Secure income funds are in vogue for pension funds with an eye on inflation. But are they really a no-brainer? Shayla Walmsley reports

A couple of things have changed since Standard Life Investments (SLI) launched the first UK fund dedicated to long-lease assets, which now owns more than a £1bn (€1.18bn) in assets, a decade ago.

The most obvious one is that there is more competition for assets. Excluding niche and sector-specific funds such as those dedicated to student accommodation, AXA Real Estate’s is the most recent addition. It launched its fund in January, acquiring two supermarkets after and raising £125m from investors.

The growing interest from investors has also increased competition for long-lease assets, forcing fund managers to look at wider range of types and sectors. At some point, a retail park seemed like a safe bet to SLI fund manager Richard Marshall. Then, three years ago, with the fallout from retail tenants, the fund sold it. “We wouldn’t buy one now,” says Marshall.

Few long-lease managers would. Hotels, on the other hands, are of interest. M&G recently acquired two airport hotels for its £1.35bn secured property income fund.

Supermarkets are perennially warm. Social housing is in demand if you can find the right portfolio – and the right partner.

But funds are also increasingly focusing on niche alternatives. They include local authority income streams, such as car parks, which make up between 4-5% of the SLI’s fund’s assets. Overall, 20% of the assets are in the ‘other’ category.

Meanwhile, the emphasis has shifted from new-build to development.

Back when SLI’s fund launched, many of the deals were sale-and-leaseback arrangements with occupiers, mostly when the buildings were first developed. Now the funding cash flows are coming in at the development stage, where the tenant is in place and the developer needs capital to complete the project.

One of the advantages of investing at that stage is that you can buy cash flows on more advantageous terms while development risk remains with the developer, says Marshall.
“The checks and balances are in place and you retain a big payment at the end. It’s an attractive way to do deals.”

That sale-and-leaseback deals still feature highly in fund managers’ asset acquisition strategies is unsurprising. Ben Jones, manager of M&G’s secured property income fund, points out that most deals start out as sale-and-leasebacks or development funding projects “because that’s how you get people on 25- or 30-year leases”. Jones is also looking at “de-risked” development, including pre-let developments to avoid market risk.

“The more diversified your sources of potential transactions, the better. We’re not relying on a single source of opportunity. We’re actively out there trying to create a lot of this stuff, and it can be a long process,” he says. “We’re talking to a range of people about a range of financing options. In most cases, they aren’t necessarily property-specific conversations.”

M&G is looking to extend the sale-and-leaseback model to new asset classes, including social infrastructure and regeneration partnership projects with local authorities, major potential providers of long-lease assets. It is unlikely to happen quickly, but Jones believes the model offers alternatives to more traditional debt, allowing local authorities to sell assets to finance new developments. “A range of issuers are looking at sale-and-leaseback deals and the list is growing by the day,” he says.

In fact, he suggests the likely future structure of private finance initiative (PFI) projects – amid strong demand for social infrastructure assets – will have a similar profile to sale-and-leaseback deals.

Because most investors, like M&G, are long-term holders of these assets, there is unlikely to be that much secondary trading – and where there is, it tends to happen as the leases get shorter. Instead, funds are likely to hold on to assets that in some cases they would rather dispose of.

Although he sees value in a broad range of assets, Jones says to sell into the current market would mean having to find something else to invest in. Once you factor in transaction costs, to sell would be “detrimental” to the fund.

Investors have been looking at a wider range of assets. But have they been assessing their underlying quality sufficiently? James Watson, head of investment at Briant Champion Long, says investors tend to focus on lease length at the expense of the asset.
Regarding supermarket acquisitions, he recently said that leases and covenants were pretty much standard across supermarkets meant asset characteristics would be what made one investable and another not.

Part of investors’ blindness to asset-specific risk comes from the tendency to see long-lease real estate as a subset of fixed income. Certain parts of the long-lease market operate like bonds – ground rents, for example, especially if they have fixed income-like revenues, and CMBS. But Tanner believes the comparisons with fixed income have sometimes been overplayed. “If you went into the market more than seven years ago, it was difficult to persuade investors that real estate had bond-like characteristics. Now they think real estate is only a bond,” he says.

If property risk associated with commercial and industrial long-lease strategies can be mitigated with amortising leases, in some sub-sectors the variety and types of risks associated with long-lease assets can be “extreme”, according to Paul Jayasingha, senior investment consultant at Towers Watson. He refers to potential political and legislative risk with social housing investments as an example.

Jones’s team regularly speaks to regulators. It did so for its recent acquisition of the £125m Genesis social housing portfolio, but also to discuss alternative public-sector funding models. “We’re doing it on a collaborative basis,” says Jones. “In a number of cases, the people who do these deals [M&G’s investment counterparties] need the approval of the regulator. That’s a good way to eliminate any political risk.”

