Long-income real estate continues to attract capital, but understand the risks and drivers of value, says Hugo James
Long-income property is real estate let on long-dated, typically inflation-linked leases for between 15 and 200 years. It is a fast-growing investment class for institutional investors, and comes in several different structures, including commercial ground rents, income strips (amortising) and other long-lease property (sale-and-leasebacks). It is increasingly recognised as a form of alternative credit.
One of the main attractions of long-income property is that it can complement the performance drivers of other cash-flow-driven investment strategies. Unlike shorter-dated commercial leases, the contractual income stream of long-income property is a larger (even sole) component of the expected return, compared with capital appreciation.
Investors should be aware that the risk-and-return profiles vary between different types of long-income property investments, with some sub-sectors much more comparable to bonds than others. Understanding the various value drivers is essential in structuring investments and portfolios to optimise risk-adjusted returns.
Value drivers of long-income property include:
• Fundamentals: Tenant credit quality, rental cover (relative to the underlying net operating income of the asset), and the sector and property fundamentals;
• Lease terms: Rent review frequency, cap and floor on the rent reviews, the reference index (for example, RPI, CPI, fixed or open-market) and lease length.
• Reversionary value: Exposure to re-letting or selling the property at the end of the lease.
Long leases can be thought of as an alternative form of fixed income. Investors can assess fundamental risk in terms of probability of default and loss-given default (LGD).
When thinking about the probability of default of long-income property, rent affordability is key. Setting the initial rent too high, or being exposed to unsustainable tenants/sectors, undermines the stability of the cash flows, which is the prime attraction of this asset class.
In assessing rent affordability, investors often use estimated rental value (ERV) as a guide to changes in underlying profitability. However, this overlooks the fact that ERV is simply the result of demand/supply pricing for space. Not only should investors consider initial affordability, consideration should be given to industry drivers that might significantly change the rental cover over the duration of the lease.
For LGD, the primary drivers will be alternative use and prevailing market values. For transactions where the full market value is not being released, the starting effective gearing and expectation of the sustainability of an appropriate collateral cushion over time must be considered, as they will heavily influence the LGD risk.
Owing to the length of leases, it is crucial to assess long-term industry trends and demand drivers, together with building suitability/flexibility when assessing the propensity of the building to hold and grow its value over the lease. Considerations such as asset quality, tenant appeal, ESG risks and barriers to entry, clearly also play their part in LGD.
Company voluntary arrangements (CVAs), which enable insolvent companies to pay debts over a fixed time, can have a material impact on value, and their use is growing in certain sectors. They must be considered for UK assets, as CVAs can impose losses on landlords without a default having occurred.
The longer the lease, the greater the credit risk of the tenant/alternative tenant, but the greater the cash-flow certainty, and this is generally reflected in a tighter yield.
Rent review frequency, whether the rental amount is contractually uplifted annually or every five years, can significantly affect returns of the property on account of the time-value of money. Investors concerned with volatility should appreciate that capital value changes will be smoother for assets with annual rent reviews, everything else being equal.
For long-lease property, rental growth is often index-linked to inflation but subject to a relatively tight inflation collar – for example, RPI floored at 0% and capped at 4%, – whereas the most common inflation linkage for ground rents and income strips is RPI (0%/5%). Investors should be aware of the potential mismatch between actual RPI and contractual rental growth rates where, for example, annual RPI (0%/3%) is expected to deliver growth 1% lower than uncapped RPI.
It is becoming more common for long-lease property rental uplifts to be linked to CPI. In the UK, the historical wedge between RPI and CPI has been 80-90bps on average (although relatively volatile), so investors should consider if the yield effectively compensates them for the lower expected rent reviews with CPI-linked leases. The proposed changes to the calculation methodology of RPI might impact this wedge.
Other secondary lease-structure value drivers include forward-starting nature, presence of a development period, tenant buyback options at maturity, whether the lease falls inside or outside the 1954 Landlord and Tenant Act, and the wider transaction structure – for example, debt secured against property and presence of head lease.
Reversionary value (RV) risk is run in long-lease formats, but is most acute in traditional sale-and-leasebacks where the RV is an inherent part of the transaction and represents a meaningful proportion (20-40%) of the expected total cash flow. Measuring how quickly value can be eroded by RV changes is a core component of financial modelling, not least because of its significant potential impact. For a typical long-lease transaction, the deviation to base-case IRR is about twice as sensitive to a 1% movement in RV growth compared with a 1% movement in inflation expectations.
When investing in long-income property, investors need to consider several wider market forces:
• Interest rates: Movements in risk-free rates, particularly long-term trends, can affect the capitalisation rates, and therefore valuations, of property assets over the medium term.
• Illiquidity: Investing in long-income property should carry a risk premium to reflect the illiquidity and relative complexity of these transactions.
• Market supply/demand: Demand for secured-income assets continues to grow apace and outstrip the volume of high-quality long-lease assets being generated. This has led to recent yield compression and highlights that returns can fluctuate in response to these market dynamics or investor sentiment.
In understanding the value drivers of long-income property and how market forces affect this asset class, investors must develop strategies for mitigating risk. For example, having an inflation cap in the rent review might reduce the degree of inflation linkage but it limits the risk of becoming over-rented.
When considering risks around term and illiquidity, investors can mitigate these by using fully amortising structures – for example, income strips, which will lower the term risk. Here, preference should be given to hybrid structures as they can deliver terms acceptable to the investor and tenant. It is worth remembering that as a ‘matching asset’, long leases held to maturity earn investors a premium to compensate for their illiquidity.
For construction risks, safeguards include phased drawdowns, performance bonds, use of escrow accounts, and step-in rights. Investors should not view these risks and mitigants in isolation, not least because the factors can overlap. A holistic transaction-assessment framework should be employed – flexible enough to enable all kinds of long-lease property to be compared consistently.
A variety of factors matter in assessing potential returns from long-income transactions, some of which can be mitigated. Overall, the portfolio implications of allocating to this asset class include risk-factor diversification as well as improved liability matching given the highly contractual nature (often index-linked) of cash flows.
Viewing opportunities through a risk-adjusted lens is paramount. Investors in long-income property will be well-rewarded for the risks run if these are underwritten and priced appropriately.
Hugo James is a partner and head of long income at Alpha Real Capital