By Ben Jones
Pension schemes continue to de-risk their portfolios and allocate more capital to fixed income investments. However, it is not only corporate bonds that can offer an attractive yield plus good levels of seniority and security. Long lease property can also give pension funds many of the matching benefits of owning long-dated corporate bonds. Furthermore, in many cases long lease property will produce higher returns with a lower level of volatility and risk.
Using real estate to back long dated assets is not new in the UK market. Many credit investments derive their underlying returns from real estate. For example, corporate bonds are often underpinned in some way by real estate lending.
Direct investment in long lease real estate, purchasing good quality buildings tenanted by creditworthy companies, whose rental payments are typically linked to an inflation index for around 25 years is not that different. Long lease property can deliver higher returns than equivalent corporate debt – helping schemes match their inflation-linked liabilities and provide the sort of growth that can eat into funding gaps.
Pension funds are generally more familiar with corporate debt but long leases and corporate bonds share a number of features.
Clearly, long leases and corporate bonds both offer a recurring cash return. In an era of depressed rates the search for cash flow has driven bond yields to extremely low levels. For example, a representative BBB rated corporate bond would give a real yield of less than 1%. A portfolio of long lease investments currently delivers a real yield of over 4% – a significantly higher return for similarly rated assets.
Secondly, both corporate bonds and long leases offer long term cashflows to pay pensions. An asset that produces growing cash returns over many decades is very well suited to matching the contracted payments of a pension fund. In the most suitable long leases for pension funds the contractual cash flows will represent the majority of the value of the investment.
Thirdly, there is the question of seniority and security. In corporate debt covenants and security over assets are designed to counteract the risks of a counterparty failing to meet repayment obligations. For long leases the security is in owning the underlying property. When investing in long leases that security is always available – for corporate debt this is not usually the case. For example, large multinationals with low leverage and diversified, stable earnings can have entirely unsecured debt structures. From a security perspective, an investor in long lease property is the ultimate long-term owner of a company’s profitable key operating assets – a position akin to a senior secured creditor. A tenant would prioritise rental payments above debt and equity holder payments.
The final commonality is the potential for growth through active management. If a skilful manager of a portfolio of corporate bonds invests on a value basis, by purchasing mis-priced bonds, they can provide clients with valuable growth in capital values as well as income. Long lease investors also seek attractively priced assets and higher returns are potentially on offer, for example as leases mature and properties are sold or a new lease formed.
Whilst these two asset classes share a number of commonalities, there are two major points of difference: liquidity and inflation.
In theory, any corporate bond investor should be able to enter or exit an investment at a time of their choosing. This has some value to any investor. However, pension schemes with very illiquid liabilities are becoming increasingly comfortable with owning investments that offer better investment characteristics but do not allow the investor immediate liquidity. Long lease property was one of the earliest types of long dated, illiquid credit to gain traction with UK pension schemes, as they recognised that such long term cash flows matched their liabilities well and could provide more than adequate compensation for the risks on offer.
The other point of difference is inflation. While a portfolio of senior and secured long lease investments can be structured to seek an attractive real yield, there are few equivalent index-linked investments available in the corporate bond market. At the same time, the index-linked gilt market, at around £500 billion, remains remarkably expensive and falls well short of the £1 trillion or so of pension scheme liabilities that must be matched. Long lease property offers a way to get higher returns from an asset that matches the type of long term, inflation-linked liabilities common to defined benefit pension schemes in the UK.
It is not surprising that long lease investment is becoming more popular with pension funds as they continue to seek stable, long-term inflation linked yield, with growth potential, whilst offering security and seniority.
Ben Jones is manager of the Secured Property Income Fund at M&G Investments
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