Renos Booth, Isabel Gossling and Kris McPhail from our real estate long income team consider the outlook for long-lease assets after a challenging period for investors.
Read this article to understand:
- How investors seeking long-term cashflows from long-lease property may be able to access income as the market nears a cyclical low
- How the structure of the market is changing
- What research shows about relative performance of assets by lease term during recovery periods
The higher rates environment, macroeconomic uncertainty and various specific, local factors all took their toll on UK and European commercial real estate markets in 2023.
The result was a more cautious mood, with lower investment flows into markets right across the region. Net flows were down by around 30 per cent on 2022 levels in the UK and Spain, and by even more (over 50 per cent) in markets like France, Germany and the Netherlands.1 No single property sector was unscathed over the full year.
The market has stabilised somewhat since then, and as we approach the second quarter of 2024 investors are pondering if inflation has peaked and how soon prospects could change by sector and specific micro-location.
Against this backdrop, the real estate long income (RELI) market has been transforming. Traditionally shaped by demand from UK defined benefit (DB) pension schemes wanting long-term, inflation-linked income secured by leases let to strong tenants, more DB schemes are reaching maturity. As these schemes look to de-risk, this is creating secondary market buying opportunities for investors such as public sector and defined contribution (DC) pension schemes.
In Europe, the issues are slightly different, as the RELI market is less mature than in the UK. Key features, such as uncapped inflation linkage, contributed to relative performance in 2023. But which other factors are likely to influence these markets over the coming months?
We caught up with our RELI team – Renos Booth (RB), Kris McPhail (KM) and Isabel Gossling (IG) – to find out more.
How would you sum up the outlook for RELI, given the challenges the market faced coming into 2024?
KM: I believe that, for RELI investors, 2024 will be a year of stabilising – and hopefully improving – asset values to coincide with lowering inflation and potential interest rate cuts in the second half.
During the last 18 months RELI asset values have fallen significantly in response to rising rates and falling property values, but the data suggests we are approaching stabilisation now: for instance, CBRE’s Long Income Index delivered a slightly positive total return for Q4 2023 of 0.4 per cent (compared with a full-year total index return of -5.2 per cent).2
What kind of discounts are available now in the secondary market?
RB: We saw unprecedented discounts emerge across the RELI market last year, partly due to an expectation that we were going to see some downward movement on valuations, but also due to a demand-supply imbalance in the market as a result of de-risking among DB pension schemes. This created a buying opportunity for those investors still seeking attractive risk-adjusted returns with secure inflation linked cashflows.
With valuations in RELI stabilising, it will be interesting to see the extent to which secondary unit discounts diminish or whether we continue to see an imbalance and further discounted opportunities.
IG: In certain markets in Europe, values started to stabilise at the prime end around June 2023, and there was a subsequent marginal improvement in financing availability. However, activity and capital raising remained subdued, contributing to further repricing across the second half of the year. Transaction evidence remains limited, with valuations in markets such as Germany still some way from fully reflecting the revised interest rate context.
Because the market is quite thin at the moment, with relatively few investors committing new capital, we are seeing some exceptionally well-priced investment opportunities coming through in a number of sectors including logistics and social infrastructure. Investors with resolve and commitment could be well placed to take advantage.
What does history teach us about the performance of long-lease assets in periods of market recovery?
RB: It can be worth taking a step back to consider the context. Our research team has been looking at the nature of the recovery after the Global Financial Crisis from a long-income perspective, comparing performance by sector, broken down by lease term (see Figure 1) and quality (see Figure 2).
What’s interesting about this analysis is the extent to which much longer leases of high quality (defined by estimated rental value) outperformed the shorter and weaker, when measured from the cyclical low. The read-through carries right across sectors, including retail, warehousing, offices and industrials.
Looking forward, we are currently forecasting a “K”-shaped recovery in real estate, and although past performance is not a guide to future returns, the historical performance data is worth pondering in this context.
We expect prime assets to do better and weaker assets to struggle, partly because refinancing risk is higher in a higher rates environment. We also expect greater divergence between prime, secondary and tertiary property, and between stronger and weaker credits. A fair amount of refinancing is going to be needed, and that is going to be challenging in some instances.
It is worth noting that despite the security of investment-grade credit and the benefits of inflation-linked cashflows, the initial yield in long income is higher than in core real estate. You need to think about that in the light of risks associated with core property now, the duration of the cashflows, and the fact potential buyers are relying on capital growth.
Although we are starting to see inflation come down, there are still a lot of unknown macro factors that could influence that, and we might still experience a bumpier ride than expected. Investors in long income should receive an element of protection in that respect.
