Achieving a steady and reliable source of long-term income is a growing challenge for many investors who are trying to meet future liabilities. Bond yields remain close to all-time lows and equities alone can’t provide a solution for liability-driven investors who are looking for consistent returns. As a result, investors are increasingly looking for real assets that are linked to inflation. Property has a vital role to play in helping investors meet their income requirements.
What do we mean by long-income property? The term refers to properties that are leased to tenants on a longer-than-average lease – typically a minimum of 10 to 15 years, depending on the market. Since leases are contractual agreements, the owner has the confidence that the tenant will make regular rental payments over the course of the lease and can plan accordingly. Government offices, supermarkets and universities are some of the tenants who would typically be interested in taking on a long lease. And since they are normally considered to be extremely reliable tenants, landlords who are trying to maximise their long-term income stream would be keen to secure this kind of lease.
While opportunities for long leases are still available, they can be difficult to source as owners are normally reluctant to sell. According to Real Capital Analytics, only €20 billion of long-leased assets were transacted over the last 10 years (to June 2018) in Europe, although we suspect that the true volume will be significantly higher as many of these deals go under the radar. Given the structural and technological changes that are affecting offices and retail in particular, investors need to think more broadly about property sectors. Alternative sectors, such as hotels, student and senior living accommodation, medical centres, car parks, and leisure centres can provide a different source of long income.
The benefits of investing in long-income assets that are linked to inflation are well known: a long lease means that they can provide a reliable and steady income over a long period of time; research shows that alternative assets have been less volatile than the main commercial real estate sectors over recent years; and rents are linked to inflation, which provide protection against eroding values. Importantly, long-income assets can also provide genuine diversification in a portfolio. This is particularly the case with alternative sectors as they don’t have economic growth as their key driver of demand. Trends in alternative sectors tend to be more influenced by demographics or structural themes, which helps to enhance diversification.
Long-income property has demonstrated strong performance characteristics, particularly since the global financial crisis.
Long-income property has demonstrated strong performance characteristics, particularly since the global financial crisis. In the UK, there are 11 long-lease funds as defined by IPD/MSCI. Between September 2010 and September 2017, annual fund-level returns averaged 9.9% across all balanced funds and 9.2% across long-lease funds. Furthermore, the range of returns was also significant. The difference between the highest and lowest annual return in the IPD/MSCI All Balanced Fund Index is 22.9%. For the long-income group, the range is less than half that at just 10.8%. This provides strong evidence that certainty of income has played a key role in driving more stable total return performance.
Investing in long-income assets produces a different set of risks to shorter-duration products. There is a greater risk of over-renting (where a property is let at a rent greater than the current open market rent), which would damage the long-term value of an asset if not appropriately managed. Tenant risk also increases as the owner needs to be certain that their tenant has long-term plans to stay in the property and that they will be able to pay their rent. Long-income properties are also vulnerable to obsolescence (wear and tear as well as becoming outdated or not fit for purpose) over the course of the lease. And structural shifts in demand for certain property types, such as the current decline in demand for some types of retail property in favour of industrials, can affect the long-term value of assets.
That said, buildings have a life cycle, from land zoning and planning applications through to demolition and change of use. Investors can participate throughout the life cycle, timing their investment to suit their needs. The level of risk associated with each stage of the asset cycle is broad and investors can either diversify across the risk spectrum or target certain periods.
For long-term strategies, it is important to identify property types that have the right performance characteristics to produce robust, long-term income. We believe the traditional commercial sectors should form part of a long-income portfolio, supported by the additional diversification and income gained from an allocation to alternative sectors.