Have long-lease properties in the UK become too expensive even for income-focused investors? Shayla Walmsley reports.
Growing competition for long-lease property in the UK is forcing buyers to pay a premium for such assets. It is a trend recently highlighted by Investment Property Databank (IPD), not least because it has implications for long-term income returns.
Income returns of long-lease assets have been less than that of standard UK assets, IPD said, and overall total returns have been much the same for the different lease lengths. The best long-lease investors can hope for, it seems, is a measure of capital protection.
For pension fund investors focused on long-term income security, the paucity of assets might be as disappointing as the unexceptional returns. The average lease length has dropped threefold to seven years since 1990, according to IPD.
Ben Jones, manager of the M&G Secured Property Income Fund, says IPD treats long leases "as a separate asset class". But this is a mistake, he says, because they require specific criteria. You could, for example, have a long lease linked to market rents, rather than inflation, which would create a very different exposure.
RREEF Real Estate, which is rumoured to be fundraising for a long-lease fund but declined to confirm its plans this week, put out a report earlier in the year claiming that the investable market for index-linked property leases was "sufficiently significant to accommodate a reasonable portion of the future demand from pension funds".
Judging by the report's conclusions, RREEF, like M&G, would focus any long-lease fund acquisition programme on inflation-linked assets.
Long leases are still prevalent among certain types of non-inflation-linked assets, including supermarkets and shopping centres. Mark Disney, head of shopping centre leasing at CBRE, points to the 9.3-year average unexpired lease for British Land's share of Meadowhall shopping centre as evidence that average leases at super-regional malls remain at 10-15 years.
Yet, IPD points to sector-specific risks such as the reform of UK primary care trusts, supermarkets - namely, Tesco - halting plans to expand, and the questionable sustainability of the budget hotel sector.
M&G Investments has invested roughly £4bn (€5bn) in long-lease assets over the past decade. Jones says that some of the risks associated with long-lease sectors have been underplayed, in some cases because investors have focused on real estate risk at the expense of credit risk.
M&G did not invest in Southern Cross care homes when it had the opportunity, for example, because the tenant credit analysis suggested the operator was over-leveraged. "Just because an asset has a long lease, that doesn't mean the tenant is creditworthy," Jones says.
In contrast, the owner of a well-located Travelodge hotel might be immune to the issues surrounding the operator's current entanglement in a CVA process. "A stronger tenant is emerging from the debt restructuring," says Jones.
Even assuming sufficient long-lease assets to go around, and sufficient skill to work them, the market is still dominated by short ones. "As a proactive manager you have to live with them - and develop strategies for managing them," says Disney.
Were the economy to pick up, short leases might appear more attractive as pricing moves out. But the economy is not picking up and vacancy is more likely than renewal when leases expire, according to research carried out by IPD's Greg Mansell.
Jones points to the hidden costs of vacancy, including capital expenditure to attract a new tenant, and the cost of offering up to two years rent-free as a sweetener. "It could be two years before you see income even once you find a new tenant," he says.
In any case, Disney admits that gleaning value from short leases is making the best of a bad situation. He was discomfited by a straw poll conducted at a recent IPD seminar, revealing that a majority of attendees would favour an asset in need of work over one with a long, unexpired lease.
"The assumption was that prime is overvalued and that those polled might see value where no one else had," he says. "In reality, in most cases, a short lease is more of a threat than an opportunity."