rent review is considerably lessened in this cycle, compared to the early 1990s' recession, by the significant shortening in lease lengths in recent years and the widespread inclusion of break clauses in a lease.
The result of shortening lease lengths and the greater use of breaks is that only 50% of income is secured by contracted leases beyond the next 10 years.For an asset with only short unexpired lease durations, a higher proportion of the value is within the future component of income beyond that secured by the current lease.
The value of this component of income is more difficult to determine due to the high degree of uncertainty surrounding whether the tenant exercises a break clause or does not renew at the end of the current lease term.So in appraising assets the investor needs to estimate not just the outlook for rental values but also the current tenant's likelihood of renewing the lease and the probable length of the void period should the tenant exercise a break clause or not renew the lease.
Such probabilities are difficult for investors to estimate. Void periods, propensity to renew and propensity to break all vary considerably during the cycle as rental values rise and fall. As occupier markets weaken, vacant periods will rise although it is actually uncertain if tenant retention weakens, as little evidence exists. It is even more uncertain if more expensive locations (known as prime) experience more durable leasing conditions and therefore shorter void periods and higher tenant retention.
So investors need to consider if they really understand how the key leasing variables behave in a downturn to be able to judge the appropriate premium that secure income should command.Judging by the last cycle, investors were prepared to pay a high premium for security and this led to commensurate lower portfolio total returns. Of course this is perfectly acceptable if the portfolio objective is to deliver a low risk rather than a superior total return to the market average.
Even armed with accurate data, the sheer number of permutations to an income stream from just whether a break clause is exercised or not and whether the tenant renews the lease or not means that investors cannot rely on rules of thumb or mental arithmetic.
To generate performance, investors need decision-making tools that can make complex calculations regarding the impact of the outlook for rents, the likelihood of tenant default, renewal rates and void periods on asset value.
Only investors that can truly estimate future cash flows can expect to ensure that they acquire and keep those assets offering the best probable returns versus their risk.
The portfolio context is also crucial: combining large numbers of shorter lease lengths into a portfolio can often provide a more secure cash flow profile than a single asset secured on a long unexpired lease term.
IPD has worked with software provider OCCAM to deliver such a tool.The IPD/OCCAM Risk Adjusted Cash Flow Model utilises the probability of leasing outcomes and projects a probability tree of all possible outcomes.
This probability tree generates a probability adjusted cash flow for units, assets, sub-portfolios and the portfolio.
The model provides both:
One might reach the conclusion that delivering real estate performance depends more on quantitative decision making power than traditional asset management. However, that would be to deny that real estate assets are not doomed to perform like the average asset.
Good property management can result in better outcomes than competitors. Effective management can increase the propensity of tenants to renew and minimise void periods. Investors must be organised to achieve this and recognise and reward success when it is achieved.
IPD has introduced a service to measure property management success. The Lease Events Benchmarking Service measures the outcomes of rent reviews, break clauses and lease expiries to enable property managers to be measured, benchmarked and rewarded according to their contribution to asset performance.
Delivering value in a downturn requires an understanding of the nature of leasing through and beyond the current cycle.In an era of shorter lease terms, those assets with longer leases may command an even greater premium due to their scarcity.
This will increase the need for investors to use decision-making tools with their power to make complex calculations as to the value of future income streams beyond that afforded by a current lease and to utilise a portfolio approach to mitigate the increased risk.Investors then need to ensure that the portfolio maximises the income from each lease through an organisational strength that measures, recognises and rewards strong property management and its contribution to portfolio performance.
Malcolm Frodsham is research director at IPD