Real InSite provides our views on topics affecting global real estate markets. In the latest monthly article, we look at the stable income offered by the UK’s long-lease sector and the similar, albeit more nascent, opportunities in Europe.
For more Real Estate articles, check out our Analysis of Real Estate issues.
There is no doubt that sourcing investment income is becoming a significant challenge for many global investors. Following unprecedented levels of central bank stimulus, bonds are no longer the bedrock of income that they used to be. The days of ‘risk free’ treasuries providing yields of 5% per annum for 15 years are now a distant memory, and forecasts suggest that we won’t return to those heady days anytime soon. As a result, investors are increasingly seeking income through real estate’s long-term cashflows.
However, is the real estate industry working hard enough to produce specific investment solutions that allow investors to tap into these income benefits? The answer is probably no, but things are changing for the better.
In the UK, there is a growing number of real estate funds targeting stable long-term cashflows linked to inflation. There are 11 ‘long lease funds’ as defined by IPD/MSCI; five of which are in the AREF/IPD UK Quarterly Property Fund Index. The total gross asset value of the wider group is £13.2 billion and accounts for roughly 9% of the IPD/MSCI UK quarterly investment universe. Not an insignificant sample. But, can these funds deliver the performance investors want?
The infancy of the proposition is an issue in terms of tracking performance. The best proxy for how these strategies have performed comes from the long-income component of the AREF/IPD UK Quarterly Property Fund Index. Between September 2010 and September 2017, annual fund level returns averaged 9.9% per annum across all balanced funds and 9.2% per annum across long-income funds.
Of more significance, however, is the range of returns over this period. Between the highest and lowest annual return in the All Balanced Fund Index, the range is 22.9%. For the long-income group, the range of return is less than half at just 10.8%, providing strong evidence that certainty of income plays a key role in driving more stable overall performance.
Source: AREF/IPD Quarterly Property Fund Indices, Standard Life Investments as at September 2017
We would argue that continental Europe offers an equally suitable platform as the UK for such strategies, albeit for slightly different reasons. Leases linked to inflation are far more prevalent on the continent, while investing across multiple, but carefully selected, jurisdictions provides added diversification. Furthermore, Europe is home to a significant number of high-quality tenants, which tend to underpin strong cashflows. Two-thirds of Fortune 500 companies have their headquarters in core markets such as Germany, France, the Netherlands, Belgium, Sweden and Denmark – countries that account for 76% of continental Europe’s investible real estate stock, according to IPD/MSCI estimates. Perceived risk in these European markets is not too dissimilar to the UK, with their mature nature providing investors with confidence. However, for interested investors there are currently very few income focused real estate investment solutions that allow access to these opportunities.
There are other challenges on the continent. Firstly, sourcing leases of sufficient length to replicate the success of UK long-income funds is a consideration. While leases are typically shorter outside the UK, long leases of over 15 years are not entirely absent from the continental European market. Assets let to government bodies; the forward funding of bespoke properties in the private sector; or sale and leasebacks are three sources of longer income prevalent in Europe. Secondly, with inflation-linked income, properties can become over-rented, which can hurt future valuations. But again, this can be overcome through specialist active management.
While European secure income-focused real estate funds are in their infancy, the opportunity for investors is clear. As part of a diversified investment strategy, an allocation to long-lease real estate can help to increase the certainty of inflation-protected income while also reducing volatility. These are clear attributes that investors would do well to consider.