Renos Booth, Isabel Gossling and Kris McPhail from our real estate long income team discuss the strengths of long-income strategies in a period of high inflation and rising rates.
Read this article to understand:
- The outlook for real estate long income in the UK and Europe
- The importance of strong investment fundamentals
- The value of tenant engagement
Going into a period of uncertainty, many institutional investors turn to real estate long income (RELI) assets. They are generally less volatile from a return perspective and considered more secure than the broader real estate market and other asset classes, because the majority of return performance comes from income secured by leases let to strong tenants.
They also offer some inflation protection as the majority of the long-term cashflows these funds provide are inflation-linked, albeit often capped at four or five per cent per annum in the UK (typically uncapped in Europe).
The UK market’s dynamics are changing. After 15 years of rapid growth, from about £2 billion in 2008 to almost £21 billion at the end of 2021,1 predominantly led by demand from defined benefit (DB) pension schemes, the UK RELI market is at an inflection point.
As some DB schemes reach maturity and look to de-risk, selling RELI holdings where values have held strong could be seen as an opportune moment to cash in. On the other hand, insurers buying out pension liabilities are increasingly investing in RELI assets, particularly where the assets can be structured to be matching-adjustment eligible.
This has created a two-tier market where insurers are buying into these assets and, in a lot of cases, driving pricing. However, insurers’ capacity is significantly smaller than DB schemes. As such, many DB schemes will need to maintain a self-sufficient strategy where RELI assets continue to offer attractive cashflows.
Although less mature than the UK, the European RELI market has seen a significant increase in momentum following similar resilient performance through the pandemic.
In this Q&A, Renos Booth (RB), Kris McPhail (KM) and Isabel Gossling (IG) from our RELI team discuss the importance of diversification and strong fundamentals.
This has been a difficult year for most asset classes. How has RELI held up relative to previous crises?
RB: RELI continues to perform as it was structured to, delivering secure, predictable income with low volatility through different market cycles when compared to traditional real estate and more liquid asset classes. This was proven during the global financial crisis, post Brexit referendum and during COVID-19. We believe it can also deliver lower volatility and more predictable inflation-linked income through this next phase of market uncertainty.
RELI still provides attractive income security compared to many other asset classes
The main difference compared to previous periods is that the relative value of RELI has reduced because of increased gilt yields. However, RELI still provides attractive income security compared to many other asset classes, and the risk of default and expected loss remains relatively low for funds that have focused on stronger credit and high-quality real estate.
The goal is to reduce the risk inherent in the asset, so the majority of the value is derived from the contractual income, as opposed the capital value in traditional real estate. Of course, we will not be totally immune to challenges in the real estate market. However, their impact on long-income strategies should be lessened by the strength of tenant credit, the quality and, in many cases, the sustainability of the assets we invest in, and the inflation protection offered by the contractual income.
KM: Inflation and rising interest rates have impacted gilt yields significantly. With the growing risk of recession leading to widening credit spreads, this has increased the required return discount rate needed for cashflows, impacting demand and valuations.
CBRE’s long-income index reported returns of one per cent in the second quarter of 2022, the lowest return in the last two years. Income strip investments were hit hardest by rising gilt yields, posting a quarterly return of minus 3.5 per cent. Returns from ground rents and sale leaseback investments have fallen versus the first quarter and are at similar levels of 1.9 per cent and two per cent respectively.
Rent collection remains strong for the majority of RELI funds
In the UK, rent collection remains strong for the majority of RELI funds. If there is a recession, RELI strategies with well-diversified portfolios, high-quality tenants, and limited exposure to discretionary sectors such as retail should remain resilient. In the case of our Lime strategy, for example, rent collection over the last three years has remained at 100 per cent, despite the impact of COVID 19 lockdowns and social distancing measures on the economy and companies. This is due to our strategy of investing in properties let to public-sector entities and corporates with investment-grade credit ratings.
IG: The RELI market in Europe is several years behind the UK in terms of maturity, but growing, and we have seen increased momentum over the last year. The stable income yield and 100 per cent rent collection rate throughout the pandemic represents strong performance and resilience, which is attractive for investors. Partly as a result of this, we are seeing more interest from investors in Ireland, Germany and Italy, for example.
