Pension schemes seeking alternatives to bonds may find amortising leases a compelling option, writes Luke Layfield.
Over the past decade, defined pension schemes wanting to de-risk their portfolios have increasingly looked for strategies that can deliver reliable contractual income. Finding suitable assets, however, has become more challenging as traditional income sources - gilts and investment-grade credit - have seen yields driven down by ultra-low interest rates and general risk aversion among investors.
In response, investors are turning to gilt substitutes; assets that provide secure and long-term contractual cashflows and an attractive pick-up over gilts. While private debt and long-income real estate have for some time fulfilled this need, a less familiar asset class – amortising lease real estate - has yet to be fully exploited.
Amortising leases: An explainer
While traditional real estate investment involves taking and managing market risk, long-lease real estate is focused on cashflow certainty. Its main value is in long-term, index-linked leases to high-quality tenants, with the market risk essentially deferred.
An amortising lease goes one step further, with a structure that removes the real estate market risk entirely to provide a pure fixed-income cashflow profile. At the end of the lease, the asset will revert to the tenant or a related party on the condition they have paid all their rent.
Figure 1 shows how differing cashflow profiles are created from real estate and how an amortising lease has a cashflow profile equivalent to a fully amortising loan, transforming an equity asset - real estate - into one with a debt cashflow profile.
Figure 1: Creating a debt cashflow profile from real estate
In recent years, amortising leases have become a popular financing solution for tenants wanting to retain long-term ownership and control of the asset. A lease can also be structured to provide more flexibility than traditional loans.
The amortising nature of the investment offers additional comfort
For pension schemes, the predictable, inflation-linked and low-risk income generated can be an attractive way to meet their liabilities. Tenants are typically local authorities, other government or quasi-government entities, and investment-grade companies; the covenant strength of these entities provides greater certainty over cashflows. The amortising nature of the investment offers additional comfort, as the lease obligation of the tenant is paid down but the underlying real estate (providing security on the lease) should increase in value over time.
Since the economic value of the transaction expires at the end of the lease term, when the asset is returned to the tenant, the cashflows provide a more precise tool to match pension liabilities than bonds or traditional long-income real estate.
The ultra-long nature of amortising leases, typically between 30 and 50 years, aligns well with the time horizon of pension liabilities. They also offer an attractive source of inflation protection, with rents explicitly linked to price increases.
Debt-like risks, equity-like returns
As a less-discovered asset class, amortising leases offer opportunities for pension schemes to secure enhanced returns for similar levels of risk. Our analysis shows that while providing the same defensive qualities as a debt investment, amortising lease investments offer a higher illiquidity premium than debt and higher risk-adjusted returns than debt or real estate.
Figure 2: Illiquidity premia: Amortising leases vs. other real assets
Figure 2 shows the illiquidity premium generated by gilt substitutes in real estate, infrastructure and private corporate debt. This is the excess return secured relative to publicly listed debt of the same credit rating and maturity. We have also overlaid the illiquidity premium generated on all amortising lease deals originated by Aviva Investors over the same timeframe, which demonstrates a significant return pick-up over debt of comparable credit quality.
Figure 3: Return spread over index-linked gilts
Figure 3 provides a forward-looking assessment of risk and return for various gilt substitutes. The box-whisker plots in the chart show the average expected real return for each asset class (relative to index-linked gilts of the same maturity), as well as the level of dispersion around this outcome. The results show that amortising lease investments offer the highest prospective risk-adjusted return.
Schemes looking to de-risk may therefore consider switching from higher risk real estate or infrastructure assets, while schemes seeking higher returns could benefit from substituting lower returning debt investments for this versatile asset class.
What’s the catch?
Whether investors’ main measure of risk is credit ratings or volatility, amortising leases offer the prospect of superior risk-adjusted returns. This begs two key questions: what is driving that and is it too good to be true?
Amortising leases have attracted interest from only a small pool of sophisticated schemes, resulting in less pricing pressure
The excess returns are primarily a function of market inefficiency, a common characteristic in private asset classes. Amortising leases are a newer and less mature asset class than private debt and traditional long-lease real estate and, as such, have attracted interest from only a small pool of sophisticated schemes, resulting in less pricing pressure.
Another advantage is that amortising leases are one of the only sources of long-duration, high-credit quality contractual cashflows yet to be monopolised by insurance investors. So, while pension schemes have been priced out of many long-duration private-debt transactions by insurers, or forced up the risk curve, amortising leases remain attractively priced for pensions’ cost of capital and a good match for liabilities.
Clearly, the equity ownership of amortising leases creates some differences with debt investments. Firstly, the security and credit quality of the investment comes primarily from the covenant strength of the tenant, rather than the underlying value of the real estate. While a senior real estate loan will only extend to around 50-60 per cent of the underlying asset value – meaning a lower expected loss if the borrower hits financial difficulties – amortising leases are more geared at the outset. Instead, they are reliant on a low probability of default and losses occurring based on the credit strength of the tenant.
Their amortising nature does, however, increase the real estate security over time, providing additional protection in terms of counterparty risk and the value of the asset.
Nevertheless, the recovery process for amortising leases has not been tested to the same extent as traditional debt investments. In the event of a debt default, the legal documentation will specify a lender has an accelerated claim for the present value of future capital payments, often at an advantageous discount rate.
Legal guidance suggests the recovery process would be similar to debt
Lease documentation is not so prescriptive, and the lack of historic defaults means there is no clear precedent. However, legal guidance suggests the recovery process would be similar to debt, with the landlord having a claim for the present value of future rents owed, discounted at the current equivalent gilt rate (less any value recovered from the real estate asset). An amortising lease claim would also benefit should the real estate asset be worth more than the amount owed. Such an outcome is not available to debtholders, where the recovery value is capped by the loss.
Another risk facing debt investors – prepayment risk – is absent in a lease. A more relevant consideration for landlords is the ability of the tenant to assign to another party, which could be of a lower credit quality. An amortising lease strategy will either prohibit assignment or limit its impact, by imposing a credit hurdle on assignment for example, to protect the expected cashflow.
In recent years, there has been a significant and growing pipeline of opportunities for institutional investors to provide funding for central and local government, NHS bodies, universities and highly-rated corporates.
Amortising leases have the potential to help meet pension schemes income needs
Although amortising leases have not yet been widely embraced by pension schemes, they have the potential to help meet their income needs; namely, a reliable fixed income cashflow profile and attractive returns relative to gilts and more established substitutes.
Investors willing to do the work to understand a less familiar asset class could reap significant benefits from an allocation to an amortising lease strategy.