Structured finance: Long-lease assets

European pension funds are keener than ever to find low-risk investment alternatives offering a premium to measly-yielding bonds. Core property fits the bill, particularly if it offers that premium wrapped up with inflation-protection and long leases matching funds’ long-term liabilities.

M&G Investments is capitalising on the demand with a new fund, the first of its kind, which will build a pan-European portfolio of long-leased assets with inflation protection. At launch in February, five continental European pension funds had committed €265 million to M&G European Secured Property Income Fund (Euro SPIF).

The open-ended, euro-denominated fund will invest on the continent, ex UK. M&G hopes to build on the success of its UK SPIF product, which is managed jointly by M&G’s fixed income and real estate divisions, has an identical strategy and has attracted billions of pounds of capital, amassing £3.2 billion ($4.5 billion; €4.1 billion) of assets.

M&G had wanted to replicate UK SPIF on the continent for some time, but had to be confident of a flow of long-lease transactions.

Alex Jeffrey, chief executive of M&G Real Estate, says long-lease property is not as established in continental Europe as in the UK, though it is evolving.

M&G will find deals from operating companies looking to raise capital from their real estate while retaining long-term occupational security over their key assets. Many are interested in sale and long-term leasebacks, particularly as alternatives have dwindled now that banks have largely retreated from long-dated financing.

“Pension funds and institutional investors, the natural owners of long-term capital, are providing long-term finance where banks previously dominated the market,” says M&G Investments’ fixed income chief executive Simon Pilcher.

A property sale and leaseback can also be an alternative to raising finance in the bond markets for some operators.

“In particular, private equity owners wishing to release capital from real estate, when their profile means they are not necessarily natural bond market issuers. A sale and leaseback transaction where the rent is set at a conservative level of gearing versus EBITDA generation of the assets allows them to access attractive long-term finance rates,” Jones says.

Setting rents at the right level at the outset is key: there were high-profile casualties in sectors like nursing homes in the wake of the 2008 crash when rents turned out to be unsustainable. Euro SPIF will seek relatively conservative real annual returns, mainly from income though hopefully with some capital growth, of 3-4 percent over inflation, and is likely to have a basket of different inflation measures depending on the assets its acquires.

A source of deals, Jones says, will be existing UK SPIF relationships. One of the fund’s two maiden deals is acquiring the David Lloyd health and racquets club in Brussels for about €50 million, on a 30-year, triple-net lease linked to Belgian CPI.

“The opportunity came off the back of completing a £350 million UK transaction with them,” Jones says, referring to UK SPIF’s acquisition last year of 44 UK health clubs.

The second acquisition is a portfolio of 12 supermarkets in Portugal sold and leased back on 20-year leases to Sonae. Euro SPIF has taken five of the assets, valued at about €50 million, while the remaining seven have been acquired by M&G Real Estate’s European Property Fund in a joint €164 million deal. There’s a third in the pipeline of German commercial ground rents and another in Dublin.

“In the UK our focus evolves as pockets of relative value shift,” Jones says. “We were an early investor into budget hotels and supermarkets. Other investors have come in and we saw those yields compress. Then we started investing in student accommodation, and other operational assets like healthcare and leisure.”

It’s a product that other fund managers would love to have. The chances are billions of euros of capital will flow this way in the next few years, if the opportunities can be structured.