Security of Income

Security of Income

Rental income is secured by a legal covenant and is not dependent on a decision by the board of a company, as is the case with equity dividends. Rent is also a prior charge on a tenant's assets, above that of secured bonds. In the event of tenant default, the lessor retains the physical asset. This contrasts with an investment in a company that subsequently goes bankrupt or is placed in receivership; in the US, Chapter 11. The degree to which rental income can be regarded as secure will vary with the type of real estate, its condition, the level of tenant demand, and the quality of the tenant's covenant. Thus, ceteris paribus, direct real estate investment may provide relatively secure forms of income for an investor and, if a tenant goes into liquidation, the investor retains the asset. Following liquidation, a company's equity shareholders often receive little or nothing.

Security of income is dependent on two main factors. These are the default risk of the tenant, and the difference between market rent and that passing at the time of default, including the associated costs of finding and negotiating with a new tenant. Rents in the UK are fixed for a set period, with reviews commonly every three to five years. However, the set period varies between asset types and markets, with the rent set subject to the vagaries of lease structure. If market rents fall, the likelihood of tenant default increases. Under modern leases, rent is normally paid quarterly in advance. This timing of receipts differs from, and is more advantageous to that of, other investments, where it is usual for payments to be made half-yearly in arrears. Fraser [1984, p. 142] claimed that the annual returns from prime real estate fluctuate far less than those of other major asset classes,stating that

'Prime commercial and industrial real estate is virtually free of two of the three risk 'strata'34 to which company shares are subject. It faces little risk from the problems of the individual company, and also from the problems of a specific trade or business type. This is because real estate is mobile as between user and, to a certain extent, use. Shops, offices, factories and warehouses can be used by many different companies and types of business, and the problems of a particular company or business type should not cause a prime property to be left unoccupied for a long period. That is why investors are reluctant to buy purpose built factories -if versatility is reduced, the risk of rental voids increases.'

Although, the recent recession in the UK, preceded by over-production in building, has disproved some of Fraser's conjecture, his fundamental point -at the individual property level - remains. However, when considered against a diversified equity portfolio, it has little value. Real estate's main attraction, relative to equities and in common with bonds, is the stability and security of its income stream. Both characteristics that should be attractive to institutions.35


34Fraser defined the three risk 'strata' as exposure to the specific risks of an individual company, sector and economy.

35It should be noted, however, that the reinvestment of large periodic income streams may be viewed as a disadvantage, due to the increased cost of management and concern over reinvestment.