Demand, diversification and discounts

Read this article to understand:

• The opportunity to access real estate long income at a discount
• Which investor groups might find long-income assets a good fit for their portfolios
• How the performance of long income is holding up relative to core balanced property in the UK and Europe

The sharp jump in inflation and yields available from index-linked debt have led some UK corporate defined-benefit pension schemes to shift out of real estate long income and other private markets as they accelerate towards buy-out. So, who else is in the market for long-lease property that can generate sustainable income through market cycles with minimal exposure to market risk?

In this Q&A, Renos Booth (RB), Kris McPhail (KM) and Isabel Gossling (IG) from our real-estate long income (RELI) team discuss whether this could be an attractive entry point for investors seeking income security and the opportunity for positive environmental, social and governance (ESG) outcomes.

How is RELI holding up relative to core balanced real estate portfolios?

RB: We are not immune to developments in the real estate market. Last year was challenging with long income valuations falling around 15 per cent in the second half of the year compared to core real estate falling around 20 per cent. But long income is comparatively well positioned due to the high asset and tenant quality, as well as inflation-linked rental uplifts.

What we are seeing now in the UK is a reaction to the changes in DB pension schemes that were exacerbated by the “mini budget” last September. It triggered an unprecedented sell-off in gilts and a search for liquidity. Now, higher rates expectations have led to an improved funding position for a number of DB schemes, which has accelerated their paths to buy-out.

It has led to a demand and supply imbalance, with UK RELI assets priced at unprecedented discounts to net asset value (NAV) in secondary markets. That is very different to what we have seen historically, when assets priced at a five to six per cent premium to cover stamp duty and other third-party costs when investing new capital.

As capital values have rebased, we see this as an opportunity for those seeking to access predictable inflation-linked cashflows with lower volatility at a historically low entry/price point.

How might RELI match the needs of other institutional investors, and what interest are you seeing from them?

RB: Historically, demand for long income has been driven by DB schemes. In the past there has been limited product to satisfy demand, but now the macro environment has altered, hence the scenario we are managing through.

We are starting to have discussions with different types of investors. If you think about what the asset class can deliver in terms of long-term, predictable, inflation-linked cashflows, you can see it ticking boxes for a broad range of investors.

Post-retirement income is an obvious target market but it could also be helpful for mid-to-late-stage defined-contribution (DC) schemes for accumulation, at the point where their members need more certainty about cashflows and the level of income they can expect. RELI can tick boxes there too: the key is how you access it.

We have also seen strong interest from local government pension schemes. Inflation-linked cashflows can pay liabilities and close funding gaps, and if assets are accessed at a small discount, you can still achieve gilts plus around 250-300 basis points (bps) and an illiquidity premia of 70-110bps over BBB+ corporate credit.

Insurers seeking matching adjustment-eligible assets are also in the mix but how they can access the cashflows will be key.

Is the downward trend in capital values continuing?

RB: We do not believe the impact of high inflation and high interest rates is fully reflected in the market. There is a lag, and we believe some capital values will decline further, perhaps by another five per cent, as we have not yet seen sufficient pricing differentiation across the market.

We expect the recovery to be “K” shaped, with more divergence between prime, secondary and tertiary properties, between stronger and weaker tenants in terms of credit quality and also reflecting the difference and cost of transitioning from a sustainability perspective. As in previous cycles, we expect prime assets and also those with tenants of higher credit quality to bounce back quickest, as well as those more sustainable assets. Secondary and tertiary assets with weaker credit and weaker sustainability credentials will likely continue to lag.

For now, transaction volumes are well below the five-year average, although we are starting to see activity pick-up in certain sectors, like build-to-rent, student accommodation and supermarkets. Yields also seem to be stabilising in industrial and retail warehousing sectors and some prime offices.

What remains most important from a long-income perspective is the credit quality of the tenant, ensuring we maintain the security of cashflows. We expect default risk to increase following the series of rapid rate hikes, albeit off a low base, with a lag of 12 to 18 months. We have exited some of our lower credit rated investments across our long income strategies, continuing to position for the future to ensure all assets are fit for purpose. This should mean we will come through the cycle with even stronger portfolios.

