Soaring inflation

How property and infrastructure investment companies can help protect portfolios.

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With UK inflation at a 40-year high of 9%, investors are looking for investments which help prevent their wealth being eroded by inflation. Today, the Association of Investment Companies (AIC) held a media webinar explaining how some property and infrastructure investment companies help protect investors’ portfolios from inflation.

We spoke to Giles Frost, Director of International Public Partnerships, Andrew Cowley, Managing Partner of Impact Healthcare REIT and Edward Hunt, Manager of HICL Infrastructure about how their investment companies provide inflation-linked income, the risks posed by rising prices, current opportunities and the social impact of their portfolio. Their comments were collated alongside the views of LXi REIT, Target Healthcare REIT and abrdn European Logistics Income.

Inflation-linked income and upward only rent reviews

Giles Frost, Director of International Public Partnerships (INPP), said: “INPP invests in public infrastructure assets and businesses internationally. Most of these benefit from revenues that are paid for or regulated by government. The majority of such revenues are explicitly linked to inflation without caps. So, while inflation linkage in the portfolio may vary from investment to investment, we calculate that on average INPP’s overall return from its portfolio is expected to increase by 0.7% per annum in response to every 1.0% per annum increase in inflation.”

Andrew Cowley, Managing Partner of Impact Healthcare REIT, said: “All our leases are long-term (20 to 30 years) and 100% of our leases have annual upward-only rental increases linked to inflation, with collars and caps of 2% and 4%. Shareholders also benefit from our accretive cost of debt at an average of 2.93%, providing them with further value in these times of high inflation.

“Our tenants have established track records of successfully passing on above inflation costs through fee increases. Importantly, our rent cover remains high at 1.95 times, showing that our tenants have sustainable, profitable businesses.”

Simon Lee, Fund Manager of LXi REIT, said: “Our income stream is protected against inflation with 96% of contracted rents containing upward-only index-linked rent reviews or fixed uplifts. We gear our returns with conservative levels of fixed or capped debt, and our debt book has a weighted average fixed cost of 2.9%.

“89% of our rents are capped or have fixed uplifts, with an average cap of 4% per annum. Capped rental uplifts are a necessary conservative measure to avoid rents growing too out of kilter with open market rents on equivalent properties and eroding operator profits.

“76% of contracted rent reviews contain either a collared or fixed uplift, averaging 2.0% per annum, which is an effective income growth hedge in a lower inflationary environment.

“Generally, over the life of the group’s leases, which average 21 years to first break and are regularly recycled, we expect inflation to average within our cap and collar and therefore our leases to be effective inflation hedges.”

Kenneth MacKenzie, CEO of Target Fund Managers which manages Target Healthcare REIT, said: “All of Target’s leases provide a robust opportunity to secure inflation-linked returns. They are tied to annual RPI uplifts, with collars and caps to ensure sustainability. Of course, even these inflationary uplifts are only as good as the underlying profitability of the tenants. Owning and operating top-class care homes results in a preponderance of private pay clients for our tenants, and full inflationary costs increases are passed to them to enable stability in bottom line performance, rather than the alternative of public pay from a stretched government treasury, needing to limit pay increases.”

Edward Hunt, Manager of HICL Infrastructure, said: “High inflation and greater market volatility serve to highlight the relative attractiveness of core infrastructure for investors. HICL’s portfolio has been deliberately positioned to offer strong inflation protection, a low beta to equity markets, and attractive, predictable yield. These factors ensure that HICL remains a compelling holding for all seasons.”

Evert Castelein, Fund Manager at abrdn European Logistics Income, said: “Unlike in the UK, a typical lease agreement on the continent may benefit from the annual indexation of rents, providing a hedge against inflation. This is one of the reasons why the focus of this income-driven strategy has been aimed at the continent. Of the company’s current expected rental income, 69% has uncapped CPI indexation built in meaning we benefit fully from the much higher levels of inflation witnessed this year, 23% has a maximum cap and 7% is subject to a German threshold indexation clause in the lease agreement. 

“As an example, just recently the company has agreed with the tenant CPI indexation on a lease for one of our large Spanish assets. With inflation levels where they are, this has resulted in a 7.2% per annum rental uplift.”

Where are you seeing the greatest opportunities?

Andrew Cowley, Managing Partner of Impact Healthcare REIT, said: “A key point to keep sight of is that demand for care beds is not directly correlated to the economic cycle, whether it is positive or negative. With our tenants, we provide essential social infrastructure.

“Market conditions in the UK elderly care sector continue to be supported by robust and strengthening long-term structural growth drivers and demographic fundamentals, including a rapidly ageing population, an ongoing shortage of good quality care homes and a need to reduce pressure on high-cost, medical care providers in the NHS.

“We own 134 properties with 7,316 beds, which means we own around 1.5% of the very fragmented UK care home market. This gives us confidence that we can continue to grow in a selective way, sustainable over the long term in partnership with our tenants who provide high quality care.”

Giles Frost, Director of International Public Partnerships (INPP), said: “Current macro trends such as decarbonisation and climate response, demographic changes and an ageing population as well as the general expectations of our communities all mean that we will need new and improved infrastructure. So, we see a very long and attractive future for the asset class. In the short term, our pipeline includes two preferred bidder positions on UK offshore transmission projects (where the revenue streams are 100% RPI linked) and we hope to invest in these later in the year.”

