Howard Meaney looks at how long income strategies can benefit income-seeking institutional investors.
It is no new phenomenon that real interest rates globally are hovering around historic lows; although the Bank of England has for the first time in a decade moved interest rates up by 25 basis points, their rhetoric and the underlying economic fundamentals indicate that this hike is likely to be a one-off, and rates are certainly expected to remain well below historic norms for the foreseeable future.
This has led to increasingly thoughtful consideration by investors and their advisers into what the options are to achieve meaningful returns without unduly compromising levels of risk within a portfolio. The preferred route for conservative income-seeking institutions has historically been the pursuit of fixed income strategies, often putting money into long-term bonds and enjoying a regular, stable income stream. While gilts and bond yields have seen significant compression over the last seven years and the returns they generate seem unlikely to budge much above their current record low levels, long income property is proving an attractive alternative for investors seeking new ways to meet their cash-flow objectives.
Long income strategies have several characteristics that make them particularly suitable for today's income-seeking institutional investors. Pension funds and insurance companies, for example, face huge issues in meeting their liabilities in the current depressed interest rate environment, while continuing to add risk to their portfolios in order to achieve the same level of returns realised in the recent past simply isn't sustainable. Long-income property can help mitigate this dilemma by providing stable income based on contractual real estate leases coupled with a risk profile similar to fixed income.
A typical long lease has an average duration of 20 years, and is nearly always subject to inflation-linked upward-only rent reviews, allowing the landlord to benefit from a known income stream throughout any market volatility. On the other hand, the occupier will usually be a durable or investment grade business that needs to be committed to a specific location and asset for a finite period of time - such as medical facilities, hotels, student accommodation, etc - and therefore finds the long-term security of tenure, predictable rent payments and balance sheet efficiency that such arrangements afford highly appealing.
The investor owns the underlying real estate asset but the performance and delivery of income is more bond-like and driven by the capacity of the operator to deliver the scheduled payments rather than the performance of the underlying property market, hence the importance of prudently selecting the right tenants to enter into such an arrangement with. In terms of expected outcomes, long income strategies sit between traditional real estate and corporate bonds from a risk profile perspective, while net yields in the sector range between 4-4.5% - a significant premium to the around 2.5% from similar risk corporate bonds or 1.5% from gilts.
Even taking Brexit uncertainty and anaemic rental growth outlook aside, the principle of long-term secured income in the current environment presents an obvious draw for certain types of investors, particularly pension and insurance funds due to the structure of long leases, which enable them to use real estate income to meet distributions further into the future.
There has been a sizeable increase in demand from investors looking to gain access to long-income assets over the past few quarters. However, in an environment characterized by aging populations relying on a longer-term pension plan, unconventional monetary policy and increased financial market regulations, all combining to depress real interest rates and showing no signs of near-term change, investors need to look much harder to generate positive returns and we're expecting long-income property to continue being recognized for the premium it can deliver.
At the same time, fund managers specialising in this asset class need to evolve their marketing proposition to effectively educate a much broader spectrum of investors on the merits of this established asset class, and, on account of the identified parallels, the fixed-income segment looks like a promising place to start.
Howard Meaney is UK head of real estate at UBS Global Asset Management
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