Long Lease Property Funds to Grow by £1bn in 2012
2012 is set to be the year in which “long lease” property funds go mainstream as pension funds look for certainty over future rental streams, according to KPMG in the UK.
KPMG estimates that there is around £30bn of commercial property investment currently under management by UK pension schemes with the majority held in traditional “balanced” funds but around 10 percent in the form of a new category of “long lease” funds. In December 2011, long lease funds broke through the £3bn barrier for the first time. According to KPMG’s estimates, the proportion of long lease funds is set to grow by at least £1 billion again in 2012, building on the 30 percent growth experienced in 2011.
Pension funds and commercial property
Commercial property has historically proved an attractive investment for a number of reasons, including providing diversification from equities, a stable income stream, a hedge against inflation and outperformance of liabilities.
Almost all of this investment has historically been done on a “balanced” basis i.e. across retail, offices and industrial properties, often through a pooled fund.
These balanced funds have provided a stable income stream but, according to KPMG, they can pose risks to pension scheme investors. For example, balanced funds rely on agreeing rents in an open market structure. Rents are often fixed for a number of years and are re-negotiated at expiry, at which point the new rent level is not guaranteed.
In recent years, a new area of property investment has developed, namely “long lease” property funds. These differ from balanced funds in a number of ways. Primarily, they overcome much of the uncertainty about the rental income stream. This is because tenants sign up to contractual, inflation proofed rents for a number of years (e.g. 15 years plus). Many tenants prefer to do this as their income stream is also largely RPI linked (e.g. supermarkets, hotels, student accommodation and professional firms) and the long lease format reduces risk for them.
Growth of the long lease fund market
The size of the long lease pooled fund market (including ground leases, which share the secure, inflation proofed income characteristics) has now broken the £3bn barrier. For the first time, one fund alone is now valued at over £1bn, with others close behind. From the launch of the first such fund in 2003, the market has averaged growth of 30 percent p.a. since end 2004, reflecting investment performance but also very strong asset inflows.
As they have grown, the funds available have offered increasing levels of diversification and a range of investment styles, from PFI and Government focussed income to a more corporate tenant bias. KPMG predicts this trend will continue, noting that other property fund managers are preparing long lease funds for launch in 2012, all of which are likely to provide a new twist to current funds.
Greg Wright, head of property research at KPMG Investment Advisory, commented: “Many pension schemes have understandably gone into property investment to provide diversification, but also to act as an inflation hedge. We believe long lease and ground lease property funds provide direct, rather than indirect inflation proofing.
“Pension schemes are also crying out for investments which can provide this type of income stream with a reasonable rate of return, rather than buy index-linked gilts on negligible real yields. New long lease funds are all trying to improve the liability matching they provide for schemes.
“They are also likely to be more and more suitable for insurance companies (who already invest this way for their annuity funds); this is helpful as many schemes will look to de-risk via buy ins in the next few years.”
He added: “Pension schemes no longer have to be exposed to the vagaries of open market rent reviews and the weakening occupier market. Fund managers must clearly focus on the quality of the tenant and the property itself but all in all, long lease provides a much better fit than balanced funds for the needs of today’s schemes.
“We believe long lease and ground lease funds should become the default position for commercial property investment. As evidence, for every £1 our clients have invested in balanced property funds in the last three years, £10 has gone into long lease. Put another way, if pension schemes had always invested in long lease funds, would they choose to invest in balanced funds now?”