The role of long leases in property portfolios

Long-let properties have traditionally been the backbone of institutional real estate portfolios. Commercial properties with long leases – i.e. unexpired lease lengths of more than 15 years – have always been sought after because they offer investors a lower-risk option.

But occupier markets and attitudes have changed in recent years, which have modified the commercial property market place. Over the period from 1999 to 2010, average lease lengths fell from 14.3 years to 9.4 years, as economic pressures required occupiers to be much more flexible. Investors have had to adapt to this changing landscape, too.

For an investor, longer-lease properties offer considerable benefits:


Stable income

Real estate has demonstrated its ability to deliver good income streams over a long period of time. Income from property is secured by the legally-binding nature of a lease; in circumstances less extreme than bankruptcy, a company in difficulty will stop paying dividends before it stops paying rent. Upward-only rent reviews in the UK also help to secure income. This is particularly valuable in protecting income streams during times of falling market rents.


The potential for better returns over the life of the lease

Average annual total returns over the ten years to the end of 2010 show that, at an all-property level, property let on 20 plus-year leases returned nearly twice that of property let on short leases of up to five years.


Lower costs and volatility

With the expectation of reduced capital, transaction, and other costs, a good tenant and regular rent reviews, long leases offer a lower-cost option for the investor. Moreover, the long lease is not subject to the same market volatility as shorter-let properties with upward-only rent reviews.


Although most tenants prefer the flexibility of shorter lets, there are certain circumstances where occupiers might be attracted to long leases. For some tenants, the type and location of the property may be important for a business, and it is in their interest to stay in the same premises. For example, large organisations often keep their HQ in the same building for many years. The same is true for large retailers and hotels in prime locations. Business continuity is a powerful reason to stay and overrides any short-to medium-term flexibility arguments. For them, it is a lower-risk scenario.

Other tenant advantages include an ability to spread out “fit-out” costs (refurbishment and maintenance costs are the tenants’ responsibility in UK commercial properties) and other tenant-related expenditure over a longer period. Long leases also offer occupiers capital-raising opportunities by way of sale-and-lease-back options (if the cost of debt is higher than the yield).

As a result of the market issues that put pressure on lease lengths, the supply of longer-lease properties is restricted. Properties with longer leases tend to be concentrated in certain sub-sectors, such as budget hotels, supermarkets, and specialised educational and medical facilities. Therefore, the pool of tenants is smaller in this category and investors need to be aware of tenant-concentration risks.

Long-let properties have a place in balanced portfolios for investors who are looking for secure income over the long term and who have a low-to medium-appetite for risk. Long-lease properties are not for the adventurous investor, though, whose risk appetites and return expectations are likely to be much higher.