In an era of low interest rates and rising maintenance costs, the benefits of long-income assets within UK real-estate portfolios are hard to ignore. Tim Perry looks at three key trends that are influencing the UK long-income market.
2 minute read
Economic uncertainty and plummeting government bond yields have increased the attractiveness of long-income real estate for liability- and cashflow-driven investors. Encouragingly, opportunities to fund or acquire assets with counterparties of strong credit quality are emerging.
While some companies are reducing their sale-and-leaseback activity, partially due to IFRS accounting changes, many public-sector entities are actively seeking new ways to finance real-estate development as well as monetise their existing ownership. These counterparties often have unique requirements, which entail complex structuring. By working bilaterally to achieve these goals, more attractive pricing should be achievable. More fundamentally, lower-for-longer interest rates, the search for alternative funding by public-sector entities and rising maintenance costs all strengthen the case for UK long-income assets.
Lower for longer supportive of long-income assets
At the end of 2018, many investors were anticipating modest increases in US rates – and bond yields – to spread to other markets, including the UK. Fast forward a year and the combination of a deteriorating global economic outlook, slowing industrial output across Europe and trade tensions has forced central banks to continue with supportive monetary policies, leading to a sharp decline in bond yields. Long-term gilt yields have not been immune, with 10- and 30-year bonds respectively falling by around 86 basis points (bps) and 107 bps, respectively, from their peak in November 2018 to today (28 January 2020).
Falling yields have impacted many defined-benefit pension schemes’ funding positions. Deficits reached an 18-month high in August, before falling somewhat in September.1 This is likely to delay planned buy-outs or buy-ins for many schemes, in turn sustaining their interest in higher-returning, low-risk asset classes such as long-income real estate.
Although the asset class offers a return profile comparable to long-duration bonds, long-income real-estate pricing is generally slow to react to changes in gilt yields. According to the CBRE Long Income Index, yields fell by just 19bps in the first nine months of the year, increasing the return premium over gilts.
Public-sector search for alternative funding creates opportunities
Public-sector access to funding has been challenging in the past decade, in no small part due to austerity measures. This has led public-sector bodies, from the National Health Service to educational institutions, to seek alternative funding sources. While each case is specific, many have turned to their real-estate assets to improve their financial position.
In terms of funding, local authorities have been under pressure, with their spending power reducing by 28.6 per cent in real terms between 2010 and 2017.2 The way in which they are funded has also changed. In 2013 business-rate retention was introduced, whereby local authorities retain 50 per cent of locally-collected business rates – and 50 per cent of the real growth in those rates – due to rise to 75 per cent by 2022. Local authorities therefore have a powerful and growing incentive to increase real-estate development in their district, to grow both business rates and council-tax revenues. As a result, they are exploring real-estate sales and leasebacks, regeneration projects or providing guarantees on new developments.
Figure 1: Local Authority discretionary spending power (£billion, 2019 prices)
This trend is likely to continue, as local authorities’ funding becomes increasingly dependent on business-rate retention, their real spending-power growth remains flat, and demand for services continues to rise.3 For investors, this will create opportunities to invest in assets providing a steady income stream and the increased income security of a public-sector counterparty.
Rising maintenance costs highlight the benefits of fully-repairing and insuring leases
When property yields are low, maintenance and vacancy costs can be a big detractor from the income available on traditional leased real estate – around 20 per cent according to our estimate. As real-estate long-income strategies are typically let on fully-repairing and insuring (FRI) inflation-linked leases, such costs are instead incurred by the tenant. The chart below illustrates how this could affect returns on an annual basis.
Figure 2: Example long-lease versus traditional lease office
Looking ahead, real-estate capital costs are likely to rise. Institutional landlords are now competing with flexible office providers and will only stay competitive by investing to improve the tenant experience and offering more flexible leases, which increase vacancy risk (See here). Meanwhile, structural changes to the retail market mean that only prime spaces offering the best experience – and therefore more expensive to upkeep – will attract customers. In this context, FRI leases could be increasingly beneficial, sparing investors the headache of rising maintenance costs. This adds another dimension to the defensive, low-risk nature of the asset class.
This article originally appeared in Institutional Real Estate, Inc. (IREI).