September 2008

PROPERTY: pays the rent

A property fund that provides investors with long-term, inflation-linked income sounds just the ticket for pension funds. Angele Spiteri Paris looks at HLV products ... Equities and credit derivatives have given investors a white-knuckle ride over the last few months. But at the same time, commercial property has not afforded much shelter either.

Commercial property in the US fell 9.6% over the twelve months to August, according to Moody’s Real Commercial Property Indices. In the UK the sector fell to a record twelve-month low producing a return of -16.1%, as measured by the IPD All Property Total Returns Index recently.

Property is supposed to be a diversifier and has increased its presence in pension scheme portfolios. But investment managers in the sector, like their equity counterparts, are looking on the bright side and say this dip presents buying opportunities. Among these managers are those that run high lease-to-value (HLV) funds, which are a relatively new and innovative addition to the property investment landscape.

Mercer Investment Management launched a fund of HLV funds in January, while Morley and M&G Investments launched their own individual HLV funds a year ago.

Managers say that the funds offer long-term, inflation-linked cashflows and should be popular with pension schemes – more so than traditional commercial property.

The distinguishing characteristic of these funds is that they contain properties with long leases, meaning that income will rise in line with inflation. Also, depending on the risk profile, they may contain infrastructure assets, private finance initiative (PFI) projects – ie, expensive projects run as partnerships between governments and private industry – or be guided by ground rents.

HLV funds should also behave similarly to index-linked bonds but with a higher yield. On average
the funds promise to return between 150bps and 200bps over gilts per annum.

Long-term investment
Hooman Kaveh, chief investment officer for Mercer in Europe, says “At least 50% of the return on commercial property comes from the capital gains over the long-term price appreciation while, typically with HLV, the majority of the total return comes through the income side of the portfolio.”

This means the return is a result of rental cashflows generated by tenants. What differentiates these from a traditional property fund is that the leases on these properties are generally very long – ranging from 20 to 999 years when one includes ground rents.

The risk profile of the funds stems mainly from which types of properties they invest in. For example, Kaveh says that investments in commercial properties are further along the risk spectrum than those that focus on ground rents.

“Ground leases are typically at the lower risk end of the HLV spectrum, whereas investment in physical property has characteristics more similar to commercial property – although still in the HLV spectrum,” he says.
“The long leases mean these properties have a less volatile cycle then traditional commercial property, but they still have a cycle,” says Kaveh.

He says a fund such as M&G Investments’ Secured Property Income Fund (Spif) would have seen markdowns on values, although not as extreme as typically found in the traditional property market.

Ben Jones, manager of M&G’s Spif, says the assets in the fund have experienced a dramatic re-pricing, but he says this has created a unique opportunity for investors to access high-quality income streams at bargain prices.

“All property assets have been universally marked down in value, regardless of their quality,” Jones says. “Therefore there is the opportunity to select the higher quality assets among them with a view to earning superior returns and potentially receiving some short-term outperformance as the irrational pricing corrects itself.”

According to Jones, the devaluation of the properties in the SPIF portfolio is a result of negative market sentiment rather than any instability of the fundamentals behind the investments.

“The market pricing has been exacerbated by illiquidity,” he says. “The assets themselves are still the same. If anything, the value of the cashflows has actually increased, since they’re largely inflation-linked. The price of securing those cashflows has fallen in the current market.”

No-one in property is immune from markdowns, says Joel Lindsey, fund manager of the Morley Lime Fund. “You cannot claim that what happens in the commercial property market does not affect the HLV market. You just have to construct a portfolio that has some counter-cyclical attributes.”

To do this Morley’s fund combines commercial property with a PFI slant.

Property market volatility
Like M&G’s Spif, the Lime Fund’s objective is to invest in properties with annual fixed uplifts or with RPI-linked rent reviews. However, while Spif concentrates on commercial properties, the Lime Fund has more than 70% of its investments in the PFI sector, including schools, hospitals and libraries.

Mercer’s Kaveh says: “These investments would be less susceptible to commercial property market volatility.” Lime fund manager Lindsey, adds: “The PFI exposure in the fund has acted as a very good buffer against the downgrading of the commercial properties sector. This is because its characteristics are less correlated with commercial property and more similar to infrastructure which has weathered the storm fairly well so far.”

M&G’s Spif, on the other hand, does not invest in PFI, feeling the sector does not fit in with its investment philosophy.

Arguably, by investing in PFI, one would be taking on operator risk, which means the payments are dependent on the services associated with that asset being maintained to a specific standard.

Dependency on tenants is arguably a key risk, particularly with long leases. Stuart Webster, head of global property at New Star, which does not run HLV funds, believes fund managers can never be totally certain about the quality of their tenants. He says that an AAA-rated tenant today could easily slide down the ladder in a short period of time. Take, for example, Bear Stearns.

Webster does not deny the possible attraction of long leases and strong covenants but says the fundamentals of a property should be the priority. “The long leases are a nice marketing tool, but by depending on a tenant you’re accentuating your risk,” he says.

Gilts are low-risk investments and HLV property funds are sometimes said to be like them – particularly those that invest in ground rents, since they offer potentially lower yields but are less volatile.

Positive returns
Close Investments has run the Freehold Income Trust (Fit), a fund investing solely in ground rents, for 14 years. Peter Roscrow, fund manager and CIO of property at Close says the average return of the fund over the last ten years has been close to 9% per annum and  has generated positive returns in every single year.

The fund also held up well throughout the property market upheavals – returning 7.2% in the 12 months to April 2008.

“The fund has a very secure income stream which has been quite resilient,” says Roscrow. “Valuers tend to look at where interest rates have been moving and therefore the fund remained relatively stable over what was a difficult time for other property funds.”

According to Roscrow, ground rents are a more attractive alternative to gilts because there is potential to renegotiate the terms of the lease and the rent that was paid under during the life of said lease.“ This gives you more chances to increase the value of the cashflows, while a gilt would give the same sum until its redemption,” he says.

Although ground rents offer less risk and more stability, the market is highly specialised and difficult to get into.

M&G’s Jones says: “Ground rents can be quite difficult to source, particularly RPI-linked ground rents. They also tend to be quite low yielding so on a risk-adjusted basis they don’t offer as good long-term returns as high-quality commercial property let to investment-grade tenants.”

Roscrow agrees that investing in ground rents is not as simple as one might hope. “It would definitely be hard for a new fund to break into the market,” he says.

Charles Crow, manager of the UBS Secured Income Property Fund explains how the firm has found a way around the lack of ground rents in the market.

“We are actually creating assets by stripping ground rents out of existing freehold properties,” he says. This has resulted in substantial interest from investors looking for a low-risk diversifier. ©  2008 Funds Europe

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