Property: a panacea for pension funds? Patrick Bone, Head of UK Property Research Traditionally, pension funds have invested in UK commercial property to derive the benefits of diversification from other growth assets, income stability and a medium term hedge against inflation. Whilst the degree to which property has met these objectives is open to debate, it is the latter characteristic that has come under particular scrutiny in the last couple of years. Liability driven investment strategies are becoming increasingly popular as a way for pension funds to manage funding level risk by matching the scheme s asset to its liabilities. Similarly, we are seeing some pension funds switching their property targets away from relative return targets towards a defined margin over inflation (i.e. retail price index (RPI) + a margin). This partly reflects the view that property, with its potential to offer a reliable real income stream, can also help to manage a pension scheme s inflation risk. So how good is property as an inflation hedge? Well the longer term evidence, on the face of it, is quite persuasive. Since 1971, property has delivered real returns of 4.2% per annum, according to the Investment Property Databank (IPD). Real returns have only been negative in three periods over the last forty years the property crashes of the early 1970s, the early 1990s and in 2007 and 2008 (see figure 1). % per annum 40.0 30.0 20.0 10.0 0.0-10.0-20.0-30.0 UK Commercial Property Return (nominal) Inflation RPI Source: IPD, June 2012
While UK commercial property may deliver positive long-run real returns, it is not in the strictest sense a hedge against inflation. From a pension scheme s perspective a hedge is often defined as moving in line with both actual inflation in the short term and longer-term inflation expectations (which matter for pension scheme liability valuations), rather than simply keeping pace with inflation over the long run. In terms of short-term inflation, the annual correlation between property returns and inflation is actually quite modest (+0.4) 1. One reason for this is that, although the demand for space is largely a function of economic growth and should be quite strongly correlated with general inflation, the supply of space tends to lag both the economic cycle and inflation. This is because of the considerable time it takes for the construction cycle to respond to any increase in demand. A second and more telling feature of property returns is that, in the short term they are also heavily influenced by changes in property yields. Changes in property yields are driven by investors expectations for future rental growth and the pricing of property relative to other financial assets such as interest rates and bond yields. As periods of rising inflation and inflation expectations are often accompanied by rising short and long term interest rates, property values are often negatively correlated to inflation and inflation expectations i.e. property values can fall in response to an unexpected rise in inflation or long-term inflation expectations. 1980 = 100 600 500 400 300 200 100 0 Property Rental Income Average Earnings Inflation Source: Datastream, IPD, Schroders, June 2012 Although they may not move in parallel, over the longer term the income component of the property return has increased broadly in line with inflation, as displayed by figure 2. Over the past three decades, UK commercial property (orange line) has generated rental income that has increased both above the rate of inflation (grey line) and average earnings growth (blue line). The income return from property has grown above inflation mainly due to a combination of relatively long lease terms and the protection against declining incomes afforded by the upward only rent review clause. This meant that even though rents fell sharply in during the recessions of the 80s, 90s and noughties, the level of income from property never fell. 1 1981-2011 for further information please refer to Inflation and Property Performance: Buck, Callender and Turner, February 2007 (updated) 2
However, in the last three years some trends have emerged that suggest that investors can no longer rely on property delivering the real income return growth seen in the past. The first is falling lease lengths which lessen the benefit of upward only rent reviews. According to the BPF/IPD 2012 annual lease review, 76% of new leases agreed in 2011 were for terms of less than five years. This is compounded by the rise in company voluntary agreements (CVAs). Whereas historically tenants have to some extent been stuck paying their contracted rent irrespective of market rates because of the terms of the lease review, a number of firms have used CVAs to re-set the rent, often at a much lower level. This has particularly affected the retail sector, though the indebted budget hotel operator Travelodge is a notable recent addition. The second reason is the deterioration in nominal rental growth. Under the weakest economic recovery since the Second World War, rental growth in the majority of sectors has been non-existent. Given the subdued prospects for economic growth in the short to medium term, our forecasts for rental growth across most commercial property sectors remain muted. Finally, a recent study by the IPF found that even where the statistics imply that property is a hedge against inflation, it does not necessarily mean that an increase in inflation will be met by an increase in nominal returns 2. That will depend on what happens to GDP growth. The study found that property returns were weakest in periods of high inflation and low growth, implying cost-push inflation is not favourable to property returns. The inflation that we have seen in the last cycle has been mainly driven by increases in energy and food prices, forces that have largely come from outside the domestic economy. Economic growth over the same period has been flat. So whilst the cost base for most tenants has risen, the weakness of the underlying economy makes it hard to pass on these costs to the end user. One area that has grown in popularity is income based products such as long lease property funds. They aim to provide investors with long income streams secured against strong covenants and often have an explicit inflation linkage. These compelling characteristics have led to a rapid growth in the sector, facilitated by sale and leasebacks, although some investors have reservations about whether they can deliver the returns expected of them. Three charges against them are: Firstly, these are not bond investments and investors should not expect to receive all of their capital back. If the open market rent on the underlying property fails to keep pace with inflation in the long term, the increasing over-renting of these buildings will start to weigh on capital values as leases shortens. So whilst the income stream may be secure (Travelodge aside), the capital value falls will erode total returns as leases reach ten years or less to expiry. If we take a 25 year lease to a supermarket for example, how confident can we be that the supermarket will still want to trade from the store in 25 years time? Given the dynamic nature of the retail environment and the threats to supermarkets from changing shopping patterns, it would be dangerous to presume that these assets would hold the same attraction for occupiers in 25 years time. A further concern is accessing properties with sufficiently long leases since the trend towards shorter leases in the UK has led to a scarcity. This creates a problem of capacity, evidenced by many long lease funds having substantial queues of unsatisfied demand. 2 Property and Inflation, IPF Research Programme, April 2011 3
