Written By: Bernard Abrahamsen
Since 2009, financial headlines have been anything but uplifting. despite this, Bernard Abrahamsen M&G feels that exciting opportunities exist for fixed income investors.
Mainstream fixed income asset classes have been performing well since the height of the crisis and there is also an ever-growing number of less mainstream, but perhaps more exciting, investment opportunities offering security, safety, impressive returns and potential capital growth. They also offer extra diversification against an investor’s more traditional fixed income assets. These less mainstream investments have become all the more attractive as banks have continued to scale back their financing activities in response to new regulations and have been forced to pay more to borrow money themselves. Institutional investors are therefore more able to replace the banks as financiers in a whole host of markets.
In this article, we’re going to look at two opportunities which are likely to become more, rather than less, familiar to institutional investors over the next few years.
Innovations in property finance
We have a long history of investing in the sale and leaseback of commercial properties. The idea behind such a transaction is to buy a “prime” property and lease it back to its previous owner (maybe a supermarket like Tesco for example), guaranteeing decades of rental income which increases in line with inflation.
From an investment perspective, the cash flows look a lot like those of a long-term inflation-linked corporate bond, but with the added benefit that they’re “secured” against prime real estate. If the tenant defaults, this property can be rented out to another retailer or simply sold for the proceeds.
But why exactly would a company like Tesco be interested in selling one of their stores and then leasing it back? For very similar reasons to those that would cause the supermarket chain to issue a bond, take out a bank loan or issue new shares. Sale and leaseback is another source of funding, and can be used to finance new investments, projects or expansions. With less bank funding available to companies now for some time, sale and leaseback has proved to be a viable alternative for a number of companies.
While institutional investors have been entering into the sale and leasebacks of commercial properties for some time, residential property sale and leasebacks have been less common. We believe the investment case can be every bit as compelling, however. We recently completed a £125 million sale and leaseback of 401 market-rented units in a brand new residential housing development near London’s Olympic Park in Stratford.
We purchased the units of this development from Genesis Housing Association, which has been given AA ratings by the ratings agencies, on behalf of our £1.3 billion pooled Secured Property Income Fund. The deal is a 35-year fully repairing and insuring lease, which means that Genesis will continue to manage the development in exactly the way it did before.
The association’s rental payments will increase in line with the retail price index (RPI), between zero and five per cent. The fact that the rents of the actual properties rise in line with inflation provides a natural inflation- hedge. Furthermore, there’s also the potential of a capital gain on the value of the property. Residential prices in central London have increased well ahead of inflation over the last few years, and many investors believe that they are likely to keep doing so.
For housing associations, finance like this helps them to build new social housing developments, and continue to maintain existing ones. The social housing sector certainly has a great deal of potential for investors, and we believe that more institutional investors and asset managers should get involved. Sale and leasebacks, as well as secured loans such as those provided by the M&G Social Housing Debt Fund, have the potential to deliver secure and predictable cash flows to investors. No investor has as yet made a loss when lending to a housing association registered provider (HARP), so we think it’s a very interesting proposition for long- term investors like pension funds and life insurance companies.
While sale and leasebacks are one way of financing worthy borrowers, so are property-related direct loans, such as commercial mortgages – both senior and junior. Over the last few years, this non-mainstream fixed income market has come alive with a growing number of opportunities to provide or buy good quality loans at attractive prices. Of course, once again, because the banks have been withdrawing from providing new finance, several good opportunities are now available to non-bank investors. We believe that more institutional investors should be getting involved in the best deals the sector currently offers.
To illustrate the potential of commercial mortgages, we can look specifically at a £50 million loan we made to a borrower using the assets we manage on behalf of our parent company – Prudential PLC’s – life insurance funds. It financed the borrower’s acquisition of a 240,000 square foot prime office complex in London’s Mayfair last summer. The interest on the loan is 3.5% above cash rates – a rate that we believe is very attractive considering the risks involved. The loan was written at an LTV (loan-to-value) ratio of 67%, with the loan secured against the underlying real estate. Put simply, an LTV of 67% means that even if the investor defaults, the value of the real estate needs to fall by 33% before the first £1 of the initial investment is at risk of being lost. Before the financial crisis, commercial mortgage loans written at around 80% LTV were very common. Certainly, conditions have changed, in favour of the lenders. The loan is just one of the €1.8 billion of senior loans that we made over the 18 months leading up to December 2012.
The credit quality of senior mortgages tends to be, we believe, equivalent to A-rated corporate bonds, for the deals we have invested in (not including the benefit of the underlying security), but in our experience the returns available in the market today are well in excess of what they are on average for A-rated corporate bonds.
As commercial mortgage loans such as these are generally around five years in length, and it’s been around five years since the height of the financial crisis, a number of investors need to refinance their loans, given the bank lending issues. This means that investors such as pension funds and insurance companies can potentially step in to refinance the most creditworthy borrowers as long as it’s on the right terms and at the right prices.
The benefits of non-mainstream fixed income assets
Traditional fixed income portfolios can be enhanced by adding private transactions such as those offered by the commercial mortgage and long- lease property markets. They offer diversification against public debt, and relatively attractive risks and returns.
Of course, separating the attractive deals from the less attractive ones requires a great deal of resource and experience. Specifically, long-lease property and commercial real estate transactions require both fixed income and property expertise. Investors need the capacity to analyse both the credit quality of investors they transact with and the properties they are either purchasing or lending against. Being able to do both is vital. Once all the appropriate skills are in place, we believe that those attractive, “less mainstream” investments, which benefit institutional investors and ultimately, the UK economy, can become a much more integral part of institutional portfolios.
The distribution of this article does not constitute an offer or solicitation. The value of investments can fall as well as rise. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Services Authority’s Handbook. They are not available to individual investors, who should not rely on this communication. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number 936683 with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Services Authority. 3678/FI/0412