Martin Steward looks at some alternative real estate-related cash flows for their inflation-sensitivity and minimal exposure to capital value volatility

Building a liability-matching portfolio has arguably never been tougher. Bond yields have sunk deep enough to give pension schemes the bends, swaps look just as expensive, and neither offer the optionality on growth that the under-funded badly need. Corporate credit helps, but where can you get the duration to manage re-investment risk?

"It's been incredibly difficult to achieve diversification in matching portfolios, so other asset classes that can provide similar cash-flow profiles would be attractive," observes Kirstin Irvine from Mercer's European real estate research team. As her job title suggests, Irvine is talking about real estate-derived cash flows - but not standard commercial property rents, which sit in growth portfolios for the good reason that they are very economically-sensitive.

Instead, advisers are talking up the advantages of asset classes with long-dated, inflation-linked cash flows but less impact from capital values and commercial rents. At Aviva Investors they call them ‘returns-enhancing and liability-matching' (REALM) assets; consultancy Redington makes the case under the ‘flightplan-consistent' rubric; and they include social housing, secured leases and ground rents. "While not 100% liability-matching, they give you inflation-linked cash flows over decades-long time horizons with a pick-up in yield of 2-3% over government bonds," says Redington co-founder Robert Gardner.

But first, it is worth taking a look closer to home - literally. Investors in residential property do pretty well. For example, over the past three years The Wellcome Trust's property portfolio has been "outperforming powerfully", thanks to the 73% that is residential. Its £900m Kensington Estate even delivered a 2% positive return for 2008-2009.

David Toplas, CEO of residential property and social infrastructure specialist Mill Group, notes that homes have outperformed commercial property, bonds and equities over the past 10, 20 and 30 years. Even as prices have fallen through the credit crisis, they have stood up well against the 40-50% swings seen in commercial property. Moreover, while commercial rents plummet in a credit crunch, a lack of mortgage finance boosts demand for home rentals.

While one might expect capital values to deliver inflation sensitivity (Toplas reports RPI+3% over any 10-year window from the last three decades), it is surprising to see rents keeping up, too. While standard revisions are not explicitly index-linked, short-term lettings means regular returns to market and therefore a close relationship with supply-and-demand dynamics and wage inflation.

And yet while this vast, multi-trillion euro market plays a part in continental European portfolios - many Danish pension schemes collect rents from apartments for their own members, for example - UK schemes are under-exposed. One reason is precisely the short lettings that deliver RPI-plus: standard practice is to redecorate for every new tenant; insurance and security costs don't go away between tenancies; locks have to be changed. Those costs erode London buy-to-let rental yields down to about 4-5%, for example. "Net income is significantly worse than on commercial," says Toplas. "However, you are compensated for that by a less volatile cycle."

The fragmented market is another significant barrier, according to Phil Clark, European head of property at AEGON Asset Management: "You can build a €100m commercial portfolio relatively quickly thanks to large lot sizes," he observes. "The equivalent in residential would take years." Investors need to find ready-consolidated portfolios, which tend to be jealously held by the likes of The Wellcome Trust.

Mill Group has come up with an innovative model to address these issues (see panel on page 62). However, even this misses one of the key advantages of the more alternative real estate-related cash flows - the significant reduction of (unpredictable) capital growth relative to inflation-linked income in the total return.

Ground rents maintain that residential property flavour in the form of long-dated, over-collateralised inflation-linked cash flows. When a developer buys land it covers some construction costs by selling a ground lease and paying the new landlord a rent. This rent, 0.10-0.25% of the leasehold value, is paid once or twice a year, typically for 125 years, in some cases for 999 years.

The link with inflation comes via lease extensions. At the end of the lease the property reverts to the landlord but, in practice, hardly anyone waits for a lease to expire because mortgage lenders tend to require 70-plus years to be left on it. At that point lessees ask to extend, and the ground rent is reviewed to take account of due compensation for pushing back the eventual reversion to the lessor. Those reviews are upward-only and can be RPI-linked (as about 50% are); fixed (always increasing by 2%, say); or linked to a house-price proxy like HPI. The shorter the lease, the sooner you can review your rents. The more frequent the reviews, the more quickly rents increase (every 20 years is standard, but every 15 years is becoming more common); and an RPI-link is a better match for inflation-indexed liabilities than fixed, or HPI with its unpredictable capital growth exposure.

