In recent months, we have seen a number of high-profile commercial chains experiencing trade difficulties in their respective sectors. Should landlords and investors be worried?
The struggles that Tesco has been experiencing as a brand, with profits dropping over the past 12 months, alongside similar issues and store closures at B&Q, characterise the situation. Our client-facing teams have heard concerns reverberating around owners’, managers’ and investors’ offices as they have been out presenting on portfolio results, and who can blame investors for their anxiety when Tesco and B&Q account for almost 5% of our average UK portfolio’s rental income?
Asked whether their fears are warranted, surprisingly, the answer is “probably not” or, at least, not as much as one might believe.
Simply put, leasing risk is different to trade risk, particularly given the strong legal structure of commercial leasing in the UK market. New analysis from the IPD Rental Income Service shows that despite the woes of the sector, both Tesco and B&Q are rated as having a low risk of defaulting on their leases, with B&Q being rated as low as negligible.
Of course, this works both ways, with appetite for risk increasing there are plenty of landlords that would welcome the return of their building, providing an opportunity to re-let or convert to an alternative use, but we don’t expect those outcomes to be prevalent.
The robust income-generating nature of real estate portfolios has been one of the principal reasons why multi-asset-class investors have increased their allocations to real estate, encouraged by and bringing with it, ever greater demand for systematic analysis of real estate risk and return drivers throughout the investment process.
In the current stage of the market cycle, investors are receiving the majority of their total return through capital value appreciation and, as a result, allocation to growth opportunities rather than income may dominate end-investors’ thoughts. This seems eerily familiar to 2006, however, and an opportune moment perhaps to remind ourselves and others that income is the principal foundation of real estate investment returns. For most markets and over the longer term, the vast majority of the real estate return comes through income rather than appreciation (which cycles around it). The UK, for example, has returned 6.2% on average per annum over the past 10 years, with 5.7% (nine-tenths) coming from income.
A lot has changed in the property sector since the 2008 crash. While most eyes have been on total or income returns, a deeper delve into the sector has shown that the crash brought about shifts in investment vehicle and underlying asset structures.
The pre-crash appetite for sale-and-leaseback agreements helped investors to meet some of their long-lease and liability matching requirements. Long-lease funds were born and grew rapidly in the ensuing low-capital-growth, risk off environment, epitomising the flight to quality, seeking core assets with long, secure income. The goal was to match liabilities and defensively ride through the crisis.
In the current environment these funds have returned a relatively modest average of 8.8%, underperforming the broader real estate market in the 12 months to June 2014. Despite its current performance, the long-lease fund seems to be here to stay, albeit laying lower in the headlines, waiting for the inevitable turn of the market.
There have been important changes at the property level too. On a like-for-like basis, UK lease lengths have shortened considerably over the past 20 years. While UK averages remain the longest of any market in our international sample, standard UK office and industrial properties now exhibit average lease terms (at around eight years) much more in line with those in other European markets. The persistently longer investment portfolio lease lengths in the UK (averaging over 11 years) have instead been explained by the significant increases in portfolio exposures to alternative asset types (for example leisure, hotels, healthcare, ground rents). The returns from these properties may not be grabbing headlines right now, but – much like the properties with 20-year, RPI-linked leases to Tesco – their presence within a host portfolios often provides the managers and investors with a sense of comfort for the medium term.
Malcolm Hunt, executive director, MSCI
