THE EVOLVING RESIDENTIAL GROUND RENT MARKET CBRE SPRING 2013

THE EVOLVING RESIDENTIAL GROUND RENT MARKET CBRE SPRING 2013

INTRODUCTION The ground rent market has undergone significant changes over the last two years. This period has been characterised by a distinct change of ownership. There has been a substantial strengthening of the market resulting in a rebasing of pricing. Residential ground rents have attracted the attention of many of the largest institutions and property funds. There are still more investors, such as fund managers and institutions, with an appetite for exposure to the residential ground rent market and are seeking opportunities to enter the sector. Ground rents fall under the umbrella of a growing group of fixedincome property investments, including income strips. The key attraction of these assets is that they provide a level of income which hedges against inflation and they allow a degree of wealth preservation. This report focuses on the long dated ground rent sector, provides an update on the market, and outlines our opinion on current issues facing the sector. Ground Rents Income Fund plc - One Park West, Liverpool 1

THE BASICS A MODERN HOUSEBUILDER LEASE WHAT ARE GROUND RENTS? Ground rents are a product of the freehold/leasehold structure in English law. The ground rent is an annual payment to the landlord in consideration of the grant of a long lease, with the landlord ultimately benefitting from the reversion at expiry. Long leases are drafted by housebuilders on disposal of flats, or in some cases houses. Over the past 30 years housebuilders have become increasingly aware of the investment value that can be created by drafting their leases in a manner that secures a ringfenced income stream for future freehold owners. This is particularly the case over the last 10 to 15 years as leases have been optimised in terms of the rent review clauses, notice fees and other provisions, to maximise freehold sales receipts for the developer. CLAUSE EXAMPLE TERMS Term 125 years Ground Rent Review Mechanism Repairs and Maintenance Insurance 250 per annum 10 yearly RPI indexation Management Company, of which lessee is a member Management Company, of which lessee is a member THE INVESTMENT APPEAL PERCEIVED RISKS Longevity of Income Modern residential long leases provide income streams of in excess of 125 years. Such terms are far in excess of those available in the wider property sector and financial markets. Disaggregation The investor s ownership is spread over thousands of units with the resultant management, legal and cost implications. Income Security Liability Matching Provisions Ancillary Income Minimal Income Erosion Ground rents are heavily collateralised. The underlying property value is often 30 to 50 times the value of the ground rent investment. The review provisions of ground rents are considered attractive, often being based on indexation to RPI or a fixed uplift as opposed to reviews to market rents. Such mechanisms enable investors to match liabilities. Unlike traditional residential and commercial assets the return generated from the investment is not solely derived from rental income. Soft income can be generated from notice fees, insurance premium commissions, service charge management and enfranchisement premiums. Minimal gross to net income deductions in comparison to the commercial and residential property sectors. The main cost involved in holding ground rent investments is the cost of ground rent collection and administering notices. Management Portfolio Size Reputational Risk Management of large ground rent portfolios is complex. Significant IT expenditure is necessary to optimally manage portfolios and maximise returns. There is arguably a shortage of independent agents who are able to undertake portfolio administration such as ground rent collection. Large portfolios are necessary to create the economies of scale which can generate optimal returns. Creating a portfolio of scale is both costly and can take a significant amount of time. The sheer number of lessees an investor has to interact with means that investors will be exposed to reputational risk, often regardless of how successful they are operating as a freeholder. Lack of Volatility Ground rent investments have historically remained relatively insulated from the market volatility that has affected both the residential and commercial investment markets over the last few years. Ground rents have been viewed as a safe haven by investors. The Right of First Refusal Lessees must be offered the right of first refusal of the freehold/headlease before it is sold in the open market. Premiums Residential ground rents can often generate significant capital sums from lease extensions and enfranchisement premiums, albeit in some cases with a reduction in ground rent receipts due to statutory provisions. Lease Extensions and Enfranchisement A leaseholder may seek to extend, or as a group of leaseholders collectively enfranchise, their leases. The freeholder can therefore potentially lose the ground rent income, albeit in return for a capital sum. 2

