Assessing long-lease real estate as an option in run-on strategies

Since September 2022, many UK DB pension schemes have reassessed their strategies for managing liabilities given the significant jump in funding levels they have seen on the back of the rise in bond yields. Many schemes are now in better positions, and this has led to a big focus on buyout, whereby pension liabilities are insured and removed from corporate balance sheets. 

However, excess demand and capacity constraints have led insurers to be more selective in the buyout deals they underwrite. With this backdrop in mind, as well as the potential for surplus extraction given recent regulatory change, an increasing number of DB scheme trustees and sponsors are exploring run-on strategies. 

We believe it is an opportune time to consider what assets are appropriate for pension schemes that find themselves in this position.

How will run-on affect asset allocation?

Where buyout is a difficult option, DB schemes are keeping control of their assets and liabilities, managing them directly instead of transferring them to an insurer. For some schemes, this approach could provide advantages over buyouts, including flexibility, surplus sharing and broader alignment with members (for example, on environmental and social issues).

A run-on strategy for a well-funded scheme will have many similarities to how an insurer would look to structure a portfolio, but without the stringent regulatory drivers. 

Gilts, linkers and credit will continue to feature heavily. Schemes, however, are also likely to look at alternative ways to generate inflation-linked cash flows, seeking an additional yield premium over that on offer from index-linked gilts. 

With that in mind, we are observing renewed demand for long-lease real estate. 

What is long-lease real estate?

In the mid-to-late 2000s, long-lease real estate grew in popularity among institutional investors. Demand came predominantly from DB pension funds attracted to the potential for long-term, secure, inflation-linked income payments.

These strategies typically aim to provide an alternative source of inflation-linked income and a higher yield than index-linked gilts. In addition, the long-income market can potentially be less volatile than broader real estate markets, albeit directional trends can be similar. 

This potentially reduced volatility, coupled with the opportunity for attractive relative value, has encouraged certain investors to consider long-lease real estate as a strategy for the first time. Most notably, DC pension schemes have been attracted by the inherent income growth, which contributes to total return, and DB schemes are showing renewed interest.

Long-income products have varying approaches; ranging from those that see themselves first and foremost as property funds to those that seek to minimise risk as far as possible in order to be viewed more as a ‘gilt-plus’ strategy – the assets they hold differ as a result.

Is now an appropriate time to consider long-income real estate? 

The property market saw a significant correction which began in early-2022 and became more acute later that year following September’s mini-budget in the UK. Interest rates had been increasing due to high inflation since late 2021, but the gilts crisis resulted in these spiking. Many long-income property assets saw significant valuation falls in line with the broader market as property yields moved up to reflect higher gilt yields. 

Today, we believe that the UK property market is well-placed to deliver attractive returns. The supply/demand dynamics are suggestive of healthy rental growth and the careful asset selection should make long-income portfolios well-positioned even if certain risks do eventuate. We are already seeing some investors committing to this strategy for the first time in a few years and expect this positivity to continue into 2025.