We know from previous recessions the sub-investment grade (IG) default rate is around twenty times that of IG, hence our strong focus on IG tenants (Figure 1). We do not believe current pricing reflects that differentiation between credits, either from an asset or sector perspective.

How are rent collections holding up?

KM: We are keeping a close eye on developments. Recent data from Remit Consulting suggests rent collection levels in the first quarter of 2023 dropped to levels not seen since 2020. Payments of rent on the due dates had been heading back towards pre-COVID levels until then and gradually increasing each quarter from December 2020.

The reversal in that trend is concerning, with the biggest drop coming from retailers who are carefully managing cashflows as they navigate higher costs for products, transport, energy and staff. We also have to factor in that inflation and debt costs are likely to stay higher for longer and there is also a corporation tax rise on the horizon.

Our RELI strategies focus on managing investment activity with the objective of providing secure income streams from strong tenants. Accordingly, we have been de-risking by selling out of investments with weaker credits than the portfolio average, particularly those entities likely to face headwinds as a result of the current high rate and tax environment.

How does the situation compare in Europe?

IG: In Europe, RELI is outperforming relative to core balanced portfolios. Long income is characterised by lower leverage and low long-term fixed-rate borrowing, so it is not as exposed as other sectors following the end of the cheap money era. European RELI went into this rate-hiking cycle at a higher yield versus core markets, which is different to the UK, where long income was at a premium. That means there is proportionately less impact on capital values and capital returns as yields move out in response to a higher risk-free rate.

In the second half of 2022, European long income saw higher and more consistent income returns and about half the capital volatility of balanced funds with relatively stable capital values. The data has not come through for the first quarter yet but, broadly speaking, we expect that trend to continue. We also have strong inflation linkage in Europe, which has helped support performance versus core balanced portfolios. It has been possible to pass through significant rental uplifts to a high-quality tenant base that can afford them.

While the market is going through a period of adjustment, our model suggests European RELI will look attractive on an absolute and risk-adjusted basis from the last quarter of 2023 and first quarter of next year versus alternative fixed-income products and core real estate strategies. Based on the quality of long-term cashflows and our view of where the real estate market will be, there is a supportive investment case for DB schemes with appetite in Europe. We are also getting interest from low-risk, defensive, income-focused family offices, charities, and others with an eye on wealth preservation and income security.

It is going to be challenging this year, but it could be a long-term growth opportunity if managers deliver consistent performance and attractive relative value (RV).

RB: The RV point is important, particularly in the UK. Some RV analysis is based on fair value, but that ignores the fact you can access these strategies at a discount now. If you apply the discount at the entry point, that could create another 30 to 50 basis points of illiquidity premia. That could be quite attractive, depending on what price you come in at. This is a fundamental change in the market we have not experienced before.

How do you see the outlook evolving?

IG: As a relatively less mature market than the UK, European RELI has just been through its first major challenge and performed well, demonstrating its resilience. It was resilient through the pandemic and is now outperforming the broader core market in the context of a rapid rate-hiking cycle and uncertain growth outlook. This reflects the value of the focus on security of income as the primary driver of return performance through cycles and is an important proof point for the strategy in Europe.

Looking forward, it needs to continue to demonstrate secure income and resilience. If RV is restored, there is scope to achieve attractive income return premia at a healthy margin over the risk-free rate. We expect the German ten-year bund yield will settle around 2.3 to 2.5 per cent, and expect RELI to deliver an attractive margin over that. Our latest RV analysis also suggests a modest margin over European real estate but with less risk for investors, by virtue of that focus on long-term inflation protection and security of cashflows. It looks comparatively more attractive from 2024 onwards.

The focus on income-driven returns will be particularly important, as investors cannot allocate to real estate and expect to rise with the tide because of ever-looser monetary policy and cheap debt. Rather, clients and managers will need to be much smarter in how they allocate and manage assets to deliver returns.