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Income Strip, Annuity, Bond – alternative investment in real estate

  • United Kingdom
  • Real estate
  • Real estate investment

10-09-2018

Eversheds Sutherland property column: September 2018

Originally published in Practical law

In these uncertain times, if cash is king, income is emperor. As a consequence, investors are looking for long-term, lower risk investments in the real estate market. Past and present sales and leasebacks have been part of the solution, but lately these safer structures are increasingly taking the form of annuity and income strip deals. Traditionally, the reserve of the institutional investors, with their long-term pension payout commitments, this type of deal is increasingly attractive to investors of all types looking for a safe harbour with a longer-term view.

At its simplest, an income strip investment combines a strong tenant covenant, with a long-term lease and a forward funding arrangement to give an investor a stable and secure income stream. The strong tenant covenant frequently comes from the public sector such as local councils, and the long-term lease often runs between 30 and 50 years. The stability and security for the landlord comes from an annual rent review linked to the Retail Priced Index (RPI) or Consumer Price Index (CPI) rather than an open market rent. This indexed review is often subject to a maximum increase, a cap, to protect the tenant from the spectre of runaway inflation, and a minimum increase, a collar, to protect the landlord from price deflation. For investors specifically looking to hedge final salary pension scheme exposures, such risks often come with a 0% collar and 5% cap, hence the popularity of matching caps in the investment leases.

For the investor, the aim is for the income strip deal to be more bond than asset. To this end, the liability for the repair and running of the building usually sits with the tenant. The passing rent for the long lease is frequently less than the market rent, allowing the long lease tenant to sublet at a profit, making the taking of responsibility for the property attractive for the tenant too. The deal will usually provide a mechanism to ensure that the seller retains the property asset at the expiry of the income producing period, frequently a buy back option in favour of the tenant to buy the freehold of the building for just £1 at the expiry of the lease term. This amortising nature of the asset gives another advantage for the bond investor looking to match against pension exposures; the economic value of the leaseback effectively expires over time and so matches the underlying pension exposure more effectively than traditional bonds, which include the return of the principal sum at the end of the bond’s life. Investors looking for income would usually prefer this capital sum to be factored into the annual return.

These models have been applied across a number of sectors and a diverse range of assets, beginning with offices and logistics, then including car parks, shopping centres, residential and student accommodation, and, lately, hotels and pubs. The long-term nature of these deals provides a way of funding regeneration and infrastructure, often through collaboration between investors, developers and local authorities. For example, we have acted for investors on a leaseback income strip deal involving 4,000 much needed houses to rent, and for a developer working in conjunction with a council to revamp the retail elements of a tired town centre. Where a public sector covenant is at the heart of an income strip deal, all stakeholders need to be alive to the need to ensure that the deal is EU procurement, state aid and vires compliant.

The drafting of the deals is not without its complications. With more than one party with a share in the capital value of the property, traditional, predictable lease drafting is often not suitable. Issues such as forfeiture, who insures, dealing with rent interruption risks, what step-in rights each party has, and how estate services charge and insurance rent obligations cascade through the structure make for complications, extensive negotiations and bespoke drafting to ensure that the investments hold up institutionally. A key issue to focus on is that the insured risk will not usually be based on the real estate value but rather on the "hell or high-water" need to ensure income continuity. The investor wants to insure the risk of the rent flow being interrupted, rather than the underlying real estate asset itself. A total loss risk (for example, fire) needs to be carefully considered as the investor will want rent (or an equivalent amount) to continue to flow, notwithstanding rebuild periods and any commercial right the tenant may have to terminate the lease.

It is not only the lease drafting that is complicated; often the landlord and tenant law inherent in the structure is challenging. Multi-layered leaseholds, intervening leases of the reversion and reversionary leases are all often involved, with investors acquiring existing long leases or being granted newly created levels of leasehold interest. Those owner/occupiers with sufficient covenant strength are actively engineering and brokering deals to make the most of their real estate assets.

Finally, we are seeing an ongoing evolution in the approach to income strips, with more focus on genuine securitising of the underlying rental flows, bringing the structure much closer to the US model of Credit Tenant Leasing (CTL). This does result in additional complexity, but the resulting financial investment is frequently more attractive to investors as there is reduced real estate risk and increased liquidity, as well as reduced transaction costs given that actual real estate transfers to the investor are not usually required,other than security interests.

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