In Ireland, much of the momentum stems from pension funds seeking to de-risk but wanting to retain an exposure to real estate and diversify their exposure outside of Ireland. In Germany, demand is driven more by insurers attracted by secure, long-term, inflation-linked cashflows.
Our European strategy is less exposed to the lowest-yielding sectors
The outlook is uncertain, but we expect RELI to continue providing resilient income-driven performance through long-term leases to investment-grade tenants with inflation-linked rent uplifts. This provides some insulation from the weaker growth outlook and current market context. Whilst not wholly immune from the re-pricing we are seeing across the broader real estate market, our European strategy is less exposed to the lowest-yielding sectors that have seen the greatest proportional yield adjustments – such as prime offices in major European cities, and some of the strongest-priced logistics assets in Europe.
Where do you see attractive opportunities and which areas look more challenged?
RB: RELI strategies continue to provide attractive inflation-linked income. From a capital perspective, we have seen some parts of long income re-price faster than others following the significant movement in the risk-free rate in 2022.
Amortising assets in particular have moved more quickly and, alongside commercial ground rents, provide more attractive pricing compared to reversionary long lease and traditional real estate, which generally suffer more of a lag. That said, the constant must be the security and quality of income, particularly through challenging periods like the current one. Security of income, for example through a high weighting to the public sector, can also ensure greater capital stability, not just income security.
KM: In the UK, our top three exposures in Lime are offices, distribution, and student accommodation.
There is still a big supply-demand dynamic for student accommodation
We are positive about the outlook for student accommodation. There is still a big supply-demand dynamic, due to the growing number of 18-year-olds and overseas students, particularly from China and India, and a weak sterling is making it attractive for them to study here. We are also attracted to the housing sector, and in particular affordable and supported living sub-sectors where there is growing demand and a lack of supply.
In the short term, we have seen good rental performance from offices, but over the longer term, there are questions about how much space occupiers will need. We continue to analyse the physical occupancy of our offices, understanding which are core assets for tenants and whether they have invested in them, funding refurbishments and providing improved facilities to encourage employees back into the office, for example.
More relevant to the distribution and industrial sector is understanding where yields will increase and values will fall. The occupational market remains strong, with record levels of take up, but the pricing and values of investments are coming under pressure. This sector has experienced significant value increases over the last few years, and with interest rates increasing this year along with gilt yields, the low yields are rising as prices fall and readjust to provide appropriate returns to investors.
IG: In terms of sectors, our focus is on those that continue to demonstrate strong long-term income characteristics through cycles, supported by structural or established demographic trends. Credit quality will always be a major focus.
In Europe, social infrastructure remains attractive
In Europe, social infrastructure remains attractive, benefiting from high-quality public credit exposure and long leases that make it a stable allocation through cycles. And because these assets are typically not in major central business districts, they can offer attractive relative value, with pricing typically less sensitive to current movements in the cost of funds than other areas.
The life sciences sector continues to benefit from strong tenant demand and a shortage of high-quality products in the right locations; good facilities in established science parks are important to attract talent and facilitate R&D and collaboration. The sector is also less exposed to the increased propensity to work from home now impacting most offices.
We have seen a pricing correction in urban logistics, but tenant demand remains strong, partly due to onshoring and shoring up of supply chains, and supply remains relatively constrained.
The challenges in the office sector have been well covered (see Inflation, volatility and net zero: The outlook for real estate equity).2 Generally, we don’t invest in offices unless they are core assets strategically important to tenants’ long-term operations.
Broadly speaking, retail remains under pressure, but we still like leisure – predominantly hotels. The sector offers relatively good inflation linkage, but the choice of operator is key, particularly given the impact of current inflationary pressures on hotels’ operating models.
In terms of geographies, Ireland and the Nordics continue to offer relatively attractive value. We expect to see improved returns in Germany and the Netherlands going forward.
How are you looking to reduce risk?
KM: A number of corporate credits were downgraded as a result of COVID-19. With any new investment, we try to improve the credit rating of the portfolio, reduce the probability of default and expected loss, while improving the inflation linkage, expiry term and diversification.