OWNERSHIP THE MARKET CHANGES IN OWNERSHIP TRENDS There has been a distinct change of ownership structure within the residential ground rent market. Over the past few years ground rents have attracted the attention of many of the largest institutions and property funds. These investors view the returns as highly attractive against the risk profile of the asset, and ahead of those available from gilts and bonds. A number of these investors have made the leap into the sector, either directly investing or indirectly investing within funds. For example, Aviva Investors and Brooks Macdonald (adviser to Ground Rents Income Fund plc) are among a new breed of investors who have been particularly active over the last 24 months creating substantial residential ground rent funds. 75,000 UNITS BOUGHT IN THE LAST 24 MONTHS A handful of new investors have dominated purchasing within the market and we estimate have acquired over 75,000 units in the last 24 months. Historically, the ground rent market has been considered a relatively discrete and closed marketplace, the preserve of a limited number of investors. The market has evolved from the traditional landed estates and family trusts through to debt securitised vehicles and to the current institutional landscape. Landed Estates Private Investors and Family Trusts Leveraged Investors Institutions and Funds DRAMATIC PRICE INCREASES The market has experienced dramatic price increases over the last two years. From our own analysis and benchmarking, gross yields on long dated residential ground rent investments have strengthened significantly since 2010, with a move of approximately 125 basis points reflecting a multiplier shift of approximately four Years Purchase (YP). Yield 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 2007 - H2 Ground Rent Investment Commercial Property Gilt 4.25% Treasury 2032 2008 - H1 2009 - H1 2009 - H2 2010 - H1 A significant number of investors with substantial funds are chasing a finite amount of available ground rent stock. Many of these investors are not reliant on debt to fund purchases and can execute transactions swiftly. These new 100% equity purchasers dominate bidding and with ambitious growth targets they need to bid aggressively to acquire stock. Existing investors and geared purchasers are still active in the market but to a lesser degree; they often have to rely on existing relationships with housebuilders, aggregating smaller purchases, or sourcing off-market opportunities. The characteristics of each ground rent investment can vary, but the principal value driver for large long dated transactions ( 500,000 plus) is the rent review mechanism. RPI-linked review mechanisms have experienced the biggest price escalations, particularly those with review frequencies of 15 years or less. The characteristics of these review mechanisms meet the funds investment criteria enabling them to match their own investor s liabilities. Year 2010 - H2 2011 - H1 2011 - H2 2012 - H1 2012 - H2 With index-linked gilt yields at historic lows we believe both residential and commercial ground rents can offer secure, long-term, inflation linked income streams. Neil Gardiner, Aviva Investors 5 YEARLY RPI VALUE SHIFT 2010 19YP 50,000 pa = 950,000 2013 26YP 50,000 pa = 1,300,000 3

In our fund s 20 year experience, we now see more money than ever seeking to buy a currently reduced number of ground rents created at an historical low point in the building cycle. Nigel Ashfield, Freehold Income Authorised Fund, Time Investments All review types, whether they be RPI linked, fixed multiple (such as doubling), fixed increments (such as of the initial ground rent) or capital value linked, have seen pricing increases. A limited number of portfolios of over 2 million are available each year and therefore attract the most aggressive bidding. Newer investors prefer larger lot sizes due to the number of units it allows them to acquire in one transaction and the consequent savings in transactional costs. Consequently it is common for large lot sizes to transact for multipliers in excess of 20 YP (5% gross yield). WEAK HOUSEBUILDING ANTAGONISES DEMAND SUPPLY IMBALANCE The relatively low level of housebuilding over the last few years serves to compound the supply and demand imbalance. Developers expectations on disposal of their ground rent interests are also changing. Housebuilders have become more aware of the benefits of structuring leases in an attractive manner to increase the value of their holdings and seek to maximise sale receipts on disposal. PRICING SNAPSHOT REVIEW MECHANISM MULTIPLIER (YP) GROSS YIELD 5 yearly RPI 26 3.8% 10 yearly RPI 23 4.3% 25 yearly RPI 19 5.3% 20 year Fixed Multiple (Doubling) 19 5.3% 25 year Fixed Multiple (Doubling) 18 5.6% 25 yearly Capital Value 17 5.9% Housebuilders are producing fewer leasehold units than pre-2007, so the supply of stock is tighter and is pushing the multiples upward. Roberta Anderson, Dorchester REAM Aviva Investors - Sailacre House, Greenwich 4

