Property generally has seen increasing popularity as an asset class since the global financial crisis.
Its quality as a ‘real asset’ offering the potential for regular, inflation-adjusted income as well as some capital growth has proved attractive for many investors seeking alternatives to conventional equities and bonds, which suffered so much.
What investors might also have discovered about property is that there is more to it than just the traditional bricks-and-mortar commercial property fund approach.
Indeed, one property sub-sector that has traditionally been the preserve of institutional investors such as pension funds, but is now opening up to a retail audience, is ‘long income’ property investments.
This is a generic term that covers two main categories of freehold commercial properties subject to ground rents or long leases. So what are the pros and cons of this sector and why would advisers wish to consider it for clients?
Ground rents are long leases (usually more than 60 years) on land and buildings. The leaseholder, who pays a ground rent to the freeholder, can also sublet the property to a tenant.
The freeholder typically receives ground rents between 10 per cent and 30 per cent of the full market rent and has full legal title on the property ahead of all leaseholder obligations, such as a mortgage. If the leaseholder fails to pay the ground rent, the freeholder has the right to extinguish their leasehold interest.
Given that the unencumbered value of the property is typically 2.5 times to four times that paid for the freehold interest subject to the ground rent, the investment is significantly over-collateralised. What’s more, the freeholder doesn’t have to incur any property maintenance or even insurance costs, as they are covered by the leaseholder.
Another benefit is that commercial ground rents are usually protected against inflation by regular rental uplifts, which are usually linked to RPI or CPI.
Commercial properties on long leases
These assets are freehold properties let to commercial tenants at market rent for long periods, usually between 20 and 40 years. As with the ground rents, the leases will usually have fixed or inflation-linked rental uplifts. However, the security of these investments is primarily linked to the quality of the tenant, the property and the location, which is where experience in this asset class and a strong track record come into play. As a result, these types of investment tend to offer a higher income return than ground rents.
While there are parallels between long income property and traditional commercial property investment, the major difference is around income security. Long income property has stronger credentials, given the requirement for long leases, fixed or inflation-linked rental uplifts and financially strong tenants.
Investors in long income property need to consider the risks. Achieving a target return will depend on a range of factors relating to either the wider economy or specifically to the properties invested in the portfolio. There may also be limited diversification across sectors and assets. Nor is real estate a very liquid asset class.