Growing inflation-linked cashflows through long lease real estate

3 min read 9 Aug 22

While real estate is normally considered an inflation hedge due largely to its capital growth component, long lease real estate transactions, which derive the majority of returns from growing cashflows, may provide less volatile inflation protection through inflation-linked rental agreements with high-quality tenants.

Income seekers feel the pinch

A surge in inflation over the past year has led many investors to experience significant losses in real terms. This has been particularly noticeable for those who require regular income, as interest rates on cash and fixed rate government and corporate bonds have turned deeply negative in real terms. 

Other traditional inflation hedges, such as dividend-paying stocks and real estate equity ownership, offer potentially attractive prospects over the long term; however, they may be vulnerable to near-term changes in interest rates and the economic cycle.

“Inflation has so far proven stickier than many central banks anticipated following the post-lockdown reopening of their economies”

Obtaining cashflows directly linked to inflation is limited to a small number of asset classes, with long lease real estate among the main options for long-term investors. For those seeking inflation-linked income, typically of investment grade quality, these transactions may offer potential diversification benefits for investors looking to protect the real value of their portfolios and to match inflation-linked liabilities.

Direct inflation protection

Long lease real estate transactions usually take one of three forms: sale and leasebacks, income strips or ground rents. Sale and leasebacks are the most common type and are well-established in the UK, with increasing popularity in continental Europe.

Through these transactions, an investment manager will purchase a real estate asset from an owner-occupier and lease the property back to that same organisation (the seller) on a long-term tenancy, typically lasting 15-25 years or longer. 

These tenancy agreements will almost always have in-built inflation protection in the form of rental uplifts. In the UK, lease contracts typically follow the Retail Price Index (RPI) or Consumer Price Index (CPI), while European contracts normally refer to the relevant country's CPI.

Many contracts include rent 'floors' and 'ceilings'. Normally, rents are 'upwards-only', meaning the minimum change will be 0%, even if inflation is negative. Meanwhile, increases are often capped, typically at 5%, although uncapped agreements are more common in continental Europe. 

By capping the maximum rent increase, both parties have more certainty that rents will remain affordable over the long term and do not decouple from property fundamentals during periods of very high inflation.

Indirect inflation protection   

In addition to their direct inflation-linked protection, sale and leasebacks offer an indirect and uncapped inflation hedge through ownership of high-quality, well-located key operating assets. Long-term values are subject to property market cycles; however, in a stable yield environment, we would expect inflation-linked rent reviews to flow through to capital values. 

Future-proofed real estate assets, specifically those with strong ESG credentials, should provide better protection due to their relative scarcity combined with increasing tenant demand – with many tenants wanting to occupy buildings that align to their ESG targets/values. 

High-quality long lease real estate portfolios are becoming increasingly difficult to replicate as build costs have increased significantly in recent years due to supply chain bottlenecks and broader inflationary pressures.  

High-quality yield premium

Long lease real estate transactions typically benefit from a meaningful yield premium over equivalent government and corporate bonds due to their relative complexity and illiquidity. 

Deals can require significant resources and expertise to arrange, and property markets are fundamentally less liquid than bond markets, resulting in a premium being required to compensate investors for this additional risk.

While this could result in higher cashflow yields than those typically available from public debt instruments, this is not at the detriment of credit quality given long lease real estate portfolios are typically investment grade. Creditworthiness can mainly be determined by analysing the tenant's ability to meet rental obligations, with higher-quality tenants ranging from universities to local authorities and FTSE 100 companies. Ownership of the underlying real estate, typically key operating assets of the tenant, can also provide additional downside protection.

A real potential opportunity

Inflation has so far proven stickier than many central banks anticipated following the post-lockdown reopening of their economies. At the same time, policymakers are restricted in raising interest rates beyond a certain point, given high levels of government and household debt and the risks of further asset price falls, which would have knock-on economic effects. As such, investors seeking positive real returns may wish to consider alternative investments, such as long lease real estate, with a view to protecting their portfolios and growing cashflows over the long term.

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.