Will the iteration of this decade be more successful than its predecessors and why have ground rent transactions found increasing favour with institutions over the last year or so?
One clear reason for the renewed popularity of these deals is investors’ desire for long term stable and predictable income (once the bastion of bonds and gilts). However the volatility of other traditional investment classes such as retail has only added to the list of potential investors beyond just the long income funds.
Those investors looking for or needing long dated income who have struggled to find suitable investment products due to the volatility of markets and low interest rates have found ground rents an attractive solution to their investment needs. These deals, far removed from the sale and leasebacks of old, offer an investor a secure income stream and potential growth both in income and in the asset’s capital value over time, in exchange for an upfront capital sum.
Lease terms of one hundred or more years are also traditionally less volatile than their shorter counterparts and therefore less sensitive to the property market cycle. The stability of the ground rent income provides certainty for the investor which is cushioned from the liabilities of the underlying operational business by the landlord / tenant relationship.
Ground rent deals are attractive for owners of land, particularly those with large sized portfolios connected to an operational business, as they provide them with the opportunity to unlock the current value of the portfolio (where property owning is not a core part of the business).
The sector has become increasingly agnostic as to the asset type constituting the underlying portfolio. As long as it can provide the requisite characteristics (outlined below) it appears to be attractive to investors in a market where demand for large scale portfolios regularly outstrips supply.
3 Characteristics Required for a Ground Rent Deal
- Firstly, the portfolio should be sufficiently large so that the income generated justifies the costs of set up. The necessary size depends upon the value of individual assets but, for example, a care homes portfolio is likely to require more assets than a leisure park due to the comparative value of the individual assets.
- Secondly, the value of the portfolio should not be concentrated in only a small number of assets to provide a natural hedge to fluctuations in the underlying business.
- Thirdly, if the nineties and noughties taught the industry anything it is that rent levels must be sustainable to avoid placing an unserviceable financial burden on the underlying business which too often led to the collapse of the business to the detriment of all parties. There may also need to be enough headroom to allow for additional leverage at the level of the operational business.
Today’s portfolios tend to comprise mature assets with a track record of stable income or sustainable growth. The rents set represent a modest percentage of EBITDA (or other business appropriate metric) and as such in many deals additional return can therefore be secured if the business performs well as rents can be recalculated on the updated EBITDA securing further capital sums for the business and additional return for the investor.
As can be seen from the above the ideal ground rent portfolio achieving a balance between cash extraction and rent burden is key to a sustainable and attractive product.
The need for balance is also carried through to the leases themselves which need to find the right combination of protecting both the interests of the operational business to retain operational flexibility and the desire of the investor to impose controls on the assets.
Control cannot stifle the freedoms necessary to generate income but equally operators need to accept that operational discretion will be fettered in the interests of preserving underlying value. This is one area where one size will not fit all and the parties need to take time to understand the operational business and what is truly needed against what is merely desirable.
Where the modern product has particularly improved, as compared to previous iterations, is over the freedoms granted to vary the portfolio following completion. It would be a rare business that does not need to vary its asset base to meet the changing demands of the market or its customer base. It is therefore not uncommon for the parties to agree that properties may be substituted within the portfolio based on pre-agreed metrics to ensure a like for like exchange, and it is flexibilities such as these which are key to both a successful relationship between investor and operator and also to the continuance and growth of the investment vehicle itself.
It would seem that, for now, ground rent transactions are here to stay. If portfolios are of the right scale, they can provide an attractive investment option for long term institutional investors looking for long dated investments, while allowing owners to unlock value. How robust the market will remain will depend upon transactions avoiding the temptation to over leverage and also on the macro-economic situation and how attractive real estate, as a long-term investment, remains compared to other asset classes.
