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What’s the alternative: five
reasons to move away
from the mainstream
June 2014
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 2013. 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 2013 (total return: 8.9% v 10.7%) 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 7.01% at
end 20121.
1
Annual Digest 2013’. IPD, 2013
What’s the alternative: five reasons to move away from the mainstream
Figure 1: alternatives have outperformed the average over the medium and long term
3
2
Relative perf,
% p.a.
1
0
-1
-2
-3
3 years
5 years
Income return
10 years
Rental value growth
2013
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 2013.
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
What’s the alternative: five reasons to move away from the mainstream
Figure 2 and Figure 3: stability of the rental cycle makes returns less volatile
Total return (2007 - 2013, % p.a.)
Estimated Rental Value (ERV) per sq m (Index, 2004=100)
140
12
10
130
Student accommodation
120
8
Equities
GP surgeries
110
6
Bonds
Leisure
4
100
Care homes
2
Industrial
Offices
All property
Retail
90
0
0
5
10
15
20
Volatility of returns (2007 – 2013)
80
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Alternatives
Offices
Source: Schroders, PMA, IPD Annual Digest, 2013.
2.
Alternatives may be less sensitive to a rise in interest rates
The Monetary Policy Committee has held interest rates at 0.5% 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 (2012)
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 20%, 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 50 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 lease3.
2
3
3
‘Property: a panacea for pension funds?’. Schroders, 2012
‘Property investment in a long-term liability matching portfolio’. Schroders Insurance Asset Management, ‘2013
What’s the alternative: five reasons to move away from the mainstream
Figure 4: higher yielding assets could be less sensitive to a rise in interest rates
Equivalent yield (%) Q4 2013
10.00
Resk of UK offices
9.00
8.00
Industrial
Care homes
All property
Distribution warehouses
Leisure
Shopping centres
Student accommodation
GP surgeries
City offices
High street shops
West End offices
Supermarkets
7.00
6.00
5.00
4.00
-10
-9
-8
Yield impact following 50bps interest rate (%)
-7
-6
-5
-4
Note: assumes 1:1 shift across sectors and the impact of rate rise is instantaneous.
Source: Schroders, IPD, PMA, Capital Economics, 2014.
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 9.0% 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 stable4
(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 1990 to 7.1 years in 2013, 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.
4
5
‘Annual Index 2013’. IPD, 2013
Unweighted and excluding leases under four years, ‘IPD Lease Events Report’. IPD, 2013
4
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
Lease (years)
% p.a.
30
30
Average 1990
25
20
20
15
10
10
0
Average 2013
5
Student halls
Care homes
Data centres
Supermarkets
Motor retail
GP surgeries
Retail
Waste management
Capital growth
Retail warehouses
Income return
Shopping centres
1981 1985 1989 1993 1997 2001 2005 2009 2013
All property
-30
Offices
Industrial
-20
C. London offices
0
-10
Source: Schroders, IPD, PMA, GVA, 2013
Leases within the alternative sector are longer: double the current average for motor showrooms
and leisure buildings and can reach over 30 years for care homes, student halls and data centres6
(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 1980s and 1990s, 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 deals7. 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
7
5
‘Alternative view in an evolving market’. GVA, Spring 2013
CBRE, 2014
What’s the alternative: five reasons to move away from the mainstream
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 20-40 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 2007,
reaching £4.6 billion in 20139, 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 2012 and 201310. 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 2014
‘Children’s Nurseries Report’. Laing and Buisson, 2013
10
‘Children’s Nurseries Report’. Laing and Buisson, 2013
9
6
What’s the alternative: five reasons to move away from the mainstream
Figure 7 and Figure 8: some alternatives are now priced as mainstream but there are other
options
£ per storage sq ft p.a.
Yield gap to All Property (%)
VAT change
Weeks
22
1.6
45
40
1.2
35
21
30
0.8
25
20
20
0.4
15
19
0
10
5
-0.4
Care homes
Leisure
At inception
Student
halls
2013
GP
surgeries
18
0
2007
2008
2009
2010
2011
2012
Avg rate per storage room (LHS)
Avg length of stay in storage
Note: “at inception” is start of equivalent yield time series. GP surgeries: 2007, Leisure: 1995, Student halls: 2004, Care
homes: 2007.
Source: Figure 7: Schroders, IPD, PMA, 2013. Figure 8: Deloitte, SSA, 2013.
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: 0.5 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 2007, 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
7
‘The Self Storage Association UK Annual Survey’. Deloitte, 2013
What’s the alternative: five reasons to move away from the mainstream
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.
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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.
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