Finally, residential ground rents are perhaps the safest cash flow asset of all - even safer than AAA-rated sovereign bonds - because if the lessee defaults, the lessor can evict the tenant and sell a new lease on the land (and its developments). A default that would result in a haircut for a bondholder is a windfall for a landlord.

"That happens very rarely," says Richard Silva, managing director at Consensus Business Group, an adviser to a family trust for which it manages a variety of strategies, including residential property, social housing and ground rents. "Over 15 years with more than 300,000 rents, we've forfeited just twice." That's not surprising - property owners do not want to lose their assets and even if they do, mortgage lenders (secured on the lease, not the property) have a clear incentive to step in and pay the rent.

"The credit risk is akin to, or even better than, government," confirms David Skinner, investment strategy and research director for real estate at Aviva Investors, which is why the firm is considering ground rents for its Lime Fund, hitherto focused on secured leases.

No risk generally means no return, but Silva insists that an investor requiring cash flows could expect an IRR of 4.5-8.0% over the life of the assets. "This comes from the portfolio effect and economies of scale associated with being able to pick up tens of thousands of units over a year," he explains.

That is easier said than done. The market is fragmented, and building strategic relationships with the larger housebuilders is the key to picking up consolidated regional portfolios. "Investments range from £20,000 capital value up to £5-6m," says Silva.  "That's 500 or so transactions to get up to the £100m level where economies of scale begin to tell." Each one of those is labour-intensive, employing legal services indistinguishable from high street conveyancing. Consensus deploys considerable staff and infrastructure to cope with that volume and act as landlord for its client's estate.

Still, the attractions of a 125-year cash flow offering 50 years' duration are clear, and compared with swaps, there is the appeal of cutting out the middleman. "Why would we want an intermediary between us of significantly lower credit quality than the cash flow it is intermediating?" says Silva. "Conversations we've had since Lehmans have suggested that buyers of inflation are quite happy to face up to the asset cash flows."

Again, staying in residential, there is a growing consensus around the social housing investment opportunity. For society, the need is clear: the waiting list keeps getting longer and for some time now the lion's share of housing associations' funding has been government grants and cheap bank loans - both sources that can ill-afford the cash today. "Social housing needs £20bn over the next five years alone, just to bring the housing stock up to a reputable state," said Adrian Bell, chair of the Genesis Housing Group, at an event hosted by Redington in April this year.

But what's in it for pension funds? The banks' retreat has opened up an opportunity to capitalise the sector at more rewarding yields. Pooled vehicles are becoming available (M&G Investments looks set to raise £1bn for a fund by the end of this year); it is scalable (50% of the UK's housing stock valued at £400bn); long duration (loan terms are generally 30 years-plus); and the supply-and-demand fundamentals are robust.

‘Supply-and-demand fundamentals' is, of course, a euphemism. Ultimately, investors in this sector squeeze rents (albeit subsidised) from the poorest in society. Earlier this year CalPERS had to introduce a policy for its portfolio "to prohibit excessive rent increases and the involuntary displacement of low-income households" after complaints from tenants' groups.

Still, the cash flow profile of social housing may be the best-suited of the ‘REALM' assets to match pension fund liabilities. Again, the rental inflation-link is implicit, but present. Bell sees no reason why the RPI plus 0.5% of recent years should not persist. Investors are not collecting those rents but negotiating loans with housing associations that are happy to pass on their inflation through loan repayments. Moreover, because this is private-placement debt, there is scope to tailor the income stream to liabilities.

"All of the work we've been doing has been at RPI floored at zero and capped 5%," says Gardner at Redington. "We are beginning to talk to some housing associations about CPI links, too."