“The expected risks in any one year are lower than for traditional property, but over 25-30 years investors want to know that managers are thinking about extreme-event risks,” says Jayasingha, citing Spain’s retrospective removal of its solar sector subsidy.

John Osborn, AXA Real Estate’s long-lease fund manager, warns against assuming that a strong covenant eliminates risk. “A triple-A-rated covenant can fail,” he says. “It’s important to have the fundamentals, especially as the lease gets shorter, for capital value and liquidity. Focusing on fundamentals is the way to mitigate downside risk – exercising selectiveness within a wide universe.”  

For some assets – though not ground rents – one way to mitigate risk is to factor in alternative use. The student accommodation opportunity SICAV launched earlier this year by Luxembourg Fund Partners, for example, targets individual assets rather than purpose-built blocks because they will be easier to sell into the residential market. “The risk profile is what you need to focus on,” says director John Hill. “Should there be a decline in student numbers, you would only convert a purpose-built block into a hotel. Managing money is about having a back-up plan.”

At the very least, having strong underlying assets with alternative tenant pools or alternative use increases the prospects of lease re-gearing before the end of the term, says Jones. “It allows you to maximise the value of your assets. If you fast-forward 15 years and all you’ve got is a lease with 10 years to run and a building that looks a bit tired, then there’s not much you can do with it,” he says.

Paying over the odds for security?
None of the fund managers interviewed admitted to taking risks within their portfolios, but there are questions over pricing – especially when, as Tanner points out, there is a gulf between actuarial and pension fund pricing assumptions.

He points to the potential value in what he describes as “odds and ends” – the “whole range of slightly odd assets with odd cash flows that don’t necessarily fit into the fund bucket”.

Tanner adds: “The smart money will use fund managers, not funds, and price assets that don’t quite fit [into fund specifications]. Assets that fall between the cracks are quite cheap.”

But secondary assets that fall between the cracks are out. Some fund managers are critical of questionable asking prices for long-lease secondary assets. Although market pricing has found its level on a sector-by-sector basis, pricing between good and bad assets overall is not wide enough, says Osborn.

“I’m quite happy for other parties to pay for poor-quality secondary,” he says. “But we designed our fund to mitigate risk with good-quality real estate that’s fit for purpose with strong residual values.”

Although Jones says it makes sense to maintain the dynamism of the M&G fund, he believes weakening the portfolio would eventually dent investors’ confidence. “The weighting to different sectors has shifted around over the life of the fund according to where we’ve seen value. The profile of the fund will look very different into five or 10 years time than it does now, but we’re quite particular about what we’ll invest in because it’s a long-term, open-ended fund,” he says. “If you start to dilute the quality of assets, your investors will start heading for the exit because you won’t be delivering what you promised to deliver.”

Third-generation long-lease funds ostensibly looking to match pension funds’ liabilities are now more likely to focus on capital value. Jones says the combination of income and capital growth is a potential differentiator for the M&G fund. “We’re of the mind that there is both capital and an income element to these investments,” he says. “Clearly, income is important because it comprises, at least initially, a large proportion of the capital you’re paying for the investments. But ultimately if you can deliver that and at the same time acquire assets that have a stronger chance of delivering long-term capital value growth, then surely that’s a better outcome for investors.”

Jones adds that it has played very well with the fund’s investors (not least the two Dutch pension funds that see it as a pure real estate, rather than a fixed income investment) that it does not focus exclusively on the income stream. “If you try to deliver bond-like cash flows, it has an income stream and capital value. It shouldn’t be any different if you’re trying to deliver bond-like returns, he says.

Yet, there is some scepticism that investing in long-lease assets is the only or optimal way pension funds can meet their long-term liabilities. Investment advisory firm Cardano recently dismissed investor confidence in ground rents as ‘misguided’, because, although returns on them may be linked to inflation, inflation swaps perform the same function without tying up capital. Moreover, the size of the market – 0.02% of UK pension fund assets – is insufficient to justify interest from pension funds.

Jayasingha points out that secure-income strategies do not provide a short-term hedge but they do provide cash flows close to liabilities. Even if it can be viewed as a long-term cash-flow hedge, such strategies do not represent a balance-sheet hedge for pension funds.

Pension funds may be matching liabilities with long-lease strategies, but are they ending up with lower returns than they would generate through traditional real estate?

But long-lease assets may outperform in the long term in any case. Market rental growth has lagged inflation over the past 23 years. If the next 23 years prove to be more difficult than the last 23, it could be even more difficult for market rental growth to beat inflation.

“That could lead to outperformance for long-term inflation-linked assets,” says Jayasingha.
“For some clients, secure income forms part of their liability portfolio,” he adds. “
For others, it’s a better place to be than traditional real estate.”