Focus on real asset investingIncome secured on real assets

For Investment Professionals only

January 2019

Income secured on real assets

The value of investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is shown, please note this is not a guide to future performance.

• Investor allocations to real assets are growing, attracted to tangible stores of value and the potential diversification of risk exposure

• Real assets and debt secured on real assets can generate attractive long-term income from tenants or operations, with a high degree of security due to contractual terms

• Income certainty is strengthened by owning the real asset, while the value of both the asset and its cashflows often grow in line with GDP or inflation over the long term

• These characteristics are well suited to the goals of investors happy to sacrifice short-term liquidity in order to generate income while maintaining a conservative risk profile

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Real assets investing continues to draw the attention of institutional investors, including pension funds and insurers, who are seeking attractive income in a low-yield environment and to diversify and lower the risk of portfolios through tapping into a tangible store of value. Appetite for real assets is reflected in the fact that 63% of institutional investors now hold at least two alternative asset classes, according to the Preqin Investor Survey in June 2018.

Real assets have a tangible existence and an investable value. Examples include real estate, land, infrastructure, forestry, agricultural and other commodities, like oil and precious metals. Not all real assets generate income; for example, gold’s value is intrinsic and it does not provide an income stream. Alongside direct ownership, this sector also includes debt secured on real assets, such as real estate or infrastructure debt and long lease real estate.

Source: Preqin Investor Survey, June 2018

Institutional allocations to private debt and real assets expected to grow in years ahead

Private equity

Hedge funds

Real Estate

Infrastructure

Private Debt

Natural Resources

29%

16%

30%

43%

31%

30%

14%

19%

17%

8%

14%

13%

Invest less capital than in past 12 months Invest more capital than in past 12 months

PrivateEquity

VentureCapital

PrivateDebt

HedgeFunds

RealEstate

Infrastructure NaturalResources

2%

20%

79%

8%

57%

35%

2%

36%

62%

16%

57%

27%

15%

31%

54%

7%

24%

70%

17%

66%

17%

Increase Stay the same Decrease

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Sought-after outcomes for long-term investors

The income that an investor such as a pension fund needs to generate from its assets can change over time, influenced by factors such as the rate at which its members retire and start to draw their pension, how long they receive pensions for, and the impact of inflation on what they receive. In addition to positioning the portfolio to deliver income for its pensioners, a pension fund typically has a strategy to avoid or overcome any funding deficit through asset growth.

Real asset investment offers a number of sought-after characteristics that can help to achieve both of these investment goals over the long term. These are summarised in the table below:

Real assets can offer Characteristics Investment strategies

Inflation-linked incomeRegular increases in the income flows, to combat the effects of rising prices

• Real estate equity• Long lease real estate

• Infrastructure debt

Long-term income Assets expected to generate income

well beyond the maturity of most long-dated public bonds

• Infrastructure equity and debt• Long lease real estate

Secure and reliable cashflows

Cashflows are usually contractual and predictable. Generally secured on a

particular asset, providing a degree of protection

• Real estate equity and debt• Long lease real estate

• Infrastructure debt

Diversification and a broader oppor-tunity set

Extend the range of income generative strategies beyond traditional financial

assets like bonds and equitiesAll

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1 M&G Real Estate, October 2018.

Directly invested real estate: income-generative with capital growth potential

Real estate investment can take the form of buying an existing building, developing a new property or investing in a pooled fund that performs such activities on a large scale. Income is generated by receiving regular, contractual rental payments from the tenants, while rental growth supports capital values. The income actually received by the investor is the result of a combination of idiosyncratic factors, such as the property type and location, the amenities and facilities it offers and the quality of the tenant. We invest in real estate worldwide, with asset origination expertise in the UK, Europe and Asia.

