Schroder Property What s the alternative: five reasons to move away from the mainstream June 214 For professional investors and advisers only Introduction Eleanor Jukes, Senior Property Research Analyst Investing in alternative property is not a new idea; the composition of the UK property market has always been more than just a commercial trio of offices, retail units and industrial assets. From students to seniors and bowling alleys to bingo halls, exposure to a tenant base outside of the mainstream has never been completely off the radar of institutional investors. This paper makes the case for investing in these assets and outlines five reasons for why investors should look to move away from the mainstream. Investors have been rewarded by long-term outperformance Nick Barker, Head of Alternatives, Property Demand for alternative property assets from institutional investors has increased over the last 25 years, with the weighting towards other in the IPD Annual Index rising steadily from 1% in 1988 to reach 8% in 213. Historically, those prepared to take on the additional risk inherent in these assets have been rewarded with outperformance. As illustrated in Figure 1, total returns from the sector have exceeded the market average over three, five and ten years. The absence of any yield impact illustrates how performance has predominately been derived through the market fundamentals of income and rental growth as opposed to a shift in pricing. The alternative market underperformed the all property benchmark in 213 (total return: 8.9% v 1.7%) as investor sentiment towards the core sectors improved, overseas capital targeted London assets and the recovery continued in the mainstream occupier markets. This is clearly reflected in the repricing of the commercial sectors, where the average equivalent yield ended the year at 6.66%, down from 7.1% at end 212 1. 1 Annual Digest 213. IPD, 213
Figure 1: alternatives have outperformed the average over the medium and long term 3 2 Relative perf, % p.a. 1-1 -2-3 3 years 5 years 1 years 213 Income return Rental value growth Yield impact Total return Note: whilst residential lets are included within the IPD definition of other they are not considered within this paper. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them can go down as well as up and may not be repeated. Source: Schroders, IPD Annual Digest, 31 December 213. We believe that over a medium and long-term horizon alternative properties should outperform once again, particularly on a risk-adjusted basis. Detailed below are five reasons why this dynamic and diverse sector should be on every investor s radar. 1. Alternatives are not as risky as you think they are Investing in any property market exposes the purchaser to a range of risks, such as obsolescence, over-renting and illiquidity. Whilst there is additional due diligence required on alternative assets, such as the regulatory requirements of a medical centre or the reputational risk associated with a care home, the fundamental drivers behind this sector make it less risky than it would first appear. Perhaps of most interest to prospective landlords is the stability of the rental cycle, which is a result of exposure to demographic and social structural forces that make the sector counter or even anticyclical. The alternative tenant base is largely composed of GPs, students and care home residents, and thus is relatively decoupled from the usual economic drivers that fuel, and reduce, demand for commercial property. In addition, the latest economic cycle has also engendered long-term behavioural changes that have benefitted the sector. For example, in the face of fiscal austerity there has been increased footfall at local leisure attractions and chain restaurants as consumers economised on luxury goods and services. This is illustrated in Figure 3 where rental values did not depreciate to the same extent as recorded in the commercial sectors during the latest downturn. The ability of the alternative sector s rental cycle to withstand economic fluctuations ultimately feeds into the stability of investment performance. This can be seen in Figure 2, where the volatility of returns from different groups of alternative assets is lower than those from traditional commercial property. Returns from student accommodation, GP surgeries and care homes all exceed the all property average and are closer to the y axis, providing more consistent and thus less risky - returns. Whilst the performance histories for the segments are relatively short compared to the core markets, we do not believe this is just a statistical anomaly. 2
Figure 2 and Figure 3: stability of the rental cycle makes returns less volatile Total return (27-213, % p.a.) 12 Estimated Rental Value (ERV) per sq m (Index, 24=1) 14 1 8 6 4 2 Student accommodation GP surgeries Equities Bonds Leisure Care homes Offices Industrial All property Retail 5 1 15 2 Volatility of returns (27 213) 13 12 11 1 9 8 24 25 26 27 28 29 21 211 212 213 Alternatives Offices Source: Schroders, PMA, IPD Annual Digest, 213. 2. Alternatives may be less sensitive to a rise in interest rates The Monetary Policy Committee has held interest rates at.5% for five years and is expected to do so for a record sixth year. However, when rates do rise this will impact traditional pricing models, which add a risk premium to a risk-free rate usually a government bond yield. A higher risk-free yield added on to the risk premium equates to a higher required rate of return. However, we believe alternatives can moderate against this. Analysis by Doherty and Bone (212) suggests that the relative pricing of a property asset will ultimately influence the impact of a rate rise: lower-yielding assets have a higher convexity and will thus be more sensitive to a change in interest rates whilst the converse is true for higher-yielding assets. For example, a 1% upward movement in pricing on a property yielding 4% would negatively impact its valuation by 2%, whilst a shift of a similar magnitude for an asset price 7% would decrease values by around 12.5% 2. The majority of alternative properties are higher yielding compared to commercial property sectors, and thus less sensitive to a change in interest rates on investment values. This is illustrated in Figure 4, below, which models the estimated impact on pricing following a 5 basis points (bps) upward shift in interest rates (all else being equal). The impact of a change in the base rate on the property market will neither be uniform nor instantaneous as there is not a 1:1 relationship between short and longterm interest rates. It will also be reliant upon transmission mechanisms such as inflation, the cost of borrowing and economic growth, and can be moderated by the terms of a lease 3. 