Finally, the pricing of these assets makes them more vulnerable to a normalisation of bond yields. Pricing for long lease assets, particularly those with inflation linkages, has become more expensive as investors have focused upon a narrow band of properties. For example, a 25 year inflation-linked lease to Tesco is priced at an initial yield of around 4.5%, compared with the IPD initial yield of 6.3%. Lower yielding assets have a higher convexity, i.e. they are more sensitive to the change in interest rates. If pension scheme trustees believe gilt yields will rise in the longer term, a parallel movement in property yields would have a disproportionate impact on the valuation of low yielding properties. Investors have also been tempted by ground rent funds which offer an income stream which is linked to inflation. Whilst the value of these assets may appreciate over time to reflect inflation rates, the total value of ground rents in UK commercial property is tiny. A recent report by Savills estimates that the house building industry is generating new ground rents with a value of 180 million per annum. In the context of UK pension funds ground rents are simply too small to be of general relevance. While the theory may be sound, in practice it remains a sector that is not practical for pension funds to consider. While long lease funds provide income security, they may not be the panacea that some investors perceive. An alternative strategy is one used by Schroders Real Income Fund. Our approach is to adopt a diversified and thematic approach to identify property which offers both a high yield and affordable rents which can genuinely grow in line with inflation. Coupled together, these address some of the drawbacks of long lease funds. Our aim is to target tenants who have pricing power i.e. the ability to pass on an increase in their cost base to the end user. This makes these occupiers more insulated against the performance of the UK economy, dampening the volatility of rents. Given a choice, these types of businesses may prefer long term rents linked to inflation because it creates greater certainty into their business model. The alternative, open market rent reviews, is less predictable and may be less desirable. For the investor, this approach provides a reliable stream of income over time which provides a good link to inflation. We believe that an income based strategy which aims to match rental growth with inflation offers the prospect of a stronger, more resilient linkage. Figure 3 compares the valuation of two assets with identical RPI-linked leases. The open market rental value of the asset represented by the blue line keeps pace with RPI, while that of the asset in orange increases by 1% below RPI, in line with long term averages. The valuation difference is stark. Whilst the Real Income approach doesn't explicitly protect capital, over the strategy s medium term time horizon we think that a by-product of this strong inflation linkage is capital protection. 4
Index value 180 170 160 150 140 130 120 110 100 90 80 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Years Inflation (RPI) Long Lease Real Income Assumptions: The chart above compares two theoretical assets with 20 year leases and five yearly uplifts in line with RPI (modelled at 2.5% pa). At the end of each lease the asset is re-let at open market rental value. For the Real Income growth asset open market rental levels match inflation, whereas open market rental levels increase by 1% below inflation for the Long Lease asset (this is in line with the long term average). The Index Value is calculated for both assets using a discounted cash flow. Source: Schroders for illustration purposes only. We think the best opportunities to achieve these returns may lie outside of the mainstream sectors. These offer three compelling benefits. Liquidity premium: These sectors are often less well understood by investors, and therefore cheaper to buy into, offering an above average initial yield. In contrast, the excess demand for long leases in mainstream commercial sectors has fed through to valuations where for example, a 25 year lease to Tesco is priced at an initial yield well below the IPD average. Convexity: Higher yielding assets have a lower convexity, i.e. they are less sensitive to the change in interest rates. In turn, this provides greater certainty of capital returns over our 7-10 year period. First mover discount: The final benefit occurs if these investments enter the mainstream. This provides capital appreciation as investment yields fall towards the average - we ve seen this before with retail warehousing in the 1990s and student accommodation in the last decade. Finally the approach is firmly focused on income. According to IPD, income has historically generated over two-thirds of total returns from UK property. However, going forward with rental growth expected to remain subdued, we expect this proportion to rise in the coming years. 5
Historical real income returns (Dec 2006=100) 115 110 105 100 95 90 Cordea Savills Student Hall Fund UNITE UK Student Accommodation Fund The Quercus Healthcare Property Partnership All pooled property funds index Source: IPD UK Pooled Property Fund Indices, June 2012. The sectors that we think exhibit these characteristics include convenience retail, healthcare, student accommodation, motor retail and affordable housing. All have strong occupier demand (for the right property), are exposed to domestic inflation (i.e. goods and/or services) and have pricing power. Some leases, though not all, have explicit RPI uplifts. We believe that these sectors will continue to see the income protection that they have provided to investors over the past five years (see figure 4). Importantly, while some managers target these sectors individually, we think a diversified approach spreads risk and provides capacity which at times can become constrained. Property remains an attractive asset class, but investors seeking a strong linkage between rental growth and inflation may need to think more creatively than in the past. The approach employed by Schroders Real Income Fund offers another source of inflation protection to UK pension schemes. This approach could be actively considered as part of a diversified pool of real investments. 6
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