Figure 1: Performance by lease term (long versus short)
Past performance is not a reliable indicator of future performance.
Note: Base = 100. Long versus short lease is defined as the differential between the upper and lower quartile each quarter. It does not include the average term.
Source: Aviva Investors, MSCI PAS, Quarterly Digest, Q2 2023.
Figure 2: Performance by quality (estimated rental value/sq. ft.) – high versus low
Past performance is not a reliable indicator of future performance.
Note: Base = 100. High versus low quality is defined as the differential between the upper and lower quartile each quarter. It does not include the average performance quality.
Source: Aviva Investors, MSCI PAS, Quarterly Digest, Q2 2023.
How have higher rates affected the development pipeline? And what are the other key considerations for long-income investors in the current environment?
RB: High inflation made many projects less viable, and that has affected the vital balance between demand and supply. The repricing we have already experienced, and the market expectation of gilt yields falling in the second half of this year, means development should now start to progress again and we anticipate greater opportunities going forward.
We also expect a pipeline of opportunities to derive from universities looking to improve their academic facilities and student accommodation, and UK local authorities coming under pressure to increase their housing stock. These are areas where stock selection will remain critical.
Paying attention to the security of the tenant is always important, but even more so in an environment of uncertainty. Having a continued disciplined focus on tenant credit quality has ensured that in the more than 20 years we have been managing long-income assets, not one of our tenants has defaulted, despite the various economic challenges that have arisen during that period.
IG: In Europe we are seeing developers look at long income as a source of funding in the absence of other lending options, and we would look at this for the right sector.
Some of the pricing adjustment in the UK reflects the maturing of the DB market. Is there still a lot of adjustment to come?
RB: It is going to be a long process, and it is not over yet. If you consider the insurance market from a buyout perspective, it is worth around £50 billion a year. It will take a long time for the insurance market to de-risk the DB pension scheme side of the market, which extends to over £1.4 trillion.
Ultimately, there will be a lot of DB schemes either in surplus or approaching surplus that will be looking to de-risk. Again, the demand-supply imbalance has created an insurance buyer’s market, and so insurers can be more selective. So for some schemes that reach that position, they will look at their options and may decide they are better off continuing down a self-sufficiency route.
KM: What's interesting is that a sizeable percentage of the activity in the long-income investment market last year involved non-UK funds. That resulted in higher yields, because overseas investors want a higher return for risk. This suggests we are seeing a two-tier market.
We are also seeing a local government pension scheme (LGPS) focus on real estate long income now. These schemes like property, they like inflation-linked structures and they like asset managers with long track records through market cycles that also integrate environmental, social and governance (ESG) considerations. But the corporate DB market, particularly disinvestment activity among these schemes, will remain a major influence on UK property for a while.
RB: It is also worth remembering that although DC schemes currently account for a very small proportion of the market, this will grow. The ability of DC schemes to invest more in real assets could contribute to the cashflows these schemes are going to need in order to provide retirement income.
Are there any other important structural changes in the market that investors need to be aware of?
IG: The UK government's review of large companies’ ability to tap the surpluses in their corporate pension schemes, as opposed to going to buy-out, might prove to be an interesting development if these schemes choose to put that capital to work in private markets. The latest estimates from the Pension Protection Fund put the surplus at over £420 billion at the end of 2023.3 That could be another feature to watch in the UK.
Are investors looking for newer or refurbished buildings capable of meeting net-zero targets over older ones? How much of a factor is this in driving valuations, occupancy prospects and investment decisions?
KM: We’ve noticed some nuances here. While UK fund and insurance investors are focused on ESG and net zero, overseas investors and private investors tend to be more focused on financial returns. ESG is something they consider, but the majority of their focus is on the cashflow the investment provides.
From the perspective of tenant demand in the office sector, everyone wants “best-in-class” from an ESG point of view. Occupiers want BREEAM “Outstanding” and EPC “A” ratings, because they have to report their carbon emissions, and their property footprint is a big part of that. That demand is feeding into rental levels, investment pricing and valuations.
However, potential buyers do not always have consistent data to compare across assets, and that makes it difficult to pinpoint the relative contribution to valuations. The quality of the occupier and length of the lease will often tend to drive the value rather than the EPC rating.
IG: In Europe, we see reporting on net zero, but buyers are not necessarily pricing it in. However, it is important when we are talking to tenants in the context of elevated energy costs and day-to-day use of assets, and our desire to retain quality tenants to protect long-term cashflow value and reduce obsolescence risk.
