We take a closer look at the characteristics of long-lease real estate in the context of insurers’ asset management requirements.

More insurers are considering long-lease real estate within their general accounts. But we have encountered a spectrum of views around the role the strategy has to play within an insurer’s overall asset allocation.

We provide our views on that question through this article. This includes exploring the characteristics of the asset class in the context of insurers’ asset allocation objectives and assessing capital efficiency under the Solvency II standard formula.

Asset allocation considerations for insurers

For insurers, the asset allocation process often starts with asset liability management (ALM). The majority of assets within an insurer’s general account are there as a result of the need to pay future claims. Naturally, ALM has to be a significant factor when thinking about where to invest.

This means insurers are focused on selecting assets that provide a good match for the estimated liability payments. In turn, there is a natural preference for assets that give certainty and stability of income. There is also a preference for assets with values that are sensitive to the same factors as the liabilities, such as interest rates.

Asset allocation decisions are not purely a function of asset liability management, though – additional factors play a role in shaping an insurer’s general account. Insurers aim to earn a profit for their shareholders (alongside a number of objectives). While underwriting income can be thought of as the predominant factor in earning that profit, investment return is clearly another key driver.

Within the investment portfolio, insurers assess the risks they want to take that aren’t present in the liabilities, such as credit risk, illiquidity risk, real estate risk and equity risk. The firm’s risk appetite, including solvency capital requirements, helps inform this process.

Additional operational considerations will arise that are specific to each insurer and play a role in the asset allocation process. One example would be the level of resource available to assess and oversee investments. However, asset allocation decisions are typically informed by assessing the degree of importance of three factors: ALM, return and solvency capital requirements.

Historically, insurers’ allocations to traditional real estate have typically arisen when greater emphasis is placed upon return. Traditional real estate has not been known for either its ALM characteristics or its solvency efficiency. However, long-lease real estate is materially different to traditional approaches to real estate. It is much more closely aligned with insurers’ preferred ALM asset classes, such as corporate bonds and private debt.

Additionally, the spread over risk-free rates on long-lease property can look compelling relative to those asset classes. This means that the solvency efficiency of long-lease real estate can be more attractive than a cursory consideration might suggest.

We dive into these areas in further detail in the rest of this article, starting with the characteristics of the long-lease real estate asset class.

The characteristics of long-lease real estate

Real assets are often the chosen solution to meet long-term income requirements. We have seen the rise of real assets allocations across institutional portfolios, as a result of the low interest rate environment. Higher economic risk, driven by the Covid-19 pandemic, reinforces the appeal of lower-risk investment strategies and the appeal of sustainable cashflows from specific types of real estate.

Real estate benefits from both bond-like contractual income and equity-style growth potential. Not all real estate assets behave in the same way and different types of real estate assets have varying degrees of exposure to these two performance characteristics. Some are more exposed to growth qualities, often because of shorter leases and more variable demand and supply drivers. Others are more similar to bonds, with a focus on secure income characteristics that tend to deliver more stable returns.

Indeed, there is clear evidence available when it comes to the differentiated performance of long-lease strategies compared to traditional 'balanced' bricks and mortar funds. According to a substantial dataset from the AREF UK MSCI Property Fund Index from December 2005 to December 2020, funds in the long lease category have returned an average 7.2% per annum with a standard deviation of 6.2%. This compares to the full index return of 6.9% per annum and standard deviation of 10.1% over the same time period.

While past performance is not a guide to future results, essentially, long-lease funds have outperformed standard real estate in absolute terms, but more critically with a much lower level of volatility. Long-lease real estate assets typically have leases with materially longer duration than the market norm. Market-average lease lengths are roughly five-to-seven years depending on the country, but leases of 12-to-15 years are prevalent across Europe. Some assets offer considerably longer lease contracts of 25 years and beyond. These longer leases are often prevalent in sectors beyond the traditional office, retail and industrial sectors.

This is important because if there are fewer possible ‘lease events’ or opportunities for cashflows to change, then valuers have fewer reasons to adjust valuations based on income risk. Therefore, assets with longer-lease profiles typically behave differently to assets that have greater income risk in the short term. This makes long leases a more defensive type of investment and this is why they are often compared with fixed income or credit in terms of their role in a portfolio. A further crucial attribute of long leases is their indexation to inflation, which is not found in most other fixed-income investments. Long-lease real estate assets mainly come in the form of standard leases to tenants, but they can also include income strips and ground rents, too. The latter two carry different risk and return profiles, but they are often an option for long-lease funds as they carry the same overall goal of delivering long-term predictable cashflows linked to inflation.

Investing in long-lease assets to capture lower volatility and longer-duration cash in depth flows requires less active asset management than traditional funds. But they do require some involvement in key areas. Accurately underwriting tenant risk is critical and requires a robust process.

This can involve more than simply checking credit assessments from third party ratings agencies. More in-depth tenant underwriting often pools expertise from other asset class research, such as equities and fixed income, with investors interrogating underlying business credentials in a more forensic and forward looking way than real estate investors would usually do. Churning assets in the portfolio as tenant covenants change, their leases run lower or re-negotiating leases as they become shorter are other important areas of asset management focus.

