The long-lease property market is starting to diversify beyond supermarkets, opening up further opportunities for schemes to access inflation linkage, finds this feature from our The Specialist investment series.
Long-lease property funds are widely held as a suitable investment vehicle for pension schemes seeking a higher-yielding and inflation-hedging alternative to record low yields on index-linked government bonds.
The Facts
What is long-lease property?
• The leases are usually 15-35 years, compared with the average UK lease term of 7-8 years.
• Many long leases have contractual rent increases in line with inflation.
• Leases are full repairing and insuring, so the investor is not responsible for maintenance or insurance of the property.
What is core property?
Property assets in prime locations in the retail, office and industrial sectors with high quality tenants, occupancy rates and strong lease covenants. The investment focus is long-term capital growth and/or income generation.
What are balanced property funds?
Pooled funds that are geographically diversified and invested across property sectors, usually in core property assets.
For the full The Specialist report on property and infrastructure, go here to find the PDF.
UK pension funds allocate between 5 per cent and 10 per cent of their total assets to property. The main focus, say investment consultants, is on securing long-term stable income streams with a contractual link to inflation.
For example, consultancy LCP is advising schemes to invest in long-lease property as part of a derisking strategy that includes an allocation to other income-generating real assets such as social housing, ground rents and infrastructure debt.
Cash flow matching
Long-lease funds typically target a return of inflation (as measured by the RPI) plus 4 per cent a year.
Consultancy KPMG estimates UK pension schemes have invested approximately £3bn in long-lease property pooled funds out of an aggregate fund size worth between £3.8bn and £4bn.
The total size of the long-lease property fund market is put at more than £10bn. The remainder of the assets under management has been invested by multi-managers and other institutional investors.
Long-lease property fund managers in the UK tend to focus on domestic real estate assets because only UK property leases are explicitly linked to RPI.
While some property leases outside the UK are linked to local inflation indices, they tend to be shorter leases, says Nick Duff, partner at Aon Hewitt.
However, average UK lease lengths have fallen dramatically over the past decade, to 4.8 years in 2011 from 7.8 years in 2002, according to the British Property Federation and data provider IPD’s Annual Lease Review 2012.
But average lease lengths vary considerably between property sectors. For instance the supermarket sector is prepared to commit to leases of between 15 and 35 years, says Charles Follows, head of property research at asset manager Kames Capital.
Concentration risk
Some investment advisers believe many long-lease property funds have focused too heavily on supermarket long leases and as a result are exposing investors to concentration risk, while driving up the prices in the sector.
The buoyancy of the supermarket sector is highlighted in a recent IPD/Briant Champion Long UK Supermarket Investment Report, which revealed institutional investors, predominantly UK-based, poured more than £1.2bn into supermarket assets last year.
Based on an analysis of £4.9bn of supermarket assets, IPD said that in the five years since the downturn, supermarkets have returned 6.9 per cent a year compared with other retail assets at 1.3 per cent.
For the full The Specialist report on property and infrastructure, go here to find the PDF.
Despite this strong performance, consultancy Redington advises first-time investors to subscribe to long-lease property funds that have less exposure to supermarkets, says Mark Herne, managing director for investment consulting.
“We would look for a diversified mix of commercial real estate plus good geographical dispersion and inflation linkage,” says Herne.
Due to concerns about concentration risk and “exceptionally strong demand” for long-lease property funds, which will “potentially drive down future returns”, the advice is to invest without delay, says Alexander Koriath, head of investment manager research at KPMG.
“There is still an opportunity and if [schemes] invest relatively quickly they might even profit from this demand, further pushing up prices,” says Koriath.
Henry Smith is editor at MandateWire Analysis
