For most of the large investment management houses, investing in alternative real estate means buying assets let to blue-chip tenants on long, usually inflation-linked leases for pension fund clients looking to match their long-term funding liabilities.
M&G, Standard Life, Legal & General, Aviva Investors and, more recently AXA and BlackRock, have all established open-ended property funds competing to carry out this strategy. It’s an approach that has proved very successful over the past six years, especially compared to the poor performance of the wider property market.
The Standard Life and M&G funds that buy stable, long-term income streams have been benchmarked in the AREF/IPD Long Income Index for over five years and have outperformed the All-Property Fund and All-Property Balanced Fund indices over the whole period. L&G’s newer Limited Price Inflation Income Property Fund has also outperformed since it joined two years ago. The Long Income Index one-year return to September 2013 was 8.8%, compared with 4.2% for All Balanced Property Funds.
Performance gap is closing
However, these assets are not cheap and critics say their outperformance was a self- fulfilling prophecy, driven by capital value growth due to the weight of money chasing them. Furthermore, the gap they have maintained over traditional property assets is starting to narrow, as capital growth has finally returned to the wider market; total returns were 2.6% for Long Income funds and 2.4% for All Balanced funds in Q3 2013.
Long-dated bond yields started rising this year in the first anticipation of higher interest rates to come and this could have an impact on one of the main reasons why institutions allocate to these funds: for extra yield to supplement their hitherto lower-yielding index-linked gilt portfolios.
For investors making commitments from property allocations, one question now is whether they will switch some of their money into alternative property strategies that may soon yield better total returns. M&G Real Estate’s Secured Property Income Fund (SPIF) was the granddaddy of these products. M&G/Prupim began buying inflation-linked, long cashflows 13 years ago, then set up the fund in 2007, quickly picking up a fan base of investors that shows no sign so far of switching money out.
SPIF fund manager Ben Jones says much depends on the basis for their allocations in the first place. “The vast majority want long- dated cashflows as opposed to trying to time the property market. It’s an allocation, especially to our fund, given its high level of inflation linkage – over 90%. So I don’t necessarily see that a perceived improvement in the property market is going to change that investment driver.
“Some may come up the risk curve and make commitments, but probably not by reallocating from this strategy – although that remains to be seen.” Jones says he would be particularly surprised if investors do switch away from long-income funds, as “they have worked very hard to get into these strategies”. He adds that SPIF continually runs “a capital queue in the hundreds of millions. We had inflows of about £500m in the 12 months to Q3 2013. We don’t market the fund because of the level of investor appetite.”
The fund’s income distribution is 4.3%. Jones sees the premium over index-gilts continuing, but concedes that it may narrow. “These yields haven’t followed bonds all the way down,” he points out, referring to the long period of very low gilt yields after the financial crisis.
Always a premium over gilts
When they rise, “the premium will be less attractive, but still attractive, and if they move out it will have an impact on all real assets. We have been doing this through a couple of cycles and there’s always been a premium of some description.” The key to SPIF’s success has been his team’s ability to find investments and improve the quality of the portfolio. As the fund has grown – its value is heading towards £2bn – so have the size of the acquisitions it is able to make.
This year was a record period, with £700m invested, in offices, retail, residential and, in October, the freeholds of 18 car auction sites spread across the country and operated by British Car Auctions. The latter involved SPIF alongside the Prudential Life fund acquiring the freeholds for £240m to secure 18 years of income with annual uplifts. The vendor had been trying to refinance the assets, which were highly-leveraged with debt from RBS, so the deal effectively stabilises the landlord ownership for British Car Auctions.
Buying Scottish Power’s Glasgow HQ for £113m on a 25-year lease was a more conventional example of how operating companies can use long leases to realise value and secure their businesses for the long term. “What more corporate tenants under-stand is that where they see themselves occupying property for a long period of time they can raise more capital because of the value a long lease creates,” Jones says.
This year SPIF bought its first large residential investments. The first deal, for the Halo development in Stratford, was a £125m, 35-year sale-and-leaseback with Genesis Housing Association. If Genesis lets the flats at rates above RPI reviews, it will keep the extra income. M&G’s fund also provided Willmott Dixon and housing association Poplar Harca with development funding to finance homes at East India Dock, in a deal worth around £70m and structured around a 30-year lease. “It’s been phenomenal, an incredibly interesting year,” Jones says. M&G Real Estate is considering expanding the strategy to the Continent next year.