RB: Portfolio diversification remains paramount, ensuring we are not overexposed to any particular sector, tenant or asset. We invest across most sectors, with a focus on high-quality real estate let to strong counterparties with a low risk of default. Social infrastructure and key operating assets also remain attractive for long-term investors.
Tenant credit quality is essential to a successful long-lease strategy
Tenant credit quality is essential to a successful long-lease strategy, because it requires confidence the tenant will be able to pay the rent throughout the lease – not just at the start.
Tenant credit quality also impacts performance in two ways:
- The probability of default increases significantly as we move down the credit rating universe. History has shown through previous recessions that sub-investment-grade counterparties’ default rate is around 20 times that of investment-grade ones
- In 18 years of managing long-income strategies, stronger counterparty credit has demonstrated not just greater income security, but also greater capital stability
In addition, we expect more dispersion in performance, even for long-income investors. Those focused on high-quality tenants should fare better than less selective investors, who may experience more defaults.
We overlay our focus on credit quality with investments in high-quality real estate that either has strong ESG attributes or gives us the ability to engage with our tenants. We partner with them to invest in sustainable initiatives that protects the long-term performance of the asset.
How is the economic context influencing our acquisition strategy?
RB: We invest for the long term. When we acquire assets, we look at a much longer trajectory in terms of the viability and sustainability of the assets and entities we are investing with. We focus on high-quality real estate and credit with stable outlooks rather than entities and assets that could be impacted by structural change.
You need to look at the underlying property fundamentals as well
KM: Energy prices are one factor, and a lot of tenants are now being asked if they have hedged their energy prices. But RELI is different to liquid markets. You need to look at the underlying property fundamentals as well.
One thing we are focusing on is assessing the cost of transitioning an asset to enable it to meet the minimum energy efficiency standards coming in 2030, and our 2040 net-zero goals. In that context, construction-cost inflation is important when looking at an existing portfolio and acquisitions.
How are net-zero targets, and ESG more broadly, influencing our strategy?
KM: ESG is an essential part of our investment process. It is considered through acquisitions and sales, whether that's screening tenants to make sure they are not in sectors we don't want to invest in; or looking at the fundamentals of the assets, their long-term contribution to the environment and the costs of keeping the assets sound from an ESG point of view (see Long income, short ESG windows: Matching real estate long income and responsible investing timelines).3
Public-sector entities have their own targets, but around 98 per cent of our corporate tenants (about 47 per cent of the portfolio) have a net-zero target.
RB: Across long income, we partner with either public sector entities or investment-grade corporates with their own net-zero pathways, so our interests are generally aligned. We engage with our tenant partners to better understand the efficiency of the buildings, but also how they are using those buildings. We often fund developments, leading to new, best-in-class, efficient buildings, but real estate may not be the tenants’ core business. We work with specialist consultants to help our tenants understand how they can use their buildings more efficiently. Whether it's reducing energy costs or helping fund solar PVs, that will help them going forward.
By investing with them in those buildings for the longer term, we can make them more sustainable and efficient. From our perspective, this will also preserve and enhance value, adding to long-term performance.
Has the challenging economic backdrop caused any change to our urban regeneration strategy?
RB: We are still keen to work in partnerships on urban regeneration where viable. There will always be a preference to convert brown assets to green as opposed to developing brand new, but that's not always possible.
One area where we are seeing more challenge is construction-cost inflation. A number of schemes are at the feasibility stage, where the cost-inflation impact could potentially make them no longer viable. We are having to think more innovatively to find ways to restructure them, to enable them to remain viable, whilst also protecting our investors.
How do you view investments with a social dimension?
KM: We recently acquired a portfolio of supported-living properties. These are residential properties that house vulnerable adults looked after by a housing association and a charity that provides care. That has unlocked an opportunity for us to invest our clients’ capital into a social-impact investment that also provides secure, inflation-linked long-term cashflows.
We work with consultants to help our tenants understand how they can use buildings more efficiently
We aim to do more, and the next deal we are looking at in this area is to invest alongside a charity to provide affordable accommodation to homeless people. We are integrating it within our social impact framework and assessing the opportunity to see whether it meets the criteria. It is a current example of trying to put our clients’ money to good use and meet their investment criteria of providing attractive returns from long-term inflation-linked cashflows.