Three trends to watch in UK long-income real estate

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

Window cleaning

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)
Local Authority discretionary spending power
Source: New Economics Foundation, September 2019

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
Example long-lease vs. traditional lease office
Source: Aviva Investors, as of 30 October 2019

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).

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL) as at January 2020. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.

In the UK & Europe this material has been prepared and issued by AIGSL, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. In France, Aviva Investors France is a portfolio management company approved by the French Authority “Autorité des Marchés Financiers”, under n° GP 97-114, a limited liability company with Board of Directors and Supervisory Board, having a share capital of 17 793 700 euros, whose registered office is located at 14 rue Roquépine, 75008 Paris and registered in the Paris Company Register under n° 335 133 229. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

In Singapore, this material is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited (AIAPL) for distribution to institutional investors only. Please note that AIAPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIAPL in respect of any matters arising from, or in connection with, this material.  AIAPL, a company incorporated under the laws of Singapore with registration number 200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583. In Australia, this material is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd (AIPPL) for distribution to wholesale investors only. Please note that AIPPL does not provide any independent research or analysis in the substance or preparation of this material. Recipients of this material are to contact AIPPL in respect of any matters arising from, or in connection with, this material. AIPPL, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000, Australia.

The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”).  AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.

Related views