According to a paper published by Alpha Real Capital LLP, the specialist manager of secure income real assets, the UK long-income real estate market is worth around £30 billion and continues to grow rapidly.
Alpha says commercial ground rents, which are financing structures whereby a real estate owner or acquirer sells the freehold land to an investor and simultaneously agrees a long-term (generally over 75 years) lease with them to continue using a real estate asset, is the fastest growing segment of the long income real estate market, and that over the past five years the sector has grown from virtually nothing to around £4 billion in size, with around £1.5 billion of new deals completed in 2019 alone.
Alpha expects this trend to continue, with both supply and demand increasing going forward. In particular, they believe there are already clear signs that the recent pandemic has led to heightened interest by owners in the ground rent structure.
Commenting on the long-income real estate market, Hugo James, Partner and Head of Long Income at Alpha Real Capital said: “What originally started as predominantly a long lease market dominated by sale & leaseback transactions has now expanded into other structures with commercial ground rents and income strips seeing significant inflows of capital in recent years. For investors, the choice of different structures provides flexibility to tailor the specific outcome that they are targeting in terms of yield, duration, income security and level of inflation protection, while for owners and acquirers of real estate it provides further options to optimise capital raising.
“We believe that the COVID-19 crisis will create more demand for commercial ground rents from tenants and that they will be the opportunity to achieve attractive returns for investors. This, coupled with the fact that the asset class has performed well so far during the pandemic will see more institutional investors looking to invest here.”
Pension schemes and insurers are the primary investors in long income real estate, attracted by the availability of high quality, inflation-linked cashflows at significantly higher yields than comparable government bonds. For pension schemes, including these ‘bond-like’ assets in their portfolios can reduce the reliance on very expensive government bonds (and LDI) to help cashflow match their longest-dated liabilities, whilst for insurers some of these assets can achieve advantageous treatment under Solvency II.
Given the characteristics and contractual nature of the cashflows, commercial ground rents share more with fixed income instruments than commercial property, which is why some asset managers categorise long income real estate in their fixed income range. By including these assets in portfolios, investors can reduce reliance on expensive government bonds while also receiving an attractive return for the amount of risk taken. The inclusion of an exposure to commercial ground rents could also enhance diversification at total portfolio level. However, investors need to be comfortable with the nature of the risk taken and the illiquidity of the underlying assets.
For investors, the key characteristics of a commercial ground rent investment are as follows:
- Very long duration: a typical duration of the cashflows is 30 to 40 years. The only other investible asset currently available in the market with that duration are the longest-dated government bonds with yields near or at their historical lows (and in the case of index-linked gilts, real yields are actually negative)
- Inflation protection: rent reviews can be effectively tied to inflation providing inflation protection to both income and underlying freehold capital value.
- Investment grade quality cashflows: security is achieved through being the most senior in the structure as the freeholder, as well as the significant over collateralisation of the income and capital. As a result, these investments are usually equivalent to investment grade credit rating in the BBB to AA range, typically clustered in the single A category.
- Illiquidity premia: as a private market asset, commercial ground rents benefit from an attractive illiquidity premium relative to listed alternatives (although liquidity options do exist).
- Enhanced diversification: the asset class’ defensive nature and unique structure should also provide an attractive diversification benefit at the portfolio level.
- Gilt spread: the current spreads over equivalent index-linked gilts is 350bps to 450bps p.a. depending on the deal characteristics. (4)
To better understand why supply is there to meet the demand from investors, and indeed to structure successful sustainable commercial ground rents, the asset owners’ and acquirers’ perspective must be considered. For them, commercial ground rents can be a very effective refinance or acquisition tool when compared to other forms of capital. For some private equity firms, commercial ground rents have become an important tool to help secure deals whereas for the owners of real estate, value can be created by monetising the freehold.
The four main reasons for this are set out below.
- Lower cost of capital: when compared to other forms of finance, ground rents can contribute to a lower cost of financing. This helps boost returns for owners of real estate and acquirers in M&A deals.
- Leaseholder flexibility: the leaseholder maintains freedom to operate the real estate asset without any onerous restrictions.
- Permanent capital: given the very long-term of the lease, the proceeds from the sale of the freehold provides effectively ‘permanent’ capital that does not carry refinance risk associated with other forms of finance.
- Remaining lease valuation: the remaining long leasehold (after ground rent is paid) still holds significant value that can be used as collateral for other forms of capital (e.g. senior or mezzanine debt).
Hugo Jamesconcluded: “The COVID-19 pandemic has impacted almost every investment asset class, with long income real estate being no exception. However, its more defensive and resilient structures and its strong track record which has been enhanced during the current crisis, means it is becoming even more attractive to investors. With more supply being made available, the market is set to grow even faster.”