The opportunity for asset managers to create value in real estate does not exist solely at the asset level. Significant benefits exist for both occupiers and investors alike in asset managers structuring lease contracts that can serve both parties’ interests. Record-low yields have driven up real estate capital values and long-lease transactions can enable occupiers to turn property from what is effectively a sunk cost, to an asset that can be monetised, allowing a more efficient use of balance sheet capital. Where these opportunities exist, extensive relationships with occupiers and investors are important for the origination of such deals and active management expertise is required to realise them.
Entering into a long-lease contract, where a freehold is sold by its owner-occupier and leased back, can help occupiers unlock capital to allocate to funding other strategic objectives and/or to reduce operating costs. Planning long-term operational requirements can provide occupiers with certain, long-term security of tenure and predictable rent payments in an otherwise uncertain environment. The benefits to occupiers in return for committing to a long-lease contract (which could be viewed as removing flexibility) is an enhanced capital receipt or potentially significantly discounted rental payments, providing flexibility elsewhere to realise corporate ambitions. For example, this could be through redeploying capital to develop new facilities core to the business or re-gearing an existing operational estate. The occupier retains full independence as to how they operate and can even modify the asset as they see fit for their business purposes, as the investor (landlord) typically believes the occupier is best positioned to make decisions about its own estate to drive business performance. Occupiers also have the ability to shape lease terms to suit their particular financial circumstances – including initial rent level, frequency of reviews and choice of inflation measure.
Sale-and-lease-back or income-strip structures can finance occupancy at competitive costs – typically significantly below most occupiers’ weighted average cost of capital (WACC) or open market cost. Depending on the structure of the deal, ownership of the asset can even be retained, or not, at lease expiry by the occupier. Regardless of this outcome, deals should be structured to give as much of the investment value created back to the occupier – whether through reducing occupancy costs, a capital receipt and or a combination of both.
What are the opportunities for long lease in Europe? The UK commercial property market is only one-third owned, with the remaining two-thirds leased. In continental Europe, the inverse applies with two-thirds owned and one-third leased. There is therefore an opportunity to tap into a market that is already present, but has considerable capacity to grow further. Focusing on high-quality, key operating assets in good locations, with investment-grade tenants, can help deliver highly secured income streams [for investors]. Individual lease cash flows are rated from a credit perspective and a corporate guarantor can often further enhance cash flow security, whilst also potentially protecting against local country considerations.
Lease cash flows are linked to inflation, creating a level of predictability not only for investors, but also for occupiers, and serves to underpin the low volatility nature of such strategies. In terms of where long-lease real estate sits within a portfolio, it is further up the risk curve than fixed income, but below that of standard real estate. In terms of our risk analysis, it is in the gap between the two that M&G finds value.
Long lease in action: Sonae supermarket portfolio, Portugal
This portfolio of 12 supermarkets was leased back on a 20-year term to Portugal’s dominant food retailer, Sonae. It is an example of defensive cash flows in this particular sector exposure, secured at a significant yield premium versus core Europe. Rental payments were set at levels to ensure long-term affordability for the occupier. The portfolio is anchored by prime, regionally dominant malls and all the stores have strong local catchments. pr