One of the most striking trends in the UK commercial real estate market in recent years has been the rapid growth of long lease funds. In a world characterised by low interest rates, yield-hungry institutional investors – both DB pension schemes and insurance companies – have gravitated towards long lease real estate funds, which provide long-term, stable and often inflation-protected income streams.
Continental European investors face exactly the same challenges as those in the UK, so we believe that there is no reason why this kind of strategy should not also appeal to European institutions.
What is a long lease real estate fund?
Long lease funds – also known as ‘secure income’ or ‘high lease value’ real estate funds – are differentiated from more conventional real estate funds in a number of important ways.
First of all, they have considerably longer average unexpired lease terms. Whereas a core pan-European real estate fund might have an average unexpired lease length of between three and seven years, a long lease fund aims at something far longer – at least 15 years.
Secondly, a long lease fund is focused only on tenants with very strong covenants, which minimises the risk of vacancy. With little risk of tenants going bust, a vacancy rate of well under 1% would be the norm.
Thirdly, active asset management assumes less importance for a long lease fund. While a conventional real estate fund looks to extract value from a portfolio through steps like development, refurbishment or changing the mix of tenants, a long lease fund operates with an asset management-lite approach. Activity is focused on extending leases or selling properties where the lease length has fallen below an acceptable level.
The net result of these steps is that much of the risk associated with real estate investment has been taken out of the equation. What is left is a very stable, long-term, inflation-protected income stream with considerably less volatility on the capital value side than a ‘normal’ real estate investment. With government bonds generally still paying meagre coupons and interest rates remaining at historic lows, this kind of investment taps into the so-called ‘illiquidity premium’.
In the UK, long lease real estate investment has been performing a role in investors’ portfolios more akin to that traditionally played by forms of fixed income; and there is no reason why it could not perform the same role in continental Europe.
Long lease investment in continental Europe
Some believe that the shorter average lease length in continental Europe, compared to the UK, makes it difficult to construct a long lease portfolio. This perception is misguided. The differences between the UK and continental Europe are far less pronounced than many believe.
It is a myth that the UK is awash with long leases. Sourcing real estate that is suitable for a long lease strategy is not easy in any market. However, a pan-European long lease fund has the benefit of having the entire continent at its disposal as a source of investment. Even if suitable product does form a small proportion of the total market, the continental European market is, in aggregate, colossal.
Just as we have seen in the UK, a great deal of product for a long lease fund in continental Europe needs to be created. Pre-let forward funding or forward purchases – where an investor commits to acquiring a pre-let property in advance of its completion – is a crucial source of real estate. Additionally, there are increasing opportunities in the sale-and-leaseback market that can be accessed.
Why long lease real estate is a compelling opportunity
Long lease real estate has established itself as an important part of many institutional investors’ portfolios in the UK. Its ability to act as a source of long-term, reliable income should also make it highly appealing to continental European institutions. If they want to tap into this opportunity, these investors would be advised to look to those asset managers with previous experience in this space as well as the ability to deploy capital across Europe.
Luke Powell is investment director at Aberdeen Standard Investments