2 Property: a panacea for pension funds?. Schroders, 212 3 Property investment in a long-term liability matching portfolio. Schroders Insurance Asset Management, 213 3
Figure 4: higher yielding assets could be less sensitive to a rise in interest rates Resk of UK offices Equivalent yield (%) Q4 213 1. 9. Industrial Care homes All property Distribution warehouses Leisure Student accommodation Shopping centres GP surgeries City offices High street shops West End offices Supermarkets -1-9 -8-7 -6-5 -4 Yield impact following 5bps interest rate (%) Note: assumes 1:1 shift across sectors and the impact of rate rise is instantaneous. Source: Schroders, IPD, PMA, Capital Economics, 214. The obvious outlier here is supermarkets. Given the issues with obsolescence in large supermarkets and announced intentions for future expansion to be only in the convenience store format, it could be argued that the current pricing does not accurately reflect the risks of investing. 3. The long-term income from alternative assets is stable and defensive The income generated from alternative assets constitutes a greater proportion of the return than for commercial properties. The importance of this to investors is evident in the drivers of long-term performance of the property market, where nominal total returns have averaged 9.% per annum since the inception of the IPD Annual Index in 1981, or 4.9% per annum in real terms. The majority of the volatility in returns has been the result of movements in capital values, whilst at 6.5% per annum the income return has not only driven returns but has remained remarkably stable 4 (Figure 5). However, structural changes to the leasing market have created a widening divergence between short and long-term income. This is illustrated by the average lease length, which has fallen from 22.5 years in 199 to 7.1 years in 213, whilst almost a third of new leases now contain a break option. 5 This increased insecurity means investors must be prepared to manage greater churn within their portfolio and price in the risk of an increasingly footloose tenant base into their cash flow projections. 8. 7. 6. 5. 4. 4 Annual Index 213. IPD, 213 5 Unweighted and excluding leases under four years, IPD Lease Events Report. IPD, 213 4
Industrial Offices C. London offices All property Retail Shopping centres Retail warehouses GP surgeries Motor retail Supermarkets Data centres Waste management Care homes Student halls What s the alternative: five reasons to move away from the mainstream Figure 5 and Figure 6: the alternatives sector is characterised by long income % p.a. 3 2 1-1 Lease (years) 3 Average 199 25 2 15 Average 213 1 5-2 -3 1981 1985 1989 1993 1997 21 25 29 213 Income return Source: Schroders, IPD, PMA, GVA, 213 Capital growth Leases within the alternative sector are longer: double the current average for motor showrooms and leisure buildings and can reach over 3 years for care homes, student halls and data centres 6 (Figure 6). Included within a portfolio alongside traditional commercial properties, these types of assets can provide a stabilising influence against wider market volatility. That many of these leases are also index linked or subject to fixed uplifts provides further stability of income. However, a long lease is not without its issues. Covenant strength, and more importantly profitability, of the tenant are vital, whilst there is also a risk of obsolescence as the building ages. This can be seen within the supermarket sector where the hypermarkets of the 198s and 199s, many on very long leases, now appear outdated as people prefer the accessibility of convenience stores. 4. Alternative assets offer interesting ways of accessing growth The increased demand from investors for exposure to the strong covenants, long income and rent indexation found in alternative assets has given rise to a range of other initiatives beyond the standard, structured lease. Property income streams are well placed to innovate to meet this demand, through vehicles such as sale and leasebacks, forward funding or income strips. Sale and leasebacks were popular in the boom years as a method of leveraging against a property portfolio to generate cash flow. This was successful for some, such as the supermarket operators and HSBC, but proved fatal when utilised by businesses that agreed to overly high rents or who did not reinvest capital, such as Southern Cross. However, sale and leasebacks are once again gaining momentum in the market; Marston s has sold several large pub portfolios over the past 12 months, as has Odeon cinemas and there have been a number of healthcare deals 7. A move away from focusing on profit and indexation towards setting sustainable rental levels and explicit capital expenditure clauses should serve to protect against the mistakes of the past, but understanding the tenant s business and the rent they can afford is essential. 6 Alternative view in an evolving market. GVA, Spring 213 7 CBRE, 214 5