Lastly, we believe the quality of the underlying real estate is also of paramount importance and not every long lease has the same long-term durability as the next. In the rare event of a tenant failure, it is important that a building’s desirability, location and function ensure that it has a second life. This is important for attracting replacement tenants on similar lease terms and reinforces the long-term durability of the income from this type of real estate.

Solvency capital requirements

The market-risk module of the solvency II standard formula provides for a capital charge on real estate investments of 25%.

Notable research by IPD/MSCI has argued that this charge is high. The data set used to formulate the original solvency capital requirements (SCR) charge of 25% used only UK market data, which has historically been more volatile than European markets. The research argued for a SCR of 15%, using a European (including UK) data-set up to 2015. The SCR charge under the standard formula remains 25%. The European Insurance and Occupational Pensions Authority has advised not to change the calibration as part of the 2020 review of Solvency II.

Additionally, a broad range of real estate strategies can be pursued and we have demonstrated that long-lease real estate strategies have exhibited lower volatility than traditional real estate strategies. This is not taken into account in the SCR calculations.

Against this backdrop, long-lease real estate faces a relatively high hurdle in terms of demonstrating its capital efficiency.

We explore this further through two examples.

Example one: on a standalone asset-class basis, we consider the income-generating ability of long-lease property relative to a typical alternative – European corporate bonds

The data shows the spread (over government bonds) and compares this with the capital requirement of the asset class. The capital requirement for corporate bonds is a function of the credit quality and duration, and is assessed under the spread risk module. The capital requirement for real estate is 25% adjusted for leverage. We have assumed a loan-to-value ratio of 25% and, as such, the capital requirement equates to 33.3%.

European long-lease real estate was generating around 350 basis points (bps) above government bonds at the second quarter of 2021. Despite the higher headline SCR requirement, this represents a extremely efficient use of capital compared with European corporate bonds.

Given the number of variables, we’ve not included a comparison with private-debt asset classes within this analysis. Clearly, insurers have been using this asset class for income-generating purposes as they take advantage of their ability to accommodate illiquidity (without necessarily having to alter their overall credit and interest-rate risk profile) and earn an illiquidity premium. If you assume private debt with the same credit and duration profile as European corporates (10+ years), the additional spread (illiquidity premium) would need to be around 120bps to have the same capital efficiency as long-lease real estate.

This analysis considers only the spread available. The total return of each asset class would have a bearing on the overall performance from a solvency efficiency perspective.

A buy-and-hold credit strategy would expect to earn the yield-to-maturity less expected credit losses. As the reference risk-free rate is currently negative, the yield-to-maturity less expected credit losses would represent a number lower than the spread. As such, the solvency efficiency results for credit would look slightly lower than in the analysis above.

Long-lease real estate total returns would comprise both income and capital value movements, which could be positive or negative.

Example two: we consider the potential impact on the aggregate market-risk capital requirement of allocating 10% from a current corporate bond allocation to long-lease real estate.

An initial- and post-allocation portfolio is shown below

Past performance is not a guide to future results.

The aggregate market-risk SCR requirement is a function of a number of risk factors, for which we have used the following assumptions to assist with assessing.

Asset portfolio value = £1,000 million

Liability value = £900 million

Liability duration = 9 years

The portfolio would be sensitive to an ‘interest rate risk-up’ stress for which we have assumed a 1% rate increase. The corresponding Solvency II ‘interest rate risk-up’ correlation matrix has been applied for the purposes of calculating the diversification benefit. We have assumed that there are no foreign-exchange or concentration-risk requirements arising. We have also assumed the same SCR requirements for corporate bonds and real estate as used in example one above.

The SCR requirements arising are shown below.

Past performance is not a guide to future results.

In considering the overall market-risk capital requirement, we see that the benefit arising from the fall in interest rate and spread risk is marginally greater than the increase arising from the allocation to long-lease real estate. Additionally, there is a diversification benefit from having another asset class added to the portfolio.

In this example, we have demonstrated that an allocation to real estate has actually reduced the overall market-risk capital requirement, despite real estate having a higher headline SCR requirement as a standalone asset class.

Our example uses a number of assumptions that will differ from insurer to insurer. In particular, should an interest-rate down stress be the biting stress for an insurer’s SCR calculations, reducing interest-rate sensitive assets (here, corporate bonds) would have the effect of increasing the interest-rate risk capital requirement rather than reducing it. The example highlights the importance of looking beyond headline SCR requirements, though, when assessing the efficiency of adding long-lease real estate to a portfolio.

Conclusion

In this paper, we have tried to shed light on the bond-like characteristics of long-lease real estate, while demonstrating the potential impact of an allocation on an insurer’s portfolio.

For any insurer who is looking to generate additional yield, without losing sight of ALM or the solvency efficiency of their portfolio, we believe long-lease real estate should be a consideration.

Past performance is not a guide to future results.