Coming out of the recession long let properties with index reviews were popular with investors. Pension funds in particular were attracted by their inflation linked characteristics, the lower inherent volatility and liability matching potential.
In the post Lehman era, rental growth in the property market was negligible or falling whilst RPI inflation was running at 4.6% in 2010, CPI 3.3%.
Since then, as the UK economy has recovered, real rental growth has re-established itself whilst inflation has dramatically reduced to 0% CPI inflation in 2015 with RPI standing at 1%. CPI inflation has remained below the MPC target of 2% since December 2013. In contrast, property rental growth, as recorded by the IPD Monthly Index was 4.2% in 2015 with offices running at 8.% per annum (led by London) industrials 5.1% per annum and retail 0.7% per annum.
Against this background it is not surprising that the Long Income Property Funds Index funds (which accounts for around £6 billion of assets) has underperformed the broader All Balanced Funds Property Index. In 2015 the former returned 8.1%, the latter 12.5%. Over three years the Long Income Property Funds Index returned 9.4% compared with 12.9% per annum.
Reduced inflation is one reason for the underperformance but the relatively high exposure to the troubled supermarket sector is an additional reason as functional obsolescence on the large format stores has become an issue and resulted in rapidly falling rental values. These funds have tended to take a fairly long exposure to supermarkets given the plentiful supply of sale and leaseback opportunities.
How attractive are indexed reviews at this point in the cycle? The OBR is forecasting CPI inflation at 0.7% (RPI 1.7%) at the end of 2016 rising to 2% (RPI 2.9%) in 2018. Most tenants willing to commit to long leases, particularly the supermarkets, budget hotel and car showroom operators, only offer CPI linked reviews often with a “cap and collar”. The review provision for instance may specify CPI over the 5 review period with a range of 0% to 4%.
These style of assets have a role to play in a balanced portfolio having regard to the timing of rent reviews in the inflation cycle. At Mayfair Capital we are now favouring open market reviews to capture the rental growth in the market. Offices and industrials are forecast by PMA to grow at 2.7% per annum over the next five years. These sectors are characterised by low vacancy rates and low levels of speculative development against a background of increased corporate activity.
Barring a shock to food or commodity prices, we believe that inflation is set to underperform rental growth for the foreseeable future. Through careful stock selection, for our absolute and relative return funds, we will expect to outperform through identifying buildings in the right locations to capture the growth either through rent reviews or open market lettings.
Long let assets with indexed reviews will continue to appeal to pension funds with 20 year plus investment horizons but at this point in the inflation cycle they will underperform the market in the short term.