5 min read 13 Nov 23
In the past, investing in UK long lease property has largely been the preserve of DB pension schemes. The asset class was effectively built for such investors owing to long leases and contracted income, linked to inflation; helping pension schemes to hedge long-term liabilities and meet their cashflow requirements.
As a hybrid between fixed income and real estate investment, the asset class offers the benefit of quarterly rental payments, akin to a coupon on a bond. Backed by prime UK real estate through structures such as sale and leasebacks, income strips and ground rent transactions, high quality portfolios might include business-critical property or key operating assets for investment grade tenants such as listed companies, universities or local authorities.
However, some traditional long income investors are now retreating, as DB schemes de-risk overall portfolios to prepare for buy-out, meaning what has until recently been an oversubscribed asset class is now accessible to new sources of capital. The return profile is well aligned to the objectives of many investors; whether seeking yield, inflation protection or liability matching, as well as the opportunity for capital value growth from the underlying property.
While strong and sustained demand from DBs for over more than a decade fuelled tight pricing for assets, entering the market today could offer good fundamental value given the asset class has repriced significantly.
“The risk/reward equation from investing in long income has never looked so good,” says Lee McDowell, Fund Manager. “We’re back to post-GFC pricing but the market was embryonic then; it’s now a mainstream asset class.”
The speed of correction underscores the potential buying opportunity. Now there looks to be more certainty around interest rates in the UK, real estate revaluations have played out with more haste – certainly faster than during the last crisis. During the GFC, repricing was debt-driven due to a credit squeeze, with falling interest rates helping to cushion the fall in values. This time around, the opposite is true; interest rates started from a low base and have corrected sharply to counter inflation. Whilst it is true gearing levels are lower, valuations have had to adjust rapidly in response.
As values find a floor, investors could target a cyclical opportunity to capture a potential valuation gain. The UK real estate market has repriced faster and further than other markets, with long lease real estate at the forefront owing to its bond-like qualities. The asset class could therefore be closer to reaching a stability in values, providing more certainty over asset pricing. Contracted rental growth also creates more liquidity than in other parts of the private market, given confidence in future cash flows. This makes it easier to ascribe a value even amid economic and rates uncertainty, helping to inform investment decisions.
"With improved value and current access to ready-made, high quality portfolios, we see a unique opportunity to enter the market,” says McDowell. “If we are at the start of a new real estate cycle, in our view this is an attractive place to invest. Long lease real estate offers a defensive, low risk real estate investment with the potential for secured cash flows, with growth over time.”
McDowell describes a ‘back to basics’ investment proposition for UK long lease real estate in today’s landscape. “Investors can now buy into high quality assets and defensive real estate sectors and be rewarded for owning prime real estate. Less than five years ago, you had to go up the risk curve to find additional yield”.
Increasingly, investment opportunities are likely to arise as a result of less liquidity in the traditional bank and bond markets. This is driving companies such as high grade corporates and public bodies to seek non-bank and non-public forms of lending, creating demand for long-dated funding structures such as income strips, which can provide a competitive source of financing for over 30 years or more.
We believe the ability to access ready-made, high quality long lease real estate portfolios with attractive cash flows could reflect a well-timed value opportunity for a range of investors. Both real estate and credit expertise will be valuable in creating innovative and resilient investments across different property types and funding structures, with the potential to deliver consistent and attractive risk-adjusted returns.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.