Income levels of nearly 5% per annum (p.a.) are forecasted for the UK market over the next five years, alongside 3.6% p.a. in Europe and 4% p.a. in Asia.1 Regular rents will typically be received quarterly, with fund payments to investors likely to be via quarterly or semi-annual distributions. A focus on active asset management, such as through refurbishment or leasing, can improve a property’s income profile, including its rental tone. Such activity can help the income stream to keep pace with, or even exceed, inflation and support the growing value of the property.

Risks include the possibility that the income stream could be interrupted, such as if a new tenant cannot be immediately found at lease expiry, creating an income gap (a “void” period) , which is why proactive leasing and other active asset management initiatives is crucial to minimising such risks. Investors can benefit from having an experienced team managing their investment that understands the market and in providing extensive, high quality due diligence on a tenant and asset basis, to help protect the investor from market risks.

Long lease real estate

This secured property income strategy focuses on targeting secured income from long-term leases, with rents subject to contractual uplifts, either linked to an inflation measure or at a fixed rate. Leases are usually agreed with an organisation for an extended period, frequently decades. The assets can be viewed as having characteristics similar to that of an inflation-linked corporate bond, with a corporate body committed to delivering an income stream, linked to inflation, over a long period. We invest in long lease real estate assets in both the UK and Continental Europe.

Terms are likely to be set to encourage tenants to commit to long leases, frequently attracting them by offering lower rents than would be available for

Real Estate

Case study: Genesis Housing Association

• 401 well-located residential units in Stratford, London

• 35-year fully repairing and insuring lease to a single A-rated tenant (rated by Moody’s)

• Annual rent increases linked to RPI, between 0-5%

• Potential for long-term capital growth from London’s residential property market

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shorter contracts. Using this approach, the risk of experiencing void periods can be reduced. Security of income is the strategy’s primary consideration and rental income is typically the main driver of returns.

Historically, income achieved has generally exceeded the yields on long-term UK government and corporate bonds and income yields of 3-5% p.a. are currently available in the UK and continental Europe.

Evaluating our long lease assets in the same way as we do corporate bonds or loans, assigning them a credit rating from our own analysis, is central to M&G’s investment process for long lease real estate. If a tenant’s credit quality is weak, we typically require additional security in the form of the property itself. Similarly, if the property is of lower value, but we assess the tenant to be “investment grade” quality, we may still invest.

Transactions can take three principal forms. A sale and leaseback deal acquires real estate freeholds and leases the property back to tenants on long – typically more than 20-year – leases. A key advantage is that this particular income stream is secured by ownership of the underlying real estate.

An income strip structure, as its name suggests, separates out or ‘strips’ the income only from a long lease transaction. An asset’s value is represented by the inflation-linked income it delivers since the tenant has the option to buy back the freehold for a nominal sum at lease end. Income strips are typically very long-dated, with leases often contracted for more than 30 or 40 years. Income strips are typically used by organisations such as universities and local authorities, which seek to release capital from their real estate yet must retain ownership of their properties at lease end.

Income strips have a profile similar to a repayment mortgage where, on the final payment, nothing further is owed by the borrower, who then owns the property outright. Alternatively, it may be viewed as a fully-amortising inflation-linked bond, secured by a real estate asset. Importantly, 100% of the income will be contractually linked to inflation. However, the annual uplifts in the underlying rents themselves are likely to be capped at 5% though also have a floor at 0%, which prevents rents from declining in periods of deflation.

Institutions such as pension funds often appreciate the clarity of income strips, since all cashflows can be anticipated and valued (with no uncertainty about the residual asset value at lease end), and so form part of a liability-matching strategy. Individual assets tend to be rated investment grade, due to the high quality of the occupying tenants and long-term returns of 1.5%-2.5% p.a. above UK retail price index (RPI) inflation are possible.

Case study: Bangor University student accommodation

• 602-bed student residence with extensive on-site facilities

• 40-year fully repairing and insuring lease directly with the university, which had a buyback option at lease end for a nominal sum

• Annual rent increases linked to UK RPI, between 0-5%

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Case study: London hotel

• M&G provided a £70 million whole loan facility secured against a Premier Inn hotel in Shoreditch, London

• The property is in a desirable part of central London and has a secure income stream from the long lease in place with Premier Inn, providing strong interest coverage

• The loan benefits from comprehensive covenant package

Ground rents are the longest-dated transaction structure that can assist pension funds further in matching the duration of their liabilities. Leases are often in excess of 100 years, with either commercial or residential tenants, and so the cashflows constitute the vast majority of returns on each investment. This is the case despite the investor retaining ownership of the real estate freehold because of the extremely long investment horizons. Ground rents set at an affordable level can offer further security of the cashflows to investors, as it represents only a modest cost to the tenant.

Real estate debt

Investors in real estate debt provide loans to owners of commercial property and receive regular interest payments, similar to a bank providing an individual with a mortgage.

Interest is typically either fixed or floating rate, with the rate influenced by factors such as the seniority of the debt, the loan-to-value ratio (LTV) and the credit rating of the borrower. A lower LTV carries less risk, so is typically eligible for a higher credit rating, implying that a borrower could face a lower interest rate. Commercial real estate debt typically has a medium term of three to five years. In Europe, where most real estate debt is floating rate, senior loans typically pay a margin of around 1.5%-2.5% above a short-term reference rate such as Libor or Euribor2, with higher margins available on mezzanine or stretch senior debt.

Key to the attraction of real estate debt is the security the underlying property provides to the lender. There can be more than one seniority of debt within the capital structure, providing different risk and return profiles to investors. Prudent lenders undertake extensive due diligence on a property’s cashflow predictability and sustainability. Financial covenants are set at the beginning of the transaction and serve to provide alerts to the lender of any deterioration in the income or the property value.

Though the expected future cashflows from loan interest payments are predictable, return of principal is variable since real estate borrowers have the right to repay their loan at any time. To mitigate this prepayment risk, lenders typically incorporate prepayment penalties within the loan terms in the event the borrower decides to repay early. Unlike other real asset investments, the income stream is not linked to inflation but, given the shorter loan tenors this is typically less of a concern to investors.

2 This is typically floored at zero if the rate is negative

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Utilities, transport networks, renewable energy projects and communications networks are all examples of investable economic infrastructure assets. Some physical buildings, particularly those in the public sector such as social housing, hospitals, student accommodation and schools are also considered social infrastructure, though outside the public sector they can be closely related to real estate.

The primary characteristics of an infrastructure investment, each of which can have significant influence on the income flow and overall risk and return profile, are:

• Essentiality – provision of necessary asset and essential services

• High barriers to entry and exit – a dominant market position can arise from significant barriers to entry for competitors and barriers to exit for customers

• Longevity – long-dated cashflows supported by long-life assets

• Stability of cashflows – reliable cashflows, often regulated, arising from the asset’s steady use or availability

• Security – ownership of, or recourse to, specified assets provides enhanced protection in case of default

• High debt recovery rates – significantly greater rates of recovery in the event of default than for normal corporate debt

• Low correlation to the economic cycle – in many cases infrastructure assets provide strong diversification within a portfolio

• Cashflows linked to inflation – revenue streams may be contractually linked to inflation, regulated or, in some cases, rise generally with volumes linked to the broad economy

Infrastructure

The scale of future infrastructure investment

Estimates vary for the scale of the world’s future infrastructure needs, but it is clear that existing infrastructure investment is dwarfed by that need. The European Council in March 2018 estimated that €180 billion of additional investment per annum is needed to reduce carbon emissions in the EU by 40% by 2030, to finance sectors such as renewable energy generation and transmission and low-carbon transportation.

In July 2017, the G20-backed Global Infrastructure Hub published a report suggesting that US$94 trillion of global infrastructure spending would be required in the period to 2040, and a further $3.5 trillion will be required to meet the United Nations’ Sustainable Development Goals for electricity and water3.

3 source: Global Infrastructure Hub, Oxford Economics: ‘Infrastructure for Growth’, 2017

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Infrastructure equity

Pension funds, like most investors, usually participate in infrastructure ownership through unlisted pooled funds. Unlisted structures ensure investors avoid the volatility of listed markets and have direct exposure to the typically stable and predictable cashflows of essential assets. Pooled funds will seek to invest in a diversified mix of assets across sector and geography. The benefits of diversification across different sectors provide further protection to cashflows, allowing for frequent distributions of income.

Brownfield infrastructure, broadly defined as assets that are already in the operational stages of their lifecycle, can generate stable, long-term income, with a meaningful portion of the targeted return expected to come from cash yield.

Returns from investing at the greenfield stage, which is earlier in the lifecycle, can offer a premium return. The greater return potential reflects the additional construction risk. There will also be a period of time before yield is received until an asset comes on stream. Once built, greenfield assets have the same characteristics as brownfield.

Infrastructure debt

Investors can access infrastructure debt through two routes: either by taking direct risk on large infrastructure corporates, or by financing specific projects through limited-recourse debt, which relies not on the strength of a large corporate but on the cashflows arising from the specific project being financed.

Corporates tend to be “perpetual”, while projects have a life which is limited either due to the length of a concession or the new project’s economic viability. For this reason, corporate infrastructure debt usually has a bullet maturity, like most other corporate debt, while project finance debt is generally fully amortising, so the average life of an investment is likely to be lower than the final maturity of the debt.

Whatever form it takes, infrastructure debt usually pays a regular income stream over the long term, which can be fixed rate, floating or index-linked.

Investors can access both types of infrastructure debt through either public or private markets, although large corporates which rely on regular access to debt typically raise finance through the issuance of public corporate bonds. Other forms of debt open to both corporate and project finance infrastructure debt include private placements or loans. The main difference in the form of debt chosen is its liquidity.

Case study: Calvin Capital

• Supplier of gas and electricity meters to UK utility companies including British Gas. We acquired Calvin Capital in 2007 and divested in 2017

• Meters, once installed, pay contracted cashflows over a 10-20-year useful life, and the meter supplier may receive additional compensation should a meter be removed before the end of that working life. There is a low level of technology risk

• Strong yielding asset with stable, long-term, low risk cashflows providing an essential service and with high barriers to entry

• We were able to deploy more than £400 million over our ownership period from an initial £30m investment

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Currently, the margins available for investment grade assets are about 1.5-2.5% p.a. over government bonds of equivalent maturity, with higher margins of up to 8% possible for sub-investment grade assets, depending on risks associated with the deal such as credit, market or regulatory risks.

Infrastructure debt investment is usually well-protected against adverse events. Loans against specific assets have strong covenants and security of shares in the borrower, the assets and key contracts. Typically, investors can expect very high recovery rates or a low level of loss given default. Research by Moody’s into project finance transactions since 1983 showed an average 80% recovery rate for lenders in cases of default, with the most likely outcome being 100% recovery of debt, which was achieved in almost two thirds of cases.

Case study: Lightsource renewable energy

• £247 million deal with a portfolio of 33 UK solar parks

• Long-dated index-linked debt paying a premium to comparable liquid assets

• Amortising loan with a weighted average life of approximately 11 years

• Investors benefit from secure government-backed revenue streams

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For Investment Professionals only.

This document reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance. The distribution of this document does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.

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 Conduct Authority’s Handbook.

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 Conduct Authority. DEC 18 / IM2387 / UK

Contact

United Kingdom

Andrew Swan +44 (0)20 7548 2375 andrew.swan@mandg.co.uk

John Atkin +44 (0)20 7548 3466 john.atkin@mandg.co.uk

Henry Barstow +44 (0)20 7548 3469 henry.barstow@mandg.co.uk

Sunita Dey +44 (0)20 7548 3393 sunita.dey@mandg.co.uk

www.mandg.co.uk/institutions

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