Institutional investors are longing for long-income property, with its apparent low risks and high yields.
Since the global financial crisis, the decline in bond yields has left institutional investors seeking alternative secure income-generating assets. Certain forms of real estate such as ground leases and properties with long leases fit the bill, and they are often labelled long-income property or LIP. Long-income property is real estate let on long leases (more than 15 years) to creditworthy tenants. The leases have inflation-linked rent reviews, providing inflation protection to the rental income received and the underlying value.
This investment type is higher yielding than bonds, but less risky than traditional real estate. LIP offers the opportunity for a significant yield pick-up over government and corporate bonds, with comparable credit quality. It suits investors such as defined-benefit pension schemes and life assurance companies because they can use the long-dated inflation-linked cash flow streams to match their liabilities.
LIP aims to provide returns that are less volatile than those of traditional real estate, thanks to having lower letting risk and lower reliance on residual values when a lease terminates. The tenants in a LIP strategy are often government offices, supermarkets, universities and hotels (especially budget hotels).
LIP aims to provide returns that are less volatile than those of traditional real estate, thanks to having lower letting risk and lower reliance on residual values when a lease terminates
Let’s take a closer look at hotels. Within the hotel sector, leased hotels are regarded as the lowest-risk operating model. Such structures give control of the business to the operator, while protecting the owner from downside trading risk (assuming the tenant stays solvent). On the other hand, a lease caps the owner’s upside.
An alternative to the lease model is to enter into a hotel management agreement, either directly with one of the big brands such as Hilton or Marriott or via a third-party management company. Under this model the appointed operator is responsible for the day-to-day running of the hotel in return for a management fee, typically linked to a percentage of revenue (a base fee) and a percentage of profit (an incentive fee). Investing in hotels is not like investing in offices and other traditional forms of real estate. Hotels are operational real estate, which means the investor owner derives an income that is directly related to the revenue generated from the asset rather than a stable lease rent.
In the hotel business, happy guests drive revenue and those guests can be fickle. TripAdvisor, Expedia and other websites let guests praise or criticise hotels. These online reviews have a significant impact on revenues – according to one survey, 76% of guests would pay more for a hotel with better review. A long lease on a half-empty hotel will not end well for investors.
At Didobi, we are currently researching hotels and other forms of operational real estate on behalf of the Investment Property Forum. Contact us if you have insights to share.
