Renos Booth, Isabel Gossling and Kris McPhail discuss what real estate long-income strategies can deliver in the face of spiking inflation across Europe.
Read this article to understand:
- How much inflation protection real estate long-income strategies can provide
- Which sectors are most attractive from a rental growth perspective
- Why DB schemes contemplating horizons to buy-out should be mindful of market risk
The ability to generate income through market cycles, with lower volatility than other liquid assets and traditional real estate, is what sets real estate long income (RELI) apart. But rising inflation has sent yields from index-linked bonds up, challenging the relative attractiveness of long-lease property.
Renos Booth (RB), Kris McPhail (KM) and Isabel Gossling (IG) from our RELI team discuss what the asset class offers in a challenging market environment, and how to select assets that will deliver the income security investors are looking for.
How has long-income property performed versus core balanced real estate in a more inflationary environment?
KM: Our flagship Lime strategy delivered a 12-month total return of -8.1 per cent in 2022 versus -10.4 per cent for the MSCI UK Property Monthly Index. It has also fared well relative to peers; it was the joint best-performing strategy in the MSCI/AREF UK Long Income Property Fund Index for those with AUM over £1 billion.
IG: By the end of Q3 last year, we had seen only half the decline in capital values versus core indices. Over the full year, we expect that to continue and for the E-RELI strategy to continue to provide higher annual income return as well.
What effect has the inflationary environment had?
RB: Rising inflation has been positive and negative for long-lease strategies. Those with leases linked to inflation will have benefitted from higher income growth; however, in some sectors this will have significantly outstripped market rental growth and created an over-rented position. For this reason, a strategy focusing on stronger credit quality and sectors or industries that can pass on the inflation costs within their business will have been less impacted, contributing to greater security of income.
Rising inflation has been positive and negative for long-lease strategies
Many of the assets we invest in are operating assets, such as student accommodation. The majority have inflation caps within their leases, but they will have been able to pass inflationary costs on due to positive demographic pressures combined with supply shortages.
High inflation has negatively impacted the construction industry. Rising rates, combined with significant cost inflation for labour and materials, mean many development schemes have become unviable. It is an area where we have had a lot of success over the years, but development funding opportunities are currently more limited.
IG: We have had strong relative performance in Europe, which reflects the fact the European long-income market tends not to have those inflation caps. In Europe, 87 per cent of our leases are uncapped. That has value when underwritten by an investment-grade tenant in a long-term lease. Long income is not intended to be a perfect inflation hedge, but it is an attractively priced source of long-term real income protection if you compare it with the cost of inflation protection delivered through swaps.
Do you believe the inflationary spike will be temporary or longer lasting?
RB: The consensus is that inflation is not likely to run this high for the long term; the view it has peaked and is on a downward trajectory. It may even drop below the government’s target of two per cent later this year or early next year. However, the UK market-implied longer-term forecast is that inflation will run slightly higher than average and higher than the target.
Our UK inflation caps are set around four per cent, sometimes higher
Our UK inflation caps are set around four per cent, sometimes higher, and we are uncapped on most European assets. In a moderate medium-term scenario, our cashflows should continue to benefit from attractive inflation-linked growth.
Where are you seeing rental growth?
KM: We continue to see rental growth on prime properties in parts of the market where fundamentals are strong. In the distribution and urban logistics sector, for instance, this is predominantly linked to lack of supply in a growing market. As a result, when we look at our distribution investments, the passing rent compared to the market rental value looks favourable.
We are also seeing rental growth in student accommodation, where there is a demand and supply imbalance, which is set to remain with increasing numbers of students from the UK and overseas. Many operators of student accommodation experienced record occupancy in the 2022/2023 academic year and were running waiting lists in key markets. This will apply upward pressure on rents for the coming year.
Parts of the office market are also strong but it is very much a two-tier market
Parts of the office market are also strong, but only for prime property with strong ESG credentials in city centre locations. It is very much a two-tier market. In the secondary market there are concerns around the transition costs to bring offices back up to grade-A status. Rental growth is not being achieved everywhere.
RB: A lot of our assets are comparatively new compared with more traditional real estate portfolios, so we benefit from slightly better sustainability credentials and better prospects for growth. Many of them are certified as “Excellent” or “Very Good” by BREEAM, for example, with good EPC ratings.
IG: We are also seeing decent rental growth in the life sciences sector, particularly on established science parks, which have their own restrictions on supply. That’s linked to the increase in healthcare spending, an established long-term trend.
