Funds line up for long lease
Pension schemes are queuing up to get into long-lease funds, and the sector could go pan-European. Rachel Fixsen investigates a fast-growing industry
Long-lease property funds in the UK have enjoyed a period of intense demand from investors in recent years.
In need of assets to match their liabilities, pension funds and insurers have sought out the funds for the inflation-proof, low-risk, longterm returns they can offer, during a time when government bond yields have been close to zero.
But a change in UK pensions policy coupled with diminishing returns from some of the funds’ key property sectors could bring the funds back down to earth.
“We continue to see very strong demand from pension funds for the long-dated inflation-linked cash flow”
Before the advent of investment funds specialising in long-lease property, this was an asset class managed by insurance companies and high-net-worth individuals, says Geoffrey Shaw, portfolio manager for the BlackRock UK Long Lease Property Fund.
“It was all in-house money and wasn’t a mature market,” Shaw says. “The first wave of long-lease funds came about a decade ago, when funds started entering the market being externally sold. This came from a desire by final salary pension schemes to invest in something that was low risk and dependable, but giving a better return than you get from Gilt portfolios.”
In 2003, Standard Life Investments established the first long-lease property fund for UK pension funds in the UK, bolstered by consultancy Mercer whose UK pension fund clients needed alternatives to government bonds to match liabilities. “We were looking at the fact that a lot of pension funds bought government bonds,” says Greg Wright, investment consultant at KPMG Investment Advisory, who worked at Mercer at the time.
“There was no reason why you couldn’t buy an office that the government uses instead,” he says, adding that the quality of counterparty was the same for such an asset, but the yield on the asset was higher.
The task then became to put together a portfolio of properties that had the same quality of tenant for security of income, long leases to give 20-year income streams, with rents that were either inflation-linked or had fixed uplifts, Wright says.
Richard Marshall, manager of the Standard Life Investments fund, says the fund is still experiencing strong appetite from investors.
At the end of last year, asset levels had reached £1.3bn (€1.6bn) from around £500m five years ago, he says, combining capital growth and income, which is reinvested.
“The reason why people invest in these funds has really changed over last two to three years,” Marshall says. “Some investors in these longlease funds still view this as real estate exposure, and most pension funds in the UK have a 5-10% exposure to real estate. Where we’re really seeing growth is in UK pension funds matching their pension liabilities,” he says.
The Standard Life Investments fund is also witnessing demand from institutional investors selling their government bonds and investing in other assets where they can get similar security but a pick-up on yield, Marshall says.
There has been a general move among longlease funds from public-sector-let property to a broader tenant mix. But departing too far from the security of the government as counterparty is not a step some funds want to make.
When the Aviva Investors Lime Property Fund was set up in 2004, it positioned itself as a low-risk real estate fund with low volatility returns. That has remained the strategy, says Renos Booth, manager of the fund. “We are the most secure of all funds in the IPD universe of over £500m, and that security is because of the underlying assets – 50% is underpinned by the public sector and the balance from very strong corporates,” he says.
But Booth does not envisage restricting the fund absolutely to properties where government bodies sign the lease.
“Diversification is also key to risk mitigation,” says Booth. “The availability of publicsector occupied property let on long leases is obviously a lot less than you’re going to get in the corporate world.”
Corporate tenants are likely to give slightly more yield, he says, but it is vital to look at the corporate covenants to evaluate their strength and probability of a default. Also important, he says, is analysing the property to assess the value of the asset in the event of a default.
Defined benefit (DB) pension schemes have been the primary investors in the Lime Property Fund from the start and the fund keeps its income stream strongly linked to inflation, says Booth. Just under 90% of the fund’s income comes from leases with guaranteed uplifts or inflation-linked uplifts, he says.
Ben Jones manages the largest long-lease fund – the M&G Secured Property Income Fund. In 2000, seven years before the now £1.9bn fund was launched, M&G Investments started investing in long-lease real estate on behalf of its parent Prudential, he says.
Across the business in total, the firm now has £4bn invested in long-lease, including mandates, he says. Having made £800m of transactions since January 2013, Jones confirms that the sector is growing.
“The breadth of transactions demonstrates that there’s an increasingly wide range of tenants and sectors, and from the capital side we continue to see very strong demand from pension funds for the long-dated inflation-linked cash flow that these assets can provide,” he says.
As these assets sit between fixed income and property, managers need particular experience and abilities. “To invest successfully in this market you need a true collaboration of fixed income and real estate skills to be able to best assess where relative value is,” Jones says. “You need to understand operational businesses and how the real estate fits into those businesses.”
