An alternative view: Why long income funds offer new hope for income investors
A decade of easy returns from the stock markets could be coming to an end.
Ongoing fallout from the Brexit vote, inter-government tension, the withdrawal of quantitative easing and trade wars between the US and China has meant a real rollercoaster ride for equity investors since the start of 2018. Approaching year end, the UK’s stock markets experienced yet more volatility in response to persistent political and economic uncertainty.
The outlook for bonds is not much better. Despite the Bank of England’s August interest rate rise, base rates are still sub 1%. Gilt yields are depressed and continue to be eroded by inflation which reached its highest level for six months1 in August this year. Over the next 30 years UK bonds are predicted to return 3.1% against inflation of 2.2%2.
All this is problematic for investors who need a stable income stream that can outpace inflation. Attempting to diversify a portfolio based on a traditional bond/equity split seems sub optimal, and investors need to cast their nets wider.
Notably, anyone planning for retirement or who needs to supplement their income must look outside the traditional investment options to find an asset class able to deliver in these difficult times.
Property offers an alternative to bonds and stocks, with traditional property funds tending to react more to market volatility and therefore may not be able to meet investors’ income requirements.
Meanwhile investing in property directly is illiquid and inflexible. The property owner is dependent on the whims of the housing and short-term rental markets, and with Brexit upsetting prices and creating uncertainty, this is a challenging place to play.
Long income funds
Long income funds offer an alternative to traditional commercial property funds. They give investors access to commercial property with leases of between 15 and 250 years and offer several benefits.
First is stability. Long income property funds have proven more resilient to the market falls following the Brexit referendum and are less volatile than traditional commercial property funds. Long income property is affected by general economic conditions in the UK, but is correlated to a lesser extent than the traditional property market and the long leases remove some of the volatility.
Next is returns. Long income property funds tend to trail traditional commercial property funds when markets are rising but they provide more consistent, predictable returns overall. In the year to June 2018, long income property rivals outpaced returns from the commercial real estate index3.
Importantly, long income protects against the corrosive impact of inflation. Freeholders set index linked upward only rent reviews for the entire term of the lease, ensuring rents keep pace with inflation irrespective of economic conditions.
This differs from traditional commercial property funds where rent reviews are typically linked to market conditions at the time of review.
The TIME:Commercial Freehold fund, for example, invests in long income property that does not act like traditional commercial property with a Weighted Average Lease Term (WALT) of around 60 years, compared to the average lease length of a traditional commercial property fund of 7-10 years and a management team that has over 25 years’ experience investing in long income real assets. TIME Investments has launched a social infrastructure fund, TIME:Social Freehold which sits alongside TIME:Commercial Freehold. Similarly, the fund delivers a secure income through investing in long leases typically ranging from between 15-30 years, whilst also creating a positive impact on society.
Investors looking at long income funds can expect a bond-like return due to the predictable nature of their income returns. These characteristics make them suitable for many types of investors, most obviously those seeking a robust income stream.
This was evident over the month of October 2018, with the FTSE 100 experiencing its worst month since August 2015, with the total return down 4.85%. The same was also the case for the IA UK Equity Income Sector, which had an equally poor month, ending October down 5.47%.
Despite the on-going uncertainty in the markets, TIME:Commercial and TIME:Social Freehold generated a positive total return, outperforming the FTSE 100.
Investing in long income property is not without risk and investors should seek advice before making financial commitments. However, for long-term investors seeking income and some growth, these funds may offer an alternative to traditional investment options.
What is long income property?
Long income property provides greater certainty of income and therefore reduces volatility. Within long income property, there are a couple of main classifications: long leases and ground rents (very long leases). The combination of long leases and ground rents serves to optimise the yield and mitigate risk at the portfolio level.
The UK freeholder leases the building to a leaseholder who is usually a commercial tenant, for lease lengths of 60-999 years, usually between 100-250 years. Typically ground rent value is less than 40% of the full market value of the underlying property; the leaseholder owns more than 60% of the full market value. Ground rent is substantially below the market rent meaning leaseholders are highly unlikely to default. 100% of rent reviews are upwards only under a Full Repairing and Insuring (FRI) lease, so all costs are typically the responsibility of the leaseholder.
Commercial freeholds with long leases are typically let to tenants for periods of between 15-40 years. As with ground rents, upwards only rent reviews are fixed or index linked, under a FRI lease. Assets are usually a profit centre of the tenant and of strategic importance to the business (as opposed to an office which is a cost centre), providing long term asset viability and security.