What are the greatest risks to investors in your asset class?

Evert Castelein, Fund Manager at abrdn European Logistics Income, said: “Eurozone inflation hit 8.1% in May 2022 and could push towards double digits later this year. This is weighing on consumer spending and has already driven consumer confidence to its lowest point since the global financial crisis. This is a particular risk to logistics tenants from the retail industry, particularly those selling discretionary items such as fast fashion and consumer electronics. That said, we believe the driver of the logistics market performance in the coming years is set to come from a structural shortage of adequate supply and therefore the impact of weaker demand is not overly concerning right now.

“Petrol and diesel price inflation is a concern for the logistics industry. While this additional cost is painful for some tenants, we also believe this will further drive supply chains to become more localised in order to reduce costs and supply chain risks. This is likely to support an increase in demand for space in Europe and within shorter distances to consumers.”

Giles Frost, Director of International Public Partnerships (INPP), said: “Traditionally governments have found inflation to be more persistent and harder to escape from than they expect. Current global events seem to us to exacerbate the possibility of this risk. We continue to seek as much inflation protection in our portfolio as we reasonably can.”

How are you approaching social impact in your portfolio?

Kenneth MacKenzie, CEO of Target Fund Managers which manages Target Healthcare REIT, said: “As the first social impact investment trust in the UK, we set out almost a decade ago to acquire best in class modern purpose-built real estate. With 71% of beds in the UK not currently fit for purpose, our mission is to provide truly fit for purpose accommodation to care for our seniors, as well as providing a socially healthy environment for them to live well and enjoy community life, all while living with the frailty of older age. Great buildings make better places for staff to prosper and provide greater service to our seniors, as they are equipped with the appropriate facilities for holistic care, including social spaces and wet rooms for all bedrooms, as well as having superb EPC ratings. Investors and debt providers see us as strong ESG advocates. It’s simply what we are.”

Evert Castelein, Fund Manager at abrdn European Logistics Income, said: “Reducing carbon emissions is a key element of our strategy planning. We have taken advice on our entire portfolio and know exactly what our carbon footprint is and are working on a company and asset level plan with target dates scheduling how and when we want to achieve meaningful reductions in carbon emissions.

“Installing solar panels on warehouse roofs is a good example of how we can relatively simply reduce net carbon emissions. We currently have solar panels on ten of our warehouses and are working on initiatives where we don’t have them yet. Such panels provide a source of green energy which can be very attractive to our tenants who are also under pressure to improve their ESG credentials. Another example is LED lighting which we have in all of our buildings.”

Simon Lee, Fund Manager of LXi REIT, said: “In terms of portfolio and investment strategy, our minimum criteria is that we will no longer acquire an asset with an EPC rating of below a C, and we will not forward fund an asset with a target EPC rating below a B. Where a built asset is expected to be a C or lower, we will obtain a decarbonisation report as part of our due diligence process and put in place a short-term plan to improve the asset rating. We have also commissioned decarbonisation reports and initiatives on all assets with a rating C or lower that are more than 0.5% of the portfolio by value.”

“These improvements in strategy have meant that assets with EPC ratings C or above have increased in the year to 85%, and 99% of the assets that the group has forward funded to date achieving an EPC rating or A or B. This shows how positively forward funding contributes to the environmental quality of the assets.”

Edward Hunt, Manager of HICL Infrastructure, said: “HICL is invested in essential assets which more than 20 million people interact with globally. From this position HICL has an exceptional vantage point to progress the ‘S’ in ESG. We view this opportunity in two parts. Firstly, by investing in assets that provide essential services to communities, HICL delivers an inherent social good. Our sustainability strategy also seeks to build on this, by actively driving improvements in the ESG performance across HICL’s assets. To take an example, InfraRed is working with HICL’s portfolio companies to address food poverty within HICL’s UK schools portfolio, for instance by supporting the Community Fridge project at Oldham Schools which provides fresh food to those most in need in the school community. Dedicated sustainability reports for both HICL and InfraRed are available on the HICL website.”

Andrew Cowley, Managing Partner of Impact Healthcare REIT, said: “All our investments are screened for current and potential sustainability, a key part of our due diligence process. Our capex projects have sustainability improvements as a key performance indicator and ‘green’ leases are now standard on new lettings. We have completed the EPC audit of our portfolio and assessed capital cost of improvements to achieve EPC band B, which would require capex of £5m.

“One of our priorities for 2022 is to produce a social impact report and we have begun work on defining and measuring the social value of our investments. Care homes are a cornerstone of social infrastructure, and our investment supports operators in providing essential services to older and vulnerable people, both for self-pay and publicly funded residents

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Notes to editors

  1. The Association of Investment Companies (AIC) was founded in 1932 to represent the interests of the investment trust industry – the oldest form of collective investment.  Today, the AIC represents a broad range of closed-ended investment companies, incorporating investment trusts and other closed-ended investment companies and VCTs. The AIC’s members believe that the industry is best served if it is united and speaks with one voice. The AIC’s mission statement is to help members add value for shareholders over the longer term. The AIC has 360 members and the industry has total assets of approximately £265 billion.
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