Crisis resilience will depend on lease length more than previously thought

Longer tenures may be more systematic drivers of return than previously thought, writes Will Robson, executive director and global head of real estate solutions research at data provider MSCI.

In 1956, California’s Van Nuys News proclaimed the three most important things about real estate to be location, location and location. In the 64 years since, asset-specific risk and high-level macro issues have become increasingly important considerations, as have understanding what drives risk and return in this complex and diverse asset class and how it correlates with others.

Lease structures and the quality of tenants have often been among the key drivers of growth and resilience of cash flows. However, the ongoing global spread and negative impact of covid-19 may be an example of a scenario where the significance of lease lengths could come to the fore.

Historically, past performance in real estate has primarily been explained in terms of property type and geographic exposure. But there are many other potential factors that can help explain real estate performance. Our analysis found that lease length has been one such cyclical factor.

Looking back to 2008, longer-lease real estate assets provided a performance boost during declining market periods, since properties with a longer weighted-average lease expiry – WALE – were likely to be more insulated from negative reversionary potential. On the flipside, longer-lease assets depressed returns during rising markets, as properties with a drawn-out expiration profile were less able to capture reversionary upside through active management intervention, compared to properties with a shorter WALE.

In the five-year period after the global financial crisis, long-lease properties in the UK, for instance, delivered an annualized total return of 9.6 percent, compared to the 5.2 percent of shorter-lease properties. By contrast, in the period from Q1 2014 to Q2 2016, shorter-lease assets stole the limelight, courtesy of buoyant growth in market rentals. From Q2 2016 to Q2 2019, longer-lease assets provided an extra 100 basis points in annual returns, aided by their reduced exposure to dilutionary lease events.

Rental growth and returns were already weakening ahead of the coronavirus outbreak in the UK, with longer leases beginning to outperform. We may see this trend accelerate as the pandemic begins to impact rental income.

After the Brexit referendum, industrial property in the UK had a strong run, delivering an annualized total return of 13.2 percent from June 2016 to December 2019, compared to the retail property sector’s -0.3%. However, with retail properties, with actively managed lease lengths, the outcome would likely have been more favorable.

Rental growth and returns were already weakening ahead of the coronavirus outbreak in the UK, with longer leases beginning to outperform

Over the same analysis period, long-lease retail property delivered an annualized total return of 5.3 percent, 380 basis points in excess of the 1.5 percent annual return of shorter-lease retail assets, as its exposure to negative rental reversions would have been more contained. By contrast, shorter-lease industrial assets, with an annualized total return of 14.9 percent, outperformed longer-lease industrial property, which produced an 11.3 percent annualized return, based on the latter’s higher exposure to accelerating market-rental growth.

In recent periods, much of the respective outperformance of shorter-leased industrial and longer-leased retail property was due to superior fundamental income growth as opposed to yield-compression-driven capital growth. This suggests the relative exposure to potential rental reversion may have been the more significant driver of relative performance during the analysis period.

With real estate now occupying a greater slice of multi-asset-class portfolios, investors have been looking beyond inherent property attributes such as sector and location as the key drivers of investment performance.

In the same way that factor analysis has helped explain more systematic drivers of performance in the broader equities market, a similar analysis might be made of real estate assets. Factors such as lease length, which were previously perceived to have been attributed to idiosyncratic risk and stock selection, may be more systematic drivers of return than previously thought.