Until the end of 2017, interest rates had not seen a rise for a decade. Even when the Bank of England made an upwards move in November, it was only to 0.5%, meaning interest rates are still at stubbornly low levels.
The economic policy was born out of the global financial crisis and is designed to help manage inflation and promote growth, yet the impact has been detrimental for savers.
Anyone looking for secure, stable sources of income has seen their usual supply cut off.
Government bonds – gilts – and higher rated corporate bonds are no longer delivering healthy yields, while there is next to no return on cash. All this in a rising inflation environment poses real challenges.
Freedom and choice
This is troubling for those saving for retirement, particularly anyone who is reaching the end of their pension accumulation phase and looking to move into safer assets to fund their final years.
This matter is further complicated by the advent of freedom and choice which allows anyone over the age of 55, who has saved into a defined contribution or personal pension plan, to draw or reinvest their fund as they wish.
Consequently, there is a need to find alternative sources of income which can deliver irrespective of low interest rates, while also possibly protecting against rising inflation and offering liquidity. In addition, since investors approaching retirement have less time to make up any losses if anything goes wrong, assets must be risk managed.
One possibility is the long lease income market where investors can access steady returns from high-quality freehold property let on long secure leases.
Long income property is similar to traditional commercial property investment, but with significantly greater income security due to the length of the leases and fixed or index-linked uplifts in rental income. The types of commercial property that lend itself to long income are those where the property itself is the profit centre for the occupier of the property, hence the desire to secure long term occupation of the building, for examples hotels.
Long income property is made up of two categories of commercial property: freeholds with long leases and freeholds with ground rents. These are set out in the illustration below:
Freeholds with long leases
The premise is straightforward in that the UK freeholder issues leases on commercial property to tenants, the leaseholder, for periods of over 15 years. Unlike ground rents, the rent is set at full market value by the leaseholder. Upwards only rent rises, typically inflation-linked or fixed are agreed in advance which protect the investor against the corrosive effects of inflation.
Commercial freeholds with long leases tend to offer a higher income return compared to those with ground rents.
The investor is also afforded some reassurance by letting only to those tenants with a strong commercial reputation which minimises the chance of default.
The strength of the tenant is critical to the success of long income leases. Often it is stable businesses that can commit to a long lease and they are willing to do so to access specific benefits.
The lower and predictable rents are an obvious attraction for businesses who want predictability for their balance sheets.
In addition, securing a long lease is important if businesses favour a specific location.
Moving is time-consuming, expensive and disruptive. Long leases provide the reassurance that even if the freehold changes hands, the business can stay in place.
As the long lease market has grown and attracted more investors, the opportunities for tenants have grown in tandem. Today we see healthcare, hospitals and leisure businesses joining alongside established tenants such as supermarkets and government buildings.
Freeholds with ground rents
The UK freeholder leases the building to a leaseholder who is usually a commercial tenant. At the start of the lease, which usually runs for 100 years or more, the freeholder sets the ground rent which is substantially below market rate. The leaseholder can occupy the building or sublet to another business at a higher rate.
By setting the rent at a lower level – normally around 15% of market rate – the leaseholder is incentivised to pay the rent on time or risk forfeiting the value of their leasehold to the freeholder.
The freeholder has full legal title to the property and is treated preferentially when it comes to the leaseholder’s payment obligations which means they are first in the queue, ahead of a mortgage provider for example.
Investors also benefit from the protection of the property value itself. Since the market value of the underlying property could be as much as four times the value of the freehold ground rent interest, they are significantly over-collateralised. Further, usually the leaseholder is responsible for maintaining the property so these costs do not affect the return to the freeholder.
Institutional investors have been using long income investments for a long time and the market is well established.
The sector has been growing for the last decade and according to research from CBRE, 2017 has been the busiest for long lease investments as more individuals and institutions continue to take advantage of the long-term, predictable inflation matching income streams[i].
In the year to end of September 2017, the long income funds sector as measured by CBRE returned income of 5% year on year[ii], which compares to yields of 1.2% from 10-year gilts as of the year to December 2017[iii].
As the economic conditions remain uncertain, particularly following the Brexit vote, the long income property sector is a useful diversifier since it tends to slightly underperform traditional commercial property when markets are rising while outperforming when they fall or times are uncertain. As interest rates stay so low, the conditions are right for the long lease sector to continue to outperform.
Long leases are not just about income either; they offer the chance for capital growth. All long income funds as measured by CBRE returned 6.9% year on year in the 12 months to September 2017[iv].
Long income investment is not without risk. Investors need strong due diligence to find fund managers with a proven track record, a diversified portfolio, and one that can demonstrate thorough research of underlying tenants.
The pro-Brexit vote is also a consideration since this may have an impact on the market; investors should be sure their managers can react appropriately.
In a world where income is hard to find, long income investment opportunities can provide a genuine alternative to traditional sources, and is now a very real consideration for those planning for retirement.
The benefits of long income investing for retirement planning
Nigel Ashfield is fund manager at TIME: Commercial Freehold