We explore ground rents as an asset class that offers a long-duration asset with attractive risk-return characteristics.
Over the last decade, insurers have been searching for assets with which to match long-duration liabilities that pay above the risk-free rate. In the case of very long-dated liabilities, for example, long-term savings contracts in Germany and deferred annuity contracts in the UK, there are very few matching assets with sufficient duration that pay a spread above the government bond or swap rate.
In this paper, we discuss ground rents as an asset class that offers attractive spreads and long-term cash flows with additional security. Ground rents have existed for some time in the UK; for the rest of Europe, such assets can sometimes be found but have attracted less institutional attention. The asset class is relatively difficult to enter, as it is relationship-driven, but for those institutions able to develop these relationships or partner with appropriate asset managers, the asset class is one of very few offering a credit spread at terms above 50 years.
1. What are ground rents?
Ground rents are the income paid to the freeholder of a property owned via long-term lease (typically 20 to 999 years). The properties can be either commercial or residential, with the ground rents due under each having differing characteristics. Ground rents have seen increasing popularity among institutional investors as they provide long-term, secured cash flows.
Typically, the ground rent is a small proportion of total rent or income and, therefore, is normally paid relatively easily. In addition, the leaseholder of the property is incentivized to make ground rent payments to avoid forfeiting significant value if the freeholder repossessed the property in the event of default. Thus, ground rent cash flows are both well-secured and stable.
2. Ground rents as an investment
Ground rents are typically relatively small. A residential rent, for instance, maybe £250 per year. Therefore, many ground rents may need to be aggregated in order to create an institutional-size investment. Ground rents are also typically private transactions and require to have a well-established network of contacts in order to gain access to opportunities in the market.
In terms of structure, both equity and debt options may be available. For example, an investor may purchase the ground rent outright or alternatively lend against such a portfolio, as the running yield provides a reliable source of income to service the debt.
For both equity and debt investment, ground rents can offer attractive yields. A ground rent portfolio can offer a running yield that may be considered attractive compared to fixed-income investments, with individual residential and commercial ground rents typically providing a running yield of 2.25%–3.75% and 2.75%–4.00% per annum, respectively, which may rise over time. Meanwhile, debt held against ground rents can yield in excess of 150 bps above swap rates.
The assets typically have limited credit risk given that lessee’s have a clear incentive to pay a relatively small amount to avoid forfeiting the property.
Ground rents are one of the few assets that can provide income for more than 60 years. Therefore, they may be attractive to companies with extremely long-dated liabilities such as deferred annuities.
In this white paper, we further explore ground rents and discuss the investor consideration when looking at this potentially underutilized asset class.
