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Tapping the potential of long lease real estate investing

Ben Jones
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M&G Investments’ Ben Jones says LGPS funds need secure, long-dated cash flows

Local Government Pension Scheme trustees contending with low yields and funding gaps will be well aware that the investment returns they need to meet their liabilities are often scarce or expensive.

However, long lease real estate has the potential to deliver secure, long-dated cash flows with contractual inflation protection - and significantly higher yields than gilts. Moreover, three distinct long lease investment structures offer investors a broad range of additional investment outcomes.

Blending fixed income and real estate characteristics

Long lease transactions are well suited to UK pension schemes, blending aspects of fixed income and real estate investment by generating long-term rental income streams from typically investment-grade tenants.

Investors are attracted by the predictable, bond-like cash flows from the rental income stream, as well as the capital growth potential and security that investment in real estate offers. This is in addition to inflation linkage and other contractual terms, such as fully repairing and insuring leases that place responsibility for ongoing maintenance costs on the tenant, rather than the landlord.

That breadth of investment characteristics means that long lease transactions can play a number of roles in DB pension fund portfolios in addition to income generation. The typical yield pick-up over gilts has attracted investors looking for growth, while income strips (see below) are well suited for liability matching purposes. The long-dated nature of long lease transactions offers a degree of protection against market cyclicality, which means they can also serve as a low volatility diversifier in a traditional core UK real estate allocation.

Like any real estate or fixed income investment, investors bear the risk of tenant default (credit risk), price risk and term risk. However, investments are secured by a real asset with inherent value. Leading asset managers with a dedicated long lease investment capability will also be able to manage risk by sourcing and structuring quality deals, negotiating optimal terms and performing rigorous due diligence on all aspects of each deal.

Three transaction types

Long lease real estate transactions typically take one of three structures, each catering to different investment objectives.

Sale and leaseback structures form the foundation of all long lease deals: an owner-occupier sells the freehold to an investor and then leases it back on a long-dated lease (typically 20-plus years). The income generated from sale and leaseback deals is typically higher than that from the other long lease structures and significantly exceeds the yields on long-term gilts.

Terms will depend on a number of factors. Tenant credit quality, lease length and the nature of the rental uplifts will all determine how a deal is priced. For example, explicit inflation linkage might be more attractive than annual, upward-only rental reviews.

The residual value and capital growth prospects of the real estate will also affect pricing. For example, exposure to the growth potential of a high quality property or location (residual value) may mitigate the risks associated with weaker tenant credit quality.

Income strips are essentially sale and leaseback structures, offering similar cash flows, except that the tenant retains the option to buy back the freehold at lease end for a nominal sum.

Income strips effectively ‘strip’ the cash flows from the lease of the underlying real estate, so that the income stream represents 100% of the investment’s return. Income strips are easier to model for liability matching purposes as they contain no uncertain residual value component. Compared to most sale and leaseback deals, the capital sum paid to the tenant is generally lower and leases are longer.

Ground rents offer another way for pensions to match the duration of their long-term liabilities. Freeholders offer very long leases, often more than 100 years to either commercial or residential tenants. Due to the length of the lease, cash flows constitute the full return on investment, offering investors another way to generate predictable, inflation-linked income secured by a real asset, yet with minimal exposure to the cyclicality of the real estate market.

Not just inflation-linked cash flows

Three distinct long lease investment structures offer LGPS valuable outcomes, not least their capacity to produce regular, high quality cash flows that increase with inflation. However, these assets also meet a range of other investment objectives for investors with a long-term focus, including growth, diversification, and long-term liability matching.

For investment professionals only

This article reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance. The distribution of this guide does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority’s Handbook. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority.

Column sponsored and supplied by M&G Investments

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