Click here to read the full paper including graphs: Attractive Characteristics, compelling opportunities
Demand for yield remains high
Local Government Pension Scheme investors continue to grapple with increasing member maturity, making the search for greater investment income ever more pressing.
The continuing low yield environment has fuelled demand for alternative investment opportunities that offer a return premium without sacrificing the required risk characteristics. However, many investors are not aware that there are real estate solutions which can meet both of these needs.
Real estate long income and real estate credit can provide the yield premium that LGPS investors require, while retaining many of the attractive features of fixed income, including long-term, predictable, inflation-linked income. But successful investment and portfolio management relies on specialist understanding of real estate markets and expert understanding of property-specific fundamentals.
Long-term, inflation-linked income
For investors searching for attractive risk-adjusted returns driven by inflation-hedged, stable cash flows over the long term, real estate long income is an attractive solution. Broadly speaking, real estate long income refers to properties that are leased to tenants for between 15 and 150 years. Depending upon the structure chosen, the investor or tenant retains the property at the end of the lease. Depending upon the specific investment, risk mitigation is gained from recourse to tenants with superior credit strength, and/or ownership of property underwritten on the basis of a lower rent than that achievable on the open market, or having been bought for an amount lower than the potential sale proceeds achievable on the open market. With returns driven by long-term cash flows and index-linked rental uplifts, the strategy also offers the ability to match investors’ liabilities. Compared with fixed income, real estate long income has historically delivered attractive risk-adjusted returns, lower volatility and a consistent illiquidity premium.
Real estate credit also offers attractive income benefits, favourable risk-adjusted returns and portfolio diversification. In simple terms, real estate credit refers to private loans, or mortgages, secured against commercial real estate and used for either acquisition financing, or refinancing of existing loans. It has historically generated higher yields than investment-grade corporate debt, while diversifying away from directly held real estate or traditional liquid investments like corporate credit. Real estate credit can also be structured to offer an explicit link to inflation through floating rate loans hedged by way of an interest rate cap.
Protected by underlying asset quality
Real estate long income also offers a viable alternative to fixed income in terms of credit quality. The credit strength of a long income investment is determined by the level of collateral provided by each property or the financial strength of the tenant counterparty. As the type and level of credit quality can vary, the attractiveness of the property is extremely important. If a tenant defaults, the recourse for investors is to retain the underlying interest in the property, making the property’s value an enduring source of security. Real estate credit offers the benefits of contractual income streams generated via lease payments from property tenants, with additional downside protection provided by the asset’s collateral. As loans are typically secured against the asset and the borrower is not personally liable, lenders need to ensure there is a good understanding of the underlying property in the event of a default. A thorough grasp of property fundamentals and how they behave across the cycle is essential to correctly assessing the risk of both these investments.
Identifying opportunities and value
CBRE Global Investors’ breadth and depth of expertise in real estate allows us to find and access compelling opportunities in real estate long income and real estate credit as they arise. We have an extensive view of the market, a heightened understanding of the risks currently at play, the information needed to identify pockets of good value, and, crucially, access to deal flow in a tight market.
With the pandemic expected to last into 2021, we are carefully monitoring some key opportunities. Demand for liquidity and credit is rising as risk appetite from traditional lenders has lowered. This leaves an opening for non-bank lenders to step in and provide flexibility and well-structured financing to borrowers at attractive prices.
We are also watching closely as pressure increases on investment-grade corporates. With volatility amplified by the pandemic, downgrades to sub-investment grade could rise. It is shortsighted to view a long-term lease with an investment-grade corporate tenant as adequate protection. In our view, the quality and attractiveness of the underlying asset is always paramount.
The compelling case for LGPS funds
Against a background of uncertainty, both real estate long income and real estate credit offer attractive characteristics as investors look to diversify investment risk towards income-oriented asset classes. With both of these investment opportunities, LGPS funds can benefit from:
- Higher yield than fixed income
- Long-term, stable cash flow
- Inflation-linked income that enables liability matching
- Attractive risk profile, supported by high quality real estate fundamentals.