MARKET TOPICS NEW INVESTORS There are still further investors, such as fund managers and institutions, with an appetite for exposure to the residential ground rent market. The challenge for these new investors is what strategy to employ to gain entry to the sector. Traditionally investors have sought to acquire small portfolios over a longer period of time directly from housebuilders or existing investors. The advantages of such an approach include the avoidance of having to bid overly aggressively to secure stock. However, such a strategy takes a significant amount of time to employ and build scale. Larger investors have sought to target portfolios in excess of 200,000, ideally with a focus on acquiring portfolios of the scale of a few million pounds. Such a strategy allows the investor to gain scale quickly, limits transaction costs and potentially includes debt from first purchase. The potential drawbacks include securing a pipeline of potential portfolio acquisitions and the potential strong pricing of large portfolios. We envisage consolidation within the sector through mergers and acquisitions. The benefits of such a strategy include: Aviva Investors - Toronto Building, Canada Water MANAGEMENT One of the major challenges for the residential ground rent sector surrounds the management of portfolios. The evolving ownership structure demands greater accountability and transparency from investors. Governances and processes need to be ensured. From an institutional investment perspective there remains a lack of wholly independent rental collection agents and managers. n the ability to deliver scale immediately, n access to mature portfolios including a mixture of review patterns and staggered rent review uplifts, n proven track record in terms of level of income generation and gross to net ratio. The main obstacle to such transactions is vendors pricing expectations. Likely future investors include pension funds, insurance companies and sovereign wealth funds. As is well known, the management is much more hands on. This is an area where we will be bringing our more institutional ethical approach as well as enhancing transparency. Charles Crowe, Pramerica Real Estate Investors The traditional ground rent market is limited by both the quantum of stock made available to purchase and the quality of management to maintain the investments at a property and asset management level both key to institutional investors. Neil Gardiner, Aviva Investors 5

ANCILLARY INCOME There is a reducing focus on ancillary income which can be generated from activities associated with long leases such as notice fees, insurance premium commissions, management fees and other fees. This change of emphasis is being both investor and housebuilder driven with recognition of the potential reputational risk involved in generating from certain types of ancillary income. Housebuilders are now more than often drafting leases with lessees as a member of the Management Company. Newer investors are regularly outsourcing landlord obligations to large independent agents. The benefit from a housebuilder s perspective is a secured capital sum to boost cash flow. For an investor it provides a pipeline of potential stock and can be used to enlarge housebuilder portfolio sales. However, there are potential liabilities from the investor s perspective as they must be sure of the covenant strength of the housebuilder prior to entering into a forward purchase transaction. These agreements are being widely utilised within the ground rent market. Recently this model has been replicated in the affordable housing sector. A modified version has been employed to provide much larger capital sums to fund affordable housing developments. FORWARD PURCHASE AGREEMENTS A forward purchase agreement is a contract between investor and housebuilder to acquire a scheme before the individual units have been sold off on long leases. Such agreements are often drafted with the housebuilder paying the ground rent for unsold units until they are disposed of. If agreed before 50% of the units are sold, this can negate the requirement to offer the freehold interest to the lessees in the first instance on a subsequent sale of the ground rent holding. Such agreements can often be in place as construction is ongoing or even prior to it commencing. One of the largest barriers to further institutional investment is that ground rents are challenging to manage and administer without significant scale, systems and well thought out procedures to make sure that the income is collected correctly, in accordance with the relevant legislation and also the terms of the lease. James Agar, Brooks Macdonald Ground Rents Income Fund plc - Clapham One, Clapham 6

CASE STUDY FREEHOLD INCOME AUTHORISED FUND, 160M GROUND RENT FUND Orchard Leaze is a development that was acquired from BDW Trading Bristol (a Barratt Homes company) in 2012. The deal was agreed at the early stages of development on the basis of a forward purchase whereby a large percentage of the price was paid at exchange of contracts (circa 60%) and the remainder was paid at completion once all the units were occupied. The acquisition was beneficial to both parties. The developer had the comfort of securing a purchaser at the initial stages of the development and received a majority percentage of the Freehold sale price. Furthermore once the site was fully built and occupied they were able to complete on the Freehold sale alleviating the need to serve section 5 notices. The purchaser had the benefit of a secured purchase and received the total ground rent income from the developer through to completion. Nigel Ashfield, Time Investments Freehold Income Authorised Fund 7