While long-lease property funds apparently focus on income streams, Jones maintains that capital growth is important. “The idea is to maximise your return from both sides of the equation,” Jones says.
Similarly, Marshall points out that his fund does still expect to deliver capital growth as well as provide a real return to investors.
“Volatility is quite a key differential to other traditional balanced funds,” he says. “Over the long run we would expect capital growth to be lower, but less volatile.”
The development of the long-lease property fund market has been described in terms of three generations. The first generation, says Shaw, were more similar to traditional balanced funds, with weightings to open-market reviews. The funds had a mix of occupiers from retailing chains to public funded tenants.
The next phase of funds came through in 2007 to 2009 when inflation was back as an issue for investors, he says. This generation subsequently focused almost solely on inflation-linked and fixed uplift leases, as well as having a more restricted view on credit strength.
“A considerable amount of capital has will see further market stratification. The emergence of the third phase is due to investors seeking liability-matching income in a low-yield world,” he says.
Wright says a wider range of tenants was seen as acceptable in these funds, provided they could be shown to be of high quality.
Pricing has been a factor in the funds’ inclusion of other types of tenant. Yields on long supermarket leases, for example, have come down to around 4% from 6% about five years ago. “These yields have caused managers to look elsewhere for returns,” he says.
Wright also thinks there could be a knock-on effect to the long-lease property fund sector and other illiquid assets from the government’s new measure to scrap compulsory annuitisation of defined contribution (DC) pensions.
But it is not so much the life insurers that will have an impact on the market, Wright says, since they mainly use government and corporate bonds to back their annuities. “What might be more of an issue is the possibility that a lot of DB members will want to transfer to DC,” in order to benefit from the new freedom to take their benefits in different ways, he says.
If the government puts in place legislation to allow this to happen, Wright says DB pension schemes will have to be careful not to sit on a heap of illiquid assets they cannot realise for cash transfers. “They might find they need to go a little slower because they don’t know what their liabilities will be in the future,” he says.
The strong performance of long-lease funds over their lifetime has caught the attention of investors that are not necessarily looking for long-term, inflation-linked income.
“What is interesting is that during the downturn they outperformed, but during the upturn they also outperformed,” says Paul Jayasingha, senior investment consultant at Towers Watson.
The rising market in this cycle was dictated by investors looking for safer assets, he explains. However, Jayasingha says the change in pricing has meant the sector is not as compelling as it was 18 months ago.
M&G Investments is now considering the idea of European long-lease property funds. “There is demand generally for long-dated cash flow and income security from pension funds, so that would suggest that there would be similar demand for that type of profile on the continent,” says Jones.
Tom Lee, head of European real estate at BlackRock, says that, in their current form, long-lease property funds are peculiar to the UK because the long-lease structure in that country is not replicated in continental Europe.
Marshall says long-lease property funds would appeal to European investors, but acknowledges that the shorter leases available outside the UK is a challenge to anyone trying to establish such a fund. “On the positive side, you see a lot more index-lined leases,” in continental Europe, he says.
A poll of Towers Watson’s European clients showed there was demand for long-lease property investments outside the UK, Jayasingha confirms. “While long-term leases are much more difficult to get in continental Europe, where you can get it is in hotels and more esoteric sectors of the real estate market,” he says.
Lee predicts that UK long-lease property funds will continue to be in demand over the next few years because they are an alternative to bonds. “We expect that, of the capital flowing into long-lease property funds, a substantial amount of that investment will be coming out of exposure to bonds,” he says.
Although Wright is positive about the targeted quite a narrow sector, driving yields down,” says Shaw, adding that aggressive yield compression will lead to a third phase, which long-lease property fund sector, he also sees challenges. In particular, managers need to deal with the pipeline problem, he says. “If there’s been a bit of disquiet among investors, it’s not the performance, but it’s the time it takes for their money to get invested,” he says. If queues end up stretching longer and longer, he warns that the investors may not bother. Although the high level of investor demand has created pressure, fund managers say they would not allow themselves to be persuaded to deploy capital too quickly. “There’s absolutely no incentive, on our part, to start diluting the quality of the investments,” says Jones.
But Wright believes some changes in the long-lease property fund sector may bring everything into better balance. With investor demand at high levels, he says the funds need to manage expectations. “If they say we can get the money in six months, and it takes two years, investors are not going to be happy,” Wright says.