Long live long leases as investment income options dwindle
Real estate investment trusts buying properties on long leases of over 15 years have become popular as investors look to lock in to reliable income streams in response to the dividend crisis, low interest rates and the threat of rising inflation.
Long leases with rents that rise with inflation are highly prized as they ensure the income they provide preserves its real value.
However, a lease is only as good as the tenants in the property. Fund managers say it is essential to have financially strong commercial tenants whose businesses can sustain the escalating rental payments.
Commercial property funds investing in inflation-linked leases may seem like a port in a Covid-19 storm for income investors but fund managers warn that not all index-linked returns are created equal.
Long-lease real estate investment trusts (Reits), which invest in properties with long-dated leases of anything from between 15 to 999-years, have grown in popularity as investors look at their dwindling options for reliable income against a backdrop of widespread dividend cuts, low interest rates and the threat of rising inflation.
Schroder’s James Agar, manager of Ground Rents Income (GRIO), the £80m investor in a portfolio of residential, commercial and student accommodation freeholds, said dividend cuts were likely to continue next year and the Bank of England would be keen to keep interest rates very low to help the economy recover from the coronavirus recession.
‘This will support pricing for defensive, non-correlative real estate assets,’ said Agar.
‘The explosion of government borrowing in the UK since the start of the pandemic could also lead to rising inflation expectations which could also lead to investor willingness to accept lower yields for real estate assets with these [index-linked] characteristics.’
Schroders has revised its retail price index (RPI) inflation rate down to 1.6% for this year and to 2.7% for 2021 but Agar said it was likely the measure will be reformed to match the CPIH, the consumer price index (CPI) plus housing costs. This would lower Schroder’s long-term inflation estimate to 1.9%.
Ben Green, who runs the £525m Supermarket Income (SUPR) Reit, which has powered through the pandemic as its tenants – which include major supermarkets Tesco, Sainsbury’s and Morrisons – saw sales rocket during lockdown, expects CPI to be between 1-1.5% next year and RPI to hit 2-2.5%.
‘We think owning RPI or CPI-linked assets will be attractive from a growth point of view,’ he said.
He said there was ‘definitely more demand’ for inflation-linked assets, as proven by SUPR’s oversubscribed £140m share issue in May, which far exceeded its initial £75m target.
SUPR collected 100% of its rents due during the lockdown thanks to the nature of its tenants – a feat that few Reits managed as some tenants saw revenues plummet to near zero under the government’s restrictions on socialising and travel.
Green said this has encouraged some property investors to try and alight on the supermarket property sector as a way to shore up more generalist portfolios and this has pushed up prices.
‘We are definitely seeing some increases in price and compression in yield but it will take a bit of time to come through in the market,’ he said.
‘When we started SUPR we thought the assets were undervalued and we are beginning to see the rest of the market recognise the value in the sector. There’s scope for yields to go down and asset prices to go up, which is great for our shareholders because they will benefit from that increase in value.’
The fortunes of long-lease funds during the Covid-19 crisis has been dependent on the sector, or sectors, the Reits invest in. Retail, hospitality, and leisure assets have been hit hardest while warehouse investors have been buoyed by an acceleration in online shopping and subsequent demand for distribution hubs.
Agar said Covid-19 ‘has exposed some weaknesses in the long income market and led to some polarisation in pricing and performance’; the 'company voluntary arrangement' (CVA) budget hotel chain Travelodge entered into in June was a case in point.
This polarisation has meant long lease investors need to be wary of where their returns are coming from.
Kenneth Mackenzie, manager of the £495m care home investor Target Healthcare (THRL) Reit, said ‘you can have all the index-linked income you want’ but investors need to understand the dynamics of the ‘core underlying performance of the businesses using the real estate’.
‘There is too much focus on the index-link rather than the sector,’ he said. ‘Not all index-linked returns are created equal.’
Mackenzie said funds need to have knowledge of the tenant’s business and be sure about how ‘robust’ the underlying sector is.
‘The fundamentals are really important,’ he said. ‘We execute investment in modern, purpose-built real estate that has a 30-40-year lease ahead of it and will be in high demand,’ he said.
‘The number of over-85s will double in the next 20 years and the chances are one in seven-and-a-half people over 85 will end up in residential care.’
Agar said index-linking was just one part of Schroder’s due diligence process, which also includes the duration of the leases, which can range from ‘vanilla long-let assets’ of 15-25 years to ground rents of 999 years.
‘Index-linked rents can lead to a disconnect from open market rents, which if it occurs can create specific valuation issues as expiry approaches,’ he said.
Green said he looked at the strength of the underlying tenants, and although SUPR’s tenant list was concentrated in a small number of supermarket groups they all had strong balance sheets.
‘If you have concentrated tenant exposure and low-quality tenants then you have a problem,’ he said.
Green warned investors against putting their money into funds where the underlying tenants were private equity groups.
‘Ultimately leasing is a way of financing a business,’ he said. ‘Typically, the private equity approach is to achieve the cheapest leverage possible against the asset you buy.’
He gave department store Debenhams as an example: the retailer was bought out by private equity firm Blackstone, which sold and leased back the buildings.
The freeholders of Debenhams stores are left with a ‘highly leveraged’ private equity tenants.
‘When everything is growing, and on the upside that [amount of leverage] is fine but when the market changes they do not have the balance sheet strength anymore,’ said Green.
A change in accounting rules was also making it less attractive to sign up to long leases, according to Green.
Under IFRS 16 rules, companies have to put the capital value of lease obligations on the balance sheet whereas previously ‘leasing used to be off the balance sheet’, said Green.
‘The trend has been to shorter leases, driven by changes in accounting standards,’ he said. ‘Longer leases have higher capital value on the balance sheet so that means tenants have been moving to short leases, but again the exception is private equity, which generally don’t mind committing to long leases if it gets them cheaper financing and that is the bit where investors need to be really careful.’
If the tenants are private equity-backed ‘that is a pretty big red flag’.