Published on: 07/07/2021

Investment Funds Availing of Irish Government Bond Arbitrage

Contents

Background

Interest rates have hovered close to 0% for over a decade now. It is unprecedented for rates to have stayed so low for so long. If you are an investment manager charged with growing a pool of capