Alpha Real Capital’s Boris Mikhailov examines why commercial ground rents have been one of the fastest growing areas of secure income and why now is a sensible time for LGPS investors to consider an allocation.
Commercial ground rents (CGRs) are a commonly used financing tool by real estate owners or acquirers, who sell the freehold of the property and typically lease it back for 99+ years. The parties to a CGR are akin to a borrower and lender, although the relationship is governed by a lease, not a loan.
For Local Government Pension Scheme (LGPS) investors (the ‘lenders’), CGRs are an asset that provides secure, long-dated, inflation-linked cashflows providing reliable income returns as well as inflation-linked capital growth.
How has the market grown?
In the UK, CGRs have been the fastest growing segment of the institutional long income real estate market in recent years, growing from virtually nothing to circa £5bn in just over five years with the market expected to reach £20bn within the next decade. There are £2bn+ per annum of investment opportunities across traditional real estate sectors, as well as alternative sectors that include hotels, leisure, pubs, garden centres, and healthcare.
Current investors include LGPS Funds, corporate defined benefit schemes and fiduciary managers, with insurers entering the market more recently.
In the UK, CGRs have been the fastest growing segment of the institutional long income real estate market in recent years, growing from virtually nothing to circa £5bn in just over five years.
Boris Mikhailov
The Investment Characteristics for LGPS Funds
CGRs are particularly attractive for LGPS investors in the current market environment because of the following characteristics:
- Inflation protection: CGRs provide very long-dated cashflows that are contractually inflation-linked. This should make them attractive to LGPS investors concerned about meeting future inflation-linked cashflows.
- Security of cashflows: The cashflows are highly secure, achieved through significant over-collateralisation of both the income and capital. The leaseholder (borrower) will typically have operating income that covers the annual ground rent approximately eight times, and at the outset the value of the underlying asset is typically two and a half times that of the capital advanced. Further security of cashflows is achieved through the CGR investor effectively being the most senior lender along with most CGR assets being assessed as investment grade, typically clustered in the single A category.
- Stability of returns: CGRs can provide diversification from publicly traded assets and have performed strongly during periods of market volatility.
- ESG benefits: CGRs can provide strong and quantifiable ESG benefits, depending on design. For example, a large percentage of CGRs are in social infrastructure assets that provide positive societal benefits. This means CGRs should be attractive to LGPS investors looking to further their ESG ambitions.
Volatile Period
The characteristics highlighted in this article evidence how CGRs could provide LGPS funds with the secure inflation-linked cashflows they need to pay member benefits through this period of volatility.
With funding levels expected to have improved for many funds along with large inflation increases coming through from April 2023, now would be a sensible time for LGPS investors to consider an allocation to this asset class.
While these are simple assets, they are not simple to source. Therefore, the ability to originate high-quality CGR assets is key to success in this space and something LGPS investors considering an allocation should focus on when assessing managers.
