April 7, 2021
Rupert Sheldon, Head of CORE REIM at Fiera Real Estate UK
High yield equals high risk. This is a key tenet of investment theory drummed into us all at an early age. Yield is relative and represents a universal measure of value, risk and return across all asset classes and markets. It is an international concept transcending all languages, business cultures and geopolitical borders. Yield is the component of return that assumes increased importance during times of economic and wider market volatility and hardship. It is perhaps not surprising therefore that as we emerge from the ravages of the COVID-19 pandemic, a flight to defensive investing and heightened demand has put downward pressure on yields. This begs the question:
What is a high yield in today’s market?
With 10-year UK Government bonds (“Gilts”) and US Treasury Bonds offering 0.8% and 1.6% respectively at the time of writing and the FTSE 100 Index offering an aggregated dividend yield of 3.8% as at 31st December 2020, what is a fair yield for core UK real estate? The graph below shows that presently, relative pricing of UK real estate when measured against 10-year gilts, sits at an appealing c.6% margin and comfortably ahead of the expected dividend outturn from equities.
Whilst at an all-time high, the all-property equivalent yield margin over gilts reflects the relative position across the MSCI measured universe including all risk assets. But what if we consider the comparable position at the core or lowest risk end of the real estate market? In other words more of a like-for-like comparison with the bond proxy segment.
Based on an average weighted annual distribution yield across the distributing funds within the MSCI Long Income Property Fund Index of 3.6% as at December 2020, there is still an appealing margin of close to 3% relative to 10-year gilts. So, for investors considering liability matching or wealth preservation strategies, it is worth taking a closer look at what the long income UK commercial real estate market has to offer.
Source: MSCI, Q4 2020
What is Long Income in UK Commercial Real Estate?
Long income describes leases with a term of 15 years or more although many long income funds seek to achieve average minimum unexpired lease terms of 20 years plus. Leases are typically structured on a traditional full repairing and insuring basis placing the cost burden for repair and maintenance on to the tenant and therefore ensuring a triple net cashflow to landlords.
Rents are typically reviewed five yearly (although sometimes annually) and in line with inflation (CPI or RPI) or via fixed rental uplifts. This enables income streams to grow with the wider economy rather than being subject to the vagaries of local real estate markets and the volatility that may bring.
The last ingredient is managing counter party risk and long income managers usually do this by building a portfolio of investment grade tenant credit with managers employing sophisticated underwriting and monitoring tools to manage this risk both at acquisition and throughout the asset hold period. The net result is to create a genuine bond proxy or liability matching investment underpinned by a real asset and appreciating residual land holding.
Fiera Real Estate’s UK Long Income Fund (“FRELIF”) is a good example of such a vehicle conforming to all of the above criteria with a minimum unexpired lease term of c. 18 years, 75% indexed or fixed rental uplifts and an overall investment grade counter party risk.
What are the risks?
For liability matching or wealth preservation investors, the case is a compelling one. However, unlike investing into Gilts, your capital and income are at risk. It is therefore imperative to understand how these risks can be mitigated:
Recent government legislation designed to protect vulnerable tenants through the pandemic, has prohibited landlords from using normal measures to collect unpaid rents. This has left many commercial landlords with a rental shortfall. The graph below illustrates rental collection statistics since December 2019, as well as for the Fiera Real Estate Long Income Fund, UK (“FRELIF”).
Source: Remit Consulting December 2020, based on 125,000 tenancies
The higher FRELIF rent collection reflects success across the three key areas of risk management being: i) top-down sector allocation – an overweight position to the out-performing industrial, logistics and food retail markets with no exposure to the underperforming high street retail and shopping centre segments. Significant underweight positions across at risk operational assets such as hotels or leisure further insulate against the effects of the pandemic in what has become a very polarised market for rent collection; ii) robust credit underwriting and monitoring – this is achieved via an established toolkit for managing tenant credit risk including both proprietary and third party systems working with partners such as EY, INCANS and Dun & Bradstreet to ensure investment grade counter party risk is achieved and maintained; and iii) strong tenant relationships built up over many years.
This consistency of rent collection has delivered stable income distributions throughout the pandemic. With a current net distribution yield to investors of 4.5%, the Fiera Real Estate Long Income Fund, UK enjoys a significant income advantage over the wider long income market and a close to 4% margin over 10-year Gilts.
Capital Value Resilience
This is best achieved through securing strong deal pipeline of best-in-class future proofed investment stock which can be effectively managed to reduce the natural depreciation curve.
Typically, a building depreciates on a straight-line basis from new until redeveloped at the end of its useful life. The depreciation curve can be flattened through capital re-investment or future proofing from new. In the case of the latter, sourcing and buying newly built ESG exemplar assets is a great way of ensuring capital value resilience in today’s market. This is something we do at Fiera Real Estate when working with our eight part-owned regional property development partners who specifically target and build ESG best in class assets to protect against future obsolescence. We also keep a close eye on residual site values, favouring assets in lower value land uses such as urban industrial, where there is cope for significant residual value upside at lease expiry to higher value uses such as residential.
A High Yielding Diversifier in a Low Returning Market
In a market where yield is increasingly hard to come by, long-income UK commercial real estate can offer attractive risk adjusted returns when compared to other perceived low risk investment alternatives across the wider investible universe. This is particularly so where income and capital risks can be effectively managed. Fiera Real Estate has a strong track record of out-performance in this market and in an uncertain world where yield and certainty of income remain paramount, long income commercial real estate investing has a natural place within a diversified liability matching or wealth preservation strategy.