Property unit trusts, county council pension plans, and other pension funds have all been able to access UK commercial property exposure via property linked notes (PLNs). While they are not an established feature of the UK commercial investment market it is likely their popularity will grow, says Phil Ljubic
Property linked notes (PLNs) offer many features that are desirable for investors. These are:
• the highest form of property diversification;
• high transparency with daily pricing;
• a high degree of liquidity;
• low pricing volatility (similar to that of direct property); and
• more attractive pricing than other forms of property, namely unlisted property funds.
To date the use of PLNs has been to manage cash drag in property funds, or as an alternative way to access the UK commercial market. Given the features listed above, PLNs could have more applications. For example, they could be used to assist real estate fund managers to create more liquid property funds to meet the needs of the pension industry as it trends from defined benefit to defined contribution. In such a case, a fund manager could hold a real estate portfolio with a combination of direct real estate, listed real estate, unlisted real estate, and PLNs.
Below we compare PLNs with other forms of real estate. While we show the benefits of PLNs we are not advocating that they offer a replacement for the other forms of property. They should be viewed as another tool/investment for the professional to consider.
Greater diversity than any property fund
PLNs are based on a property index, which is much more diverse than any fund (unlisted or listed) could be. For example, the IPD UK ALL property index is based off £134.5bn (€152bn) of UK commercial property spanning 11,276 properties in the office, retail and industrial sectors.
Pricing transparency and liquidity
Every day banks show firm two-way pricing on PLNs as to where they would issue PLNs and then buy them back from investors. Typically bid-offer spreads range between 0.5% and 1.5% which is in direct contrast to property unlisted funds where bid-offer spreads typically range between 2% and 5%. In addition the daily pricing displayed for PLNs is firm/executable in at least £10m which for smaller pension funds should be ideal as they get the broadest level of diversification possible for a relatively small outlay.
In terms of liquidity, PLNs are one of the most liquid forms of property, and it is fairly easy to trade much larger size on any given day (ie, £25m). Compare this with the listed real estate sector which is perceived to be liquid; however it can still take time to fully execute larger deals. For example the average daily turnover this year for REITs such as British Land and Land Securities (two of the largest REITs in the UK) is around £20-25m. So an investor wanting to conduct a £25m trade on one of those stocks will have to double volumes for the day which may impact the price, or alternatively the trade could be spread over a few days to achieve better price execution.
As we move away from the major listed real estate stocks liquidity is much lower. For example a REIT like SEGRO (still major in its own right) has a daily average turnover this year of around £6m; or a property company like Helical Bar has a average daily turnover of only £400,000. Therefore PLNs in comparison to listed real estate stacks up fairly well.
PLN volatility is similar to that of direct real estate over time
RBS has found that the volatility (as measured by standard deviation) of PLNs over the past five years has varied between 2.61% pa and 23.74% pa. Similarly using results of the IPD transactional-based index, volatility (on a five-year rolling basis) has varied between 2.15% and 25.71% over the past 30 years (peaking in 2008).
Comparing the costs
Presently there is a 4.5% premium for an investor to enter into a PLN compared no premium in the unlisted market (unlisted trading at flat NAV). However, an investor cannot directly compare the two prices because there are a number of additional costs in the unlisted market that are not present for a PLN. Once accounting for those additional costs we show that the pricing of a PLN is potentially cheaper to that of unlisted funds.
In addition if the investor wants to sell, or close out, their position it would typically be much cheaper under the PLN rather than the unlisted fund. This is because the bid-offer for the PLN is typically around 0.5-1.5%, while the bid-offer for an unlisted fund can range between 2% and 5%.
Philip Ljubic is a director of property derivatives at Royal Bank of Scotland