Yields are coming in at around RPI plus 2% for credit exposure to entities whose product is subsidised and over-subscribed, and which have seen no defaults for 20 years. Investors note the importance of scrutinising housing associations' management and assuming that one will, in extremis, take possession of housing estates - but ultimately they regard this as a less liquid, quasi-government exposure.

Location, location, location
A similar risk profile is available from secured long leases, whereby an investor/lessor leases buildings to a tenant for at least 15 years (and generally 25 years or more), for an RPI-linked rent. If the lessor holds a concessionary lease the lessee ultimately takes possession of the buildings, whereas under a reversionary lease they ‘revert' to the lessor.

"For many pension funds the structure without reversion is more attractive," says Skinner at Aviva, whose Lime Property Fund has been investing in these assets for six years. A reversionary lease necessarily extends duration by introducing a back-ended cash flow that is not explicitly inflation-linked. Moreover, the market assumes you want these buildings and pays you for conceding them - Skinner says that while comparisons are tricky, a big UK corporate tenant might offer a yield of 5.1-5.2% on a concessionary lease, versus 4.5% on a reversionary freehold.

Still, many are prepared to take the bricks-and-mortar risk. "We like the idea that we own the property at the end," says William Nicoll, director of fixed income at M&G, which runs its Secured Property Income Fund with PRUPIM. "But you have to make sure you have a good tenant, a good site, and your analysis includes a worst-case scenario for capital values."

At AEGON, Clark insists that his mandate is "absolutely bricks-and-mortar with freehold ownership", which is why the firm does not lend to housing associations, but likes reversionary leases on nursing homes. "The length of the lease suits operators that want a long-term solution to the fundamental lack of supply and the fundamental growth in demand coming with ageing baby boomers. Getting these homes located near the right sort of population is great for both of us."

Taking a long-term view on a nursing home seems sensible - given equally long-term trends in western European demographics, and the potential longevity exposure for pension funds. But many private sector reversionary leases are taken by supermarket chains. "Who knows what shopping habits are going to be like in 30 years?" muses Chris Helyar, a partner at Lane, Clark & Peacock. On the one hand you get a decent inflation-linked return even if the shop is worth nothing at the end of the term; on the other, you may be surrendering 60bps of yield for a useless pile of bricks. Supermarket chains will extend leases to keep competitors off of their prime locations today - they could be dud locations tomorrow.

"Some properties could saddle you with costs at the end of 25 years," concedes Gardner at Redington. "But a supermarket is just a glorified shed. The real value is the location close to transport arteries - you can pull down the supermarket and build whatever you want."

Perhaps the overwhelming fact is that the market remains unaware or unable to take the illiquidity risk of these opportunities, leading to pricing anomalies across corporate exposures. If you eventually have to demolish that supermarket you still get the same initial yield on a 25-year lease as you get on the firm's bond - which offers neither the RPI-uplift nor any security.

What it does offer is liquidity, which is in short supply in all of these ‘REALM' assets. Does that matter? Gardner says that most of his clients that have bought-in use their income for pensions-in-payment rather than re-investment. Nicoll confirms that he expects M&G's new social housing fund to deliver biannual LPI-linked cash flows. Why would a pension scheme to want to sell?

To be blunt, while a lease might last 25 years, a pension scheme might not. "What happens if you want to do a buyout 10 years down the line?" Helyar wonders. "They may not want to take these securities on, and that could affect your choice of providers. I do think that's quite a serious hurdle."

On the other hand, there is a reason why these investments tend to be managed by the likes of L&G, M&G, Aviva and AEGON. Nicoll points to M&G's portfolio of social housing loans backing its annuity book, put in place before the banks came in. Silva at Consensus confirms talks with several annuity providers about its ground rents strategy, involving both their own staff pension scheme and their managed funds.

"We certainly have clients flagging this, but, essentially, there is no reason an insurance company should refuse these assets," says Gardner.

There are a number of trade-offs to be considered with these assets - (quasi) government risk versus corporate; cash flows versus capital values; the ability to tailor cash flows versus the ability to sell - but in the end there is a strong case for considering them as alternatives to expensive or capacity-constrained inflation-linked bonds and swaps in matching portfolios.