THE FUTURE OUTLOOK Following a period of strengthening in the ground rent investment market pricing has been rebased. We envisage current market levels will become the market norm in the long term. In a number of cases funds/investors have been diverting investment away from a gilts or bonds allocation to residential ground rents. This is in addition to monies diverted away from property allocations. The returns currently offered from residential ground rents are considered by investors to be significantly in excess of those available from gilts or bonds. This has led a number of funds benchmarking against gilts or bonds. However, a linkage between residential ground rents with gilts and bonds could see a reverse in the price increasing experienced over the last two years if there were to be a rise in interest rates and gilt yields. It could also see a number of the newer investors potentially divesting their holdings. We think going forward it is important that investors have access to a very large pool of capital, an established and experienced legal team, an ability to hit strict deadlines and a willingness to be flexible and innovative. Charles Crowe, Pramerica Real Estate Investors There may be some risk of downward movements in value should interest rates and gilt yields begin to increase but we believe there will not be major pricing readjustments. With more money flowing into the sector and significant capital to be exhausted we envisage the market remaining buoyant for the foreseeable future. The market has rebased itself due to the evolution of investors within the market, and these investors are acquiring investments to meet long term obligations. In my opinion there is currently very little formal asset allocation to ground rents from institutional investors, however the underlying, secure dynamics of the instruments and their appeal in relation to indexlinked income will continue to make ground rents attractive. James Agar, Brooks Macdonald In a low gilt yield environment it is likely that investors will continue to chase a return premium by investing in illiquid assets such as ground rents. Neil Gardiner, Aviva Investors SUMMARY n There has been a distinct change of ownership structure within the market. Over the past few years ground rents have attracted the attention of many of the largest institutions and property funds. n Following a period of strengthening in the ground rent investment market pricing has been rebased. We envisage current market levels will become the market norm in the long term. n The market has experienced dramatic price increases over the last two years. n There are still more investors, such as fund managers and institutions, with an appetite for exposure to the residential ground rent market. 8

CONTACTS CBRE provides valuation, advisory, and agency services, as well as debt financing and equity advice, in both the residential ground rent investment market and wider fixed income property asset class. For further information please contact: James Castle Associate Director Valuation and Advisory Services - Residential e: james.castle@cbre.com t: 020 7182 2731 Jane Asquith Director Valuation and Advisory Services e: jane.asquith@cbre.com t: 020 7182 2242 CBRE DISCLAIMER 2013 CBRE Limited confirms that information contained herein, including projections, has been obtained from sources believed to be reliable. While we do not doubt their accuracy, we have not verified them and make no guarantee, warranty or representation about them. It is your responsibility to confirm independently their accuracy and completeness. This information is presented exclusively for use by CBRE clients and professionals and all rights to the material are reserved and cannot be reproduced without prior written permission of CBRE. The focus of this paper is long dated residential ground rent investments. i.e. those with over 90 years unexpired. These are generally transacted on a multiplier (known as YP (Years Purchase) which is equates to a gross yield) of the current annual ground rent income. There is no widely accepted index or benchmark within the ground rent sector. This stems from the relative size of the market as well as the lack of transparency. Portfolios generally trade principal to principal with details of the transaction rarely reaching the wider market. Each portfolio transaction has different characteristics in terms of units within the portfolio and the long leases which these are subject to. The graph displaying a comparison between long dated residential ground rent investments, UK gilts and commercial property equivalent yields is for illustrative purposes only. The long dated residential ground rent investment yields are based on comparable sales evidence collated, transactions we have been involved with directly and our interpretation of the movement in market multipliers. The UK gilt yield is taken from the UK Debt Management Office and is based on redemption yields. The commercial property yield is from the CBRE index and is an all equivalent property yield. The snapshot of pricing is based on our opinion of multipliers in the current market as at Q1 2013. The multipliers assume freehold, good quality well located town centre schemes with a lot size of over 400,000, new leases with 125 plus year terms, ground rent per unit of 250 per annum, landlord retains insurance rights with management obligations falling to a management company, normalised notice fee provisions, no rental or service charge arrears. The comments provided by investors within this paper are their opinion alone and do not constitute CBRE Limited s view or opinion. CBRE would like to thank Aviva Investors, Time Investments, Ground Rents Income Fund plc, Brooks Macdonald, Pramerica Real Estate Investors and Dorchester REAM for their contribution to the paper. More specifically CBRE is grateful to the following for their input; Neil Gardiner, Nigel Ashfield, James Agar, Charles Crowe and Roberta Anderson. CBRE CBRE Group, Inc. (NYSE:CBG), a Fortune 500 and S&P 500 company headquartered in Los Angeles, is the world s largest commercial real estate services firm (in terms of 2010 revenue). The Company has approximately 31,000 employees (excluding affiliates), and serves real estate owners, investors and occupiers through more than 300 offices (excluding affiliates) worldwide. CBRE offers strategic advice and execution for property sales and leasing; corporate services; property, facilities and project management; mortgage banking; appraisal and valuation; development services; investment management; and research and consulting. Please visit our web site at www.cbre.com. 9