LONG LEASE FUNDS
Billions flow in, but critics say the assets are expensive and not bullet-proof, writes Jane Roberts
Pension fund capital has poured into long- lease, inflation-linked assets in the past three years, making it the stand-out success story for property fund managers who switched into the strategy quickly enough, and the top recommendation to clients of pension fund consultants (see pp12-14).
Standard Life Investments was an early mover and runs one of the longer-standing funds; late last year, assets under management in its Long Lease Property Fund passed the £1bn mark.
M&G’s Secured Property Income Fund has grown to £1.35bn invested since its launch in 2007. It has more than trebled in size in the past three years and has a further £300m of commitments to invest.
Legal & General’s Limited Price Inflation Income Fund, launched in 2010, has taken in £220m and Legal & General Property also invests in long-leased, inflation-linked assets for its in-house annuity client. It has invested about £1bn for the two clients in the past 18 months.
Slightly later to the party was Aviva Investors, which launched its Return Enhancing and Liability Matching product late in 2011. The group set up five REaLM funds to buy long-leased assets in various sub-sectors: infrastructure, commercial property, social housing, student housing and ground rents, while a more recent umbrella fund, targeted at smaller pension funds, invests in them all. In all, REaLM has attracted more than £1bn.
Meanwhile, Pramerica has a successful ground lease fund, while AXA Real Estate has just set up a UK long lease fund, and bought its first assets in January.
Funds defy the doubters
By and large these managers have defied the doubters who said they wouldn’t find enough liability-matching product, often by creating it themselves and by taking advantage of the lack of development finance to fund assets from student accommodation to supermarkets, budget hotels or data centres.
Most notably, long-leased property has significantly outperformed in the downturn and more than kept pace during the subsequent recovery. According to IPD, which now publishes data on four of these funds in the Long Income Property Fund subset of its quarterly Pooled Property Fund Index (see table below), M&G was the top performer in the three years to December 2012, with an average 11.1%, followed by Standard Life’s at 10.5%.
Last year, the LPI Income Property Fund returned 8%, M&G’s 7.6% and Standard Life’s 6.5%, compared to the IPD Quarterly Index’s more measly 2.7%.
But not everyone is wholeheartedly a fan. “Long-leased funds have performed so well because they have been a self-fulfilling prophecy,” says Neil Cable, head of European real estate at Fidelity Investments International, referring to the weight of money chasing them. “These are income products, yet all the outperformance has been capital.” Cable runs two UK and European funds with a very different focus on good-quality, higher-yielding secondary property.
“Long-leased funds are sold as a liability-matching tool and consultants have been recommending them,” he adds. “I think there are a lot of nuances to pay attention to: one Waitrose 20-year property could make sense more than another, depending on location. It’s important to look at residual values, but do the pension funds taking the advice realise this?”
Graeme Rutter, head of Schroders’ multi manager arm, says: “We see long-leased funds as being expensive. Do investors expect them to perform like property or bonds? They may think they are bullet proof, but if bond yields move, these funds’ yields will move too, and a quarter point yield out on an investment at 4% is more dramatic than on a higher-yielding one.”
M&G’s response is that investors’ expectations can indeed depend on where they are coming from (see panel below) and “what you are making the comparison with,” says Ben Jones, fund manager of M&G SPIF. “Compared with an index- linked gilt they look attractively priced.”
He adds that while initial yields may look low compared with other property, “our fund costs are quite low precisely because we don’t need asset managers to work on the property, so our net cashflow is the same as our gross cashflow”. M&G SPIF distributes 4% net.
Managers of these typically single-let investments do expect to be relatively passive, because tenants are likely to do the investing in the real estate to increase value in their operating businesses.
‘Sensible investments’ even if values fall
However, M&G says that even if the value of the properties did fall, they still make sense as investments. For example, it points out that with 3% annual inflation, a 25-year lease to Tesco on a property bought at a 4.55% initial yield still outperforms a Tesco 5.5% 2033 corporate bond, even if the property value crashes to 30%.
With single lets, it is true that credit assessment of tenants is very important in these deals, and it is important to avoid con-centration risk, says Jones’s fixed income colleague Andrew Swan. But big tenants can get into difficulties – as Travelodge did – or go bust. Not so long ago people thought Sony and Olympus were top-quality credits.
Managing liquidity is an issue for many property funds, not just long-leased funds. But a particular question for them is what would happen to these open-ended funds if the bond investments they are compared to become cheaper.
Will the large inflows reverse and become outflows? Will defined benefit pension scheme investors change their behaviour as they begin to run down the size of their funds, switching into more liquid bonds?
Jones says a lot of the money from the 80 or so mainly UK and Dutch pension funds in M&G SPIF comes from their property, rather than fixed-income, allocation, and that their assets could be sold if necessary to meet redemptions “as they are at the most liquid end of the property spectrum”.
If inflation rises above the 4-5% RPI cap in place for most of the leases “these funds would underperform the wider property market”, Jones agrees. But he claims it is “not a huge issue” for most investors, because their own payments on pensions are capped at the same or similar levels, so remain matched.
Rivals for capital will be watching this part of the market closely in coming months to spot signs of consultants cooling on them.
“There are signs of secondary market activity,” says Schroders’ Rutter, implying that some investors may be taking money off the table. It will be interesting to see whether this becomes a trend, driven by a perception of better value in ‘traditional’ property.
M&G moves pension funds into rented housing
In pursuit of bond-like income for its investors, M&G has bought commercial real estate, ground rents and housing, as well as financing developments.
Ben Jones, fund manager of the Secured Property Income Fund, recently bought its first big residential investment: Halo in Stratford, next to the Olympic Park. M&G paid Genesis Housing Association £125m for the 401 market-rented flats, beating rival Legal & General to the deal.
Under the sale-and-leaseback agreement, Genesis took a 35-year lease with annual RPI reviews at 0-5% and all responsibility for letting and managing the flats.
“Pension funds are interested in this sector, but it has been difficult for them to access it because they don’t have the resources to manage individual tenancies,” Jones says. If Genesis lets flats at rents above the RPI level it keeps the extra revenue. M&G is talking to the NHS about some similar projects, he adds.
Ground leases with index-linked rents are rare but the fund completed one last December, secured on Hilton’s 350-bed, five-star hotel near Heathrow Terminal 5. The 200-year ground lease has 0-4% RPI- linked uplifts set at 15% of earnings.
In return for financing development ofan ‘on-airport’ budget hotel at Gatwick for Premier Inn late last year, SPIF received a 19% uplift in the first year, equating to a 5.4% net yield, 3% in year two (5.6% net yield) and annual CPI-linked uplifts after that.
“It earned some capital appreciation on completion above the income returns,” says Jones, adding: “Our pipeline of development transactions is growing by the day.”
Property ‘hybrid’ goes head to head with bonds
For pension funds with inflation-linked liabilities, long-dated bonds are natural investments. But, says Andrew Swan, M&G Investments’ fixed income director, index- linked government bonds are very expensive and conventional corporate bonds offer no direct inflation protection. They are also in relatively short supply.
Long-lease property is a “hybrid between fixed income and property”, Swan says, blending credit and real estate characteristics. Property has advantages and disadvantages over bonds, he adds. If a bond issuer goes belly-up, “you might get 30% of your capital back, while a property that had the same tenant has a value”, and can be re-let or sold. But property doesn’t have a bond’s liquidity.
Compared to shorter-leased property, these assets look expensive, but compared to bonds yielding 1.5% over the past three or four years, they look cheaper – it depends where you’re coming from.