A combination of low European government and corporate bond yields and an uncertain macroeconomic environment have led institutional and other real money investors to seek alternative sources of long-dated secure income to meet their liabilities.
With expectations for European real and nominal yields to remain low, and the uncertain macroeconomic environment set to continue, European long income property offers investors the opportunity for a significant yield pick-up over government and corporate bonds with comparable credit quality.
Long income property is real estate let on long leases where the covenant strength and/or property/ income over-collateralisation offer defensive value characteristics for investors. The long-dated contractual inflation-linked income provides returns that are primarily driven by income rather than capital. The returns are expected to be less volatile through market cycles than those of traditional real estate, whilst providing an inflation hedge for both the income received and capital values over time. Further, long income property valuations are less sensitive to interest rate fluctuations than secure income liquid alternatives and so potentially more defensive against rising rates.
The eurozone has a large pool of freehold, owner operated, high quality, income generating assets that are well-suited to long income property. This fact, coupled with owner occupiers' increasing acceptance of selling the freehold to release capital tied up in real estate, as part of an efficient capital structure, helps provide a large supply of investment opportunities.
Benefits of lease financing for asset owners
There are several benefits, and these include:
- Capital structure optimisation - release additional capital to reinvest back into their core business, at a lower weighted average cost of capital than traditional financing.
- Reduces refinancing risk in contrast to bullet bonds or bank loans.
- Bespoke structuring facilitates financing in smaller lot sizes.
- Raise finance through an alternative source to traditional bank financing and without entering negative/restrictive covenants.
- Removes real estate valuation risk from operating business.
Why invest in European long encome property?
There are several benefits from investing in long income property, and these include:
- Attractive risk-adjusted returns - potential to deliver a significant net yield pick-up over government and corporate bonds (with comparable credit quality) and an attractive risk-adjusted return.
- Income security - the investor (freeholder) typically has first ranking title in the event of tenant default, which is underpinned by the property value and/or income over collateralisation and/or the credit quality of the tenant. Further, the contractual cashflows have lower letting risk compared with traditional real estate on shorter leases, meaning cashflows are more predictable and secure over the long run.
- Inflation protection - the majority of long income property targeted by Alpha have rent reviews that are linked to inflation, providing inflation protection to the rental income received and also to the underlying freehold capital value. The inclusion of a rent review floor or catchup provisions (e.g. no negative rent reviews) in a lease can help protect performance in a low or negative inflation environment. Conversely, the inclusion of a cap can reduce the ability to track inflation in highly inflationary environments. The cap does however act as an important feature to enhance the credit and long-term sustainability of an investment by preventing the rent from increasing higher than the earnings of the underlying operating business.
- Duration - institutional and other real money investors with long-dated liabilities, can use the long-dated inflation-linked cashflow streams to match their liabilities. Further, in the long-run, long income property yields tend to trend in line with changes in government bond yields, providing a natural interest rate hedge.
- Low volatility - the inflation-linked income stream and defensive nature of the asset, typically results in lower expected volatility (from an income and capital perspective) through market cycles, compared to traditional real estate. At a time of macroeconomic uncertainty, returns driven by income rather than capital value growth, offers an attractive, lower-risk alternative option for investors.
- Portfolio diversification - investors gain access to different return drivers versus liquid and traditional real estate assets, helping to enhance investors portfolio diversification and provide a lower range of expected outcomes. Sufficient diversification is possible with opportunities across alternative and core real estate sectors and geographies.
- Large pool of freehold properties - the eurozone has a large pool of freehold, owner-operated (over 69%), high quality, income generating assets that are well-suited to Long Income Property.
How should investors best approach investment into long income property?
Finding high quality off the shelf yielding assets is a challenge in the current low-yield environment. To invest successfully in long income property, we recommend investors focus on the following areas:
- Defining investment objectives - It is important to carefully consider what you are trying to achieve through your investments. Differently structured transactions may offer very different risks and rewards while sitting within the general catch-all of "long income". Directly negotiated transactions can offer better outcomes for both investor and tenant. Proactive origination. The most effective way to access opportunities is to source investments directly by working collaboratively with owners, acquirers and advisors of real estate, and to establish long term sustainable structures. Proactive origination is centred around an understanding of:
- Markets that have a suitable legal framework and that are likely sources of suitable transactions
- Owner occupier/acquirer drivers
- Market drivers for transactions (eg, M&A, refinancing & expansion)
- Flexibility - creating structures that meet owner occupier/acquirer needs and facilitates long term sustainability
- Security of income. Originating assets directly this way requires experience in credit and real estate research and analysis and deal structuring. We approach each opportunity from a fixed income rather than an equity mind-set, undertaking a detailed look-through analysis into the security of the underlying cashflows with a specific focus on downside protection and consistent performance. It is important to focus on the relationship between income security, covenant risk and asset quality, assessing the sustainability of a tenant's business model and the ability to replace lost income in the event of default.
- Environmental, social and governance considerations as part of the investment process. Given the long-dated nature of the assets, a successful strategy needs to be cognisant of the fact that the way in which buildings are designed, built, managed and occupied, significantly influences their impact on the environment and affected communities. Through the implementation of socially responsible policies, sustainability related risks, for example: climate change, site contamination, use of hazardous materials and local community impact, can be successfully managed. It should be noted that, in long income property, the day-to-day operation of the assets are under the control of the operator (leaseholder) and engagement with the freeholder is periodic in nature with the level of influence afforded to the freeholder related to preserving collateral.
Since the global financial crisis, the decline in government and corporate bond yields in Europe has left institutional and other real money investors seeking alternative, secure income generating assets in order to help meet their liabilities.
We believe European long income property, including ground rents, income strips and other long lease property, can specifically meet these income requirements by providing an attractive risk-adjusted return whilst complementing the existing matching and growth assets held.
With Europe's large pool of owner-occupied income generating assets and increasing acceptance of long income property as an efficient source of capital, now is an opportune time for investors to consider this emerging asset class.
Hugo James is partner and head of Long Income, Alpha Real Capital