The market is seeing the emergence of a ‘third generation’ of long-lease funds. Greg Wright assesses their appeal to pension funds
Mobile phone networks may be moving on to 4G but the world of long-lease (or long-income) property is arguably about to move into its third generation. What does this mean?
The first generation was born around 10 years ago and aimed to exploit a market opportunity whereby investors could receive long-term, inflation-proofed income from property let to the government at a better real yield than index-linked gilts. Similar early funds tended to focus on the safest assets and tenants, not only in terms of tenant credit rating but also in terms of an explicit link between the tenant’s revenue and inflation (for example supermarkets).
Around five years ago, the second generation arrived, which explored how far the tenant (or credit) quality boundaries could be relaxed in favour of the specific property fundamentals. This shift took place against the backdrop of the UK property boom and brought in a wider range of assets such as hotels and other retail. In the meantime, as inflation-linked leases became more common, new sectors continued to be developed, for example student accommodation.
The third generation is discussed in more detail later, noting that over this period the long-lease sector has become firmly established in the minds of UK pension scheme trustees. Arguably, it ‘came of age’ at the end of 2012 when IPD created a dedicated index of four long-lease funds with a combined size of just under £3bn (€3.5bn). (This understates a true sector size of around £4bn, as not all funds are yet represented in the index.)
Why has long lease become so popular? We have long advocated the strategic benefits of long lease to pension funds that have ‘end game’ plans in mind and a need for a secure, long-term, inflation-proofed income. Such assets are a great match for liability cash flows, and pension funds can generally accept the illiquidity associated with long lease. From a property perspective, we continue to believe long-lease funds meet these new strategic needs better than traditional balanced property funds.
Over the same period, the index-linked gilt market became increasingly expensive, so much so that 20-year index-linked gilts, which would have provided a 2% real yield 10 years ago, now offer effectively a zero real yield. This yield shift has resulted in a 40-50% rise in prices for index-linked gilts. At the same time, the property market has recovered most of the losses in the 2007-09 crash, thus providing capital appreciation on top of the income return. Therefore, the tactical case for long lease as a ‘surrogate’ matching asset (albeit less precise than index-linked gilts) has been robust in recent years.
All in all, this has led some property managers to question whether this represents a structural shift in the market, and thus whether they should be developing funds to meet investor demand. We firmly believe this market will continue to expand. UK pension funds already invest over £30bn in unlisted, pooled property funds so the potential take-up is huge.
So what might the new funds offer, and does long lease still make sense as both a strategic and tactical investment?
A few well-established property managers are likely to finalise the development of long-lease funds by the end of 2013, which we believe could well bring the number of credible options for pension funds close to 10.
These newer funds offer some similarities with existing funds but also interesting new ‘twists’. They target an ever wider range of asset types, from car parks to non-UK leases and social housing to other infrastructure-like assets. As long as these assets offer the right fundamental characteristics and the manager is sufficiently skilled at underwriting and closing on deals properly, a wider choice for clients should be viewed as a positive change to the market. We also believe it is possible to source enough assets with inflation-proofed income to avoid the need to use derivatives to reshape fixed cash flows.
The strategic case may, if anything, be strengthening. Most pension schemes now have a journey plan in place and trustees are expressing frustration at the inability to de-risk from equities to gilts because of persistently low yields.
Many of our clients are prepared to use their ability to accept illiquidity to their advantage, to harness the real cash flows provided by long-lease as part of a ‘cash flow-driven investment’ strategy.
The real worry is about pricing. To put it simply, has long lease become so fashionable that a bubble is forming? For example, last year, the long-lease funds in the IPD survey provided a return of almost 7%, versus just 1% for balanced funds.
We do not believe a pricing bubble exists, although some sectors have arguably become a bit frothy. However, this has been partially offset by the wider range of property stock being sourced, which is still providing good yield. We often focus our discussions with managers on expected returns of potential transactions.
So while the market is showing signs of heating up, the relative-value argument remains strong, particularly when compared with real gilt yields (which, incidentally, we believe may stay ‘lower for longer’).
What could go wrong? Despite this generally rosy picture, a few other issues do need to be addressed.
From a purely investment perspective, trustees should be aware of the factors that could depress the capital value. These include residual value (a property expected to be empty and unmarketable at the end of the lease will have a lower capital value), and where RPI-linked leases escalate to more than open market rent (an ‘over-rented’ property). Also, tenant quality needs to be carefully allowed for – who precisely is on the lease? How sustainable is their credit quality? All these factors point to a need for expert underwriting and due diligence in acquisition and ongoing management.
From a pension fund perspective, trustees should note that long lease is not a matching asset like index-linked gilts. It is primarily priced as a property asset rather than a bond. Due to this, the sensitivity of fund values to interest rates may be significantly lower than pension liabilities. So, while you can aim to identify the underlying cash flows, its use in a matching programme needs to be carefully assessed.
Some schemes are waiting in queues to invest (upwards of a year in some instances). This has been caused by funds making commitments and the fund managers drawing these down as suitable assets are identified and purchased. We hope the new funds will help alleviate these bottlenecks and shorten waiting times which are a source of frustration.
Finally, although most pension schemes are still some years from a buyout position, if yields rose sharply and unexpectedly, they may be in a position to transfer assets and liabilities to insurers. As noted above, we think this will be less of a problem in the future, but many insurers could still require trustees to sell down their long-lease holding, which would take months, not weeks.
We believe the strategic and tactical case for long-lease property remains strong, at least while other matching assets remain so expensive. Trustees will soon have a wider range of fund options which will enhance choice and further cement the case for long lease as the default property option for UK pension funds.
Greg Wright is a director, pensions investment advisory at KPMG