Alternatively, an investor could participate in a joint venture arrangement with an operator in order to provide development funding and a lease on a new building. Structured correctly, the funding partner can ensure that rents are affordable and that the tenant is incentivised to maintain the properties. This arrangement is advantageous to the tenant because they do not have to go to the wider market for funding, where lending margins would be higher. Aligning with an operator in this way allows both parties to access the income stream, whilst keeping costs down by cutting out the use of an external developer. One example of this is the Schroder Property team working with Care UK, one of the UK s largest care home operators, to build and run five elderly residential homes. 5. There is still further to travel up the risk spectrum The maturity of a number of the alternative sectors is now so far advanced as to almost be considered mainstream. Priced at around 6.25% and inline with the market average, the potential for yield compression on prime student accommodation portfolios is arguably limited, for example (Figure 7) 8. Less well known alternatives may offer advantages such as greater scope for yield compression ( first mover advantage ), asset management opportunities and lower costs, although carry greater inherent risk because of the lack of transparency. One such sector is private nurseries. An upswing in the domestic birth rate and substantial immigration of 2-4 years olds alongside a rise in the number of working mothers has created a surge in demand for nursery care. The value of the market has increased by 16% since 27, reaching 4.6 billion in 213 9, bolstered by generous support from the UK government towards childcare costs via subsidised places and universal credit. The majority of the 7 billion annual contribution is the childcare voucher scheme, which provides tax relief on nursery and child minding costs and is widely supported by corporate organisations. There are many features of this market that appeal to investors. It is highly fragmented, which is attractive to institutional investors looking to consolidate assets, but nursery groups are now increasingly able to secure funding to expand and develop on their own. In parallel to GP surgeries and care homes, the quasi-government backing provides a steady income with fee increases tracking inflation in 212 and 213 1. There will be a further injection of funding towards lowerincome families this year. Unsurprisingly the sector is highly regulated, which provides a substantial barrier to entry for investors. 8 Student accommodation sector report. PMA, Spring 214 9 Children s Nurseries Report. Laing and Buisson, 213 1 Children s Nurseries Report. Laing and Buisson, 213 6
Figure 7 and Figure 8: some alternatives are now priced as mainstream but there are other options Yield gap to All Property (%) per storage sq ft p.a. VAT change Weeks 1.6 22 45 4 1.2 21 35.8.4 2 3 25 2 15 19 1 5 -.4 Care homes Leisure Student halls At inception 213 GP surgeries 18 27 28 29 21 211 212 Avg rate per storage room (LHS) Avg length of stay in storage Note: at inception is start of equivalent yield time series. GP surgeries: 27, Leisure: 1995, Student halls: 24, Care homes: 27. Source: Figure 7: Schroders, IPD, PMA, 213. Figure 8: Deloitte, SSA, 213. Finally, no motorway junction is seemingly complete without a self-storage warehouse. This sector has evolved over the last decade as a result of structural changes in the wider economy, such as the growth in private renting, an increase in the number of students and a more mobile workforce. Dedicated storage sites also appeal to commercial customers, such as retailers and tradesmen. However, provision in the UK still lags behind other developed economies:.5 sq ft per person compared to 1.1 sq ft in Australia and 7.4 sq ft in the US 11. Average length of stay within a storage warehouse has steadily increased since 27, whilst storage room rates held up during the worst of the downturn, although have recently been moderated due to the VAT implications (Figure 8). Conclusion Alternative properties have outperformed the market average over the medium and long term, and on a risk-adjusted basis we believe the sector will be market leading once again. Alternative assets are attractive to investors for a range of reasons, not least that rental cycles are often decoupled from the economy and can deliver a steady income return. These characteristics mean the inclusion of alternatives within a portfolio can be defensive and deliver a stabilising function. There are many other reasons why alternatives appeal. For those not familiar with the market or who do not wish to take on the role of landlord, there are various innovative ways of accessing the sector s income stream and diverse range of tenants. In addition, the depth and variety of assets in the sector means that the full spectrum of risk and reward is available to investors; a higher yield can be found in emerging sectors such as private nurseries, self storage or car showrooms for example. Investing outside of the mainstream property sectors offers a range of attractive opportunities for all criteria. 11 The Self Storage Association UK Annual Survey. Deloitte, 213 7
Important Information The views and opinions contained herein are those of Eleanor Jukes, Senior Property Research Analyst, Schroders and Nick Barker, Head of Alternatives, Property, Schroders and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisors only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Property Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Use of IPD data and indices: and database right Investment Property Databank Limited and its Licensors 214. All rights reserved. IPD has no liability to any person for any losses, damages, costs or expenses suffered as a result of any use of or reliance on any of the information which may be attributed to it. Any forecasts in this document should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them can go down as well as up and may not be repeated. Issued by Schroder Property Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 118824 England. Authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored. 8