Can long-lease property investments play a role in a pension fund’s liability-driven investment strategy? Deborah Shire explores
Until recently, only a limited number of UK pension funds would have considered real estate as one of the potential solutions for their liability-driven investment (LDI) programmes. This position has changed, most notably over the last few years, as funding gaps have widened and interest rates have fallen to record lows. UK defined benefit pension schemes with liability matching requirements are challenged by this environment and will, at least in our opinion, continue their quest for alternatives to supplement their ‘low-yielding’ gilt exposure.
Historically, many pension schemes with liability matching requirements focused on low-risk investments with a perceived low-volatility/low-return target, such as inflation-linked government bonds, government bonds and corporate bonds, which would be combined with hedging strategies to build a liability matching portfolio. Assets such as equities, high-yield bonds, private equity, commodities and hedge funds would be added to potentially enhance returns at the expense of higher risk.
We expect that investors with – or requiring – an LDI strategy will need to supplement their traditional low-risk strategy with investments that can provide both a degree of interest-rate and inflation hedging not offered by risky assets and a higher return than that currently offered by UK gilts. Infrastructure and property are two asset classes that exhibit these qualities and may potentially be suitable to supplement the low-risk component.
Long-lease property is an attractive supplement to an LDI-based investment strategy and offers diversification to the underlying sovereign risk of a government bonds-focused portfolio. The income derived from long-lease property can have an element of inflation indexation through rent uplift mechanisms related to the retail price index (RPI) or consumer price index (CPI). This inflation link is upwards only, meaning that the rental income would not fall in times of deflation.
Lease terms of so-called long-lease properties can stretch out to 20 years and beyond, and provide the maturity profile of cash flows that is required by pension funds, which is rare for most types of investments.
In the current environment, the inflation-linked income of long-lease property can, to a certain extent, provide the inflation-linked returns required by pension funds at a higher yield than those of gilts. While UK 10-year gilts are trading at a yield of around 1.82%, UK long-lease property yields are approximately 361bps higher. Property, however, is rather illiquid compared to government bonds.
The most important factor to consider when investing in long-lease property as part of an LDI strategy is the stability of the underlying cash flows. The credit quality and financial stability of the tenant are good indicators of the robustness of the cash flows at the property level (rental income), although, fundamentally, it is the economic value of undertaking business in the property that determines the value of the cash flow. There are generally strong tenant covenants available in the UK long-lease sector, including the UK government, major supermarket chains or well-known hotel operators. To mitigate the risk of a potential tenant default, we believe that only tenants with strong covenant quality and stable/growing revenue/profitability should be considered suitable for inclusion in an LDI portfolio.
Another key priority is cash flow diversification. A well-diversified portfolio should limit problems that can arise with a single tenant, a single type of asset or a single sector. The inclusion of ‘alternative’ property sectors such as medical properties, student accommodation, social housing or car parks can provide some good diversification benefits and broaden the exposure to different sectors and tenant covenants.
However, investment in these sectors requires specialist knowledge and an in-depth understanding of relevant operators and drivers. Strong deal sourcing capability is also a prerequisite to successfully implement a diversified strategy. We believe that long-standing local relationships with agents, banks, vendors, occupiers, operators and investors are essential to source investment opportunities in this competitive environment.
Ultimately, the underlying investment is still property and, therefore, it is important to fully understand and include the relevant property fundamentals in the investment decision-making process. There are two related reasons for this. First, at some point the lease will (unless extended indefinitely) expire and vacant possession will return to the investor-landlord. This represents the residual value at the end of the cash flow. On a long lease, this should be a small part of the initial value, although its proportion increases as the unexpired lease length declines. Second, there is always a risk of tenant failure or default, and the letting value to an alternative user will be dictated by the market, which may be different to the previously received index-linked rent.
There needs to be an awareness of the key elements that will affect the residual value of a property. Some of the questions to determine the attractiveness from a tenant’s perspective include: Does the property have the right specifications for its use (‘fit for purpose’)? Is the property in a good location for its use? Is the rent level sustainable? And, where possible: Is the property suitable for/can it be easily converted for other uses? The analysis of an investment in a long-lease property in a liability-matching framework therefore goes far beyond a simple analysis of the cash flow.
When properly implemented, long-lease property investment can be an appropriate component in an LDI investment strategy. It is one of the very few asset classes outside inflation-linked bonds that can provide long-dated upward-only inflation-linked cash flows and, at the same time, help diversify a fixed-income focused LDI portfolio.
Deborah Shire is global head of business development at AXA Real Estate