What premia can be found over index-linked debt?
RB: It depends on the strategy. Long-lease strategies like Lime and E-RELI are more traditional in terms of the long cashflows, but they include an equity tranche whereby we own the underlying real estate.
We also have the REaLM suite, which are amortising structures; these provide fixed-income-like cashflows, with little if any equity risk at the end of the lease. Because of the cleaner, more predictable cashflows, these assets are more closely correlated to liquid markets.
Last year, gilts fell around 30 per cent, the total return from REaLM was around -19 per cent, whereas Lime was -8.1 per cent. You could argue from a relative pricing perspective that REaLM assets are currently better positioned than traditional long lease, which still has a little further to go on a risk-adjusted return basis.
We expect further pricing adjustments across the real estate market
We expect further pricing adjustments across the real estate market. Traditional long-lease strategies are not immune to what's going on in the broader real estate market, but the asset quality and inflation protection and strength of tenant credit should mean these strategies stabilise faster. It’s what happened after the Global Financial Crisis, the EU referendum and the pandemic, where long lease experienced far less volatility compared to real estate as a whole.
IG: There is little inflation-linked debt available for investors in Europe from sovereigns or corporates. While long income is under pressure from an income return standpoint, there are merits from the inflation linkage, lower volatility and higher recovery rates you tend to see in default scenarios.
How has appetite for RELI changed now many defined-benefit (DB) schemes are back in surplus and not needing income from illiquid markets so urgently?
RB: Historically, much of the investment coming into long income has been through the DB market. Events in the UK last September raised questions for them, so a lot of those schemes will be looking across their liabilities and their terminal portfolio strategies.
Whereas DB schemes might have been looking over a ten-year horizon or even longer, they may now be contemplating a shorter horizon to buyout. But a lot of schemes thinking about de-risking may find they do not actually wish to do so when they get to making the final decision.
The insurance market is still relatively small compared to the DB market
The insurance market is still relatively small compared to the DB market, so it will be a buyers’ market for insurers, and therefore may prove less attractive for some pensions schemes to de-risk. You might find some deciding to switch back to self-sufficiency mode, in which case long-income assets may still be appropriate.
DB schemes will want to avoid a situation where they decide to sell assets, in some cases at a discount to create liquidity, then find they want to buy the assets back later at a premium.
We are currently seeking to diversify our investor base in long-income strategies with increased interest from local government pension schemes and international investors. We are also seeing increased appetite from insurers for matching adjustment-eligible assets.
How much has the recent uncertainty in the UK impacted international interest?
RB: We are starting to have more conversations with international investors, particularly from Asia, who are exploring how attractive the market is from a relative-value perspective. They are thinking about whether they could pick up assets from the secondary market at an attractive discount, whereas they would normally come via a primary route and pay a premium.
We are seeing major changes to the way that we live and work. How are you reflecting that in asset selection?
IG: There are long-term drivers around deglobalisation, decarbonisation and demographics. These throw up lots of ideas around logistics, energy efficiency, servicing an aging population, rising healthcare spending, how to address the problem of chronically undersupplied housing and so on.
Then we move to fundamentals – assets able to generate stable cashflows with sustainable inflation linkage in the right locations with the right covenants.
KM: We look at the cashflow and the security of the tenant, but our analysis goes well beyond that to assess the underlying property and where it sits in its sub-market. You have to ask: “How sustainable is all this? What is the relationship between net income, the rent the tenant is paying and the market rent?”
Would you buy an office now if it wasn't rated “excellent” by BREEAM?
We need to be sure it’s a sector we want to invest in. For example, would you buy an office now if it wasn't rated “excellent” by BREEAM? You would question whether that would cause liquidity problems. You also need to be thinking about agile working practices with collaborative workspaces, and if the building itself will contribute to net-zero targets.
RB: We have a diverse team that includes everyone from corporate financiers to surveyors and public-sector advisors. That enables us to challenge each other about opportunities and being more innovative in terms of structuring to deliver secure inflation-linked cashflows with attractive risk-adjusted returns. Recently we have been using that expertise for structuring around social assets, which is an area we are working on now.
On the social side, you recently flagged a co-investment alongside a charity to provide affordable accommodation to homeless people. Can you update us?
KM: We closed that transaction and are working with a charity to structure a new transaction which potentially ticks many boxes for us - the fundamentals box, the demand box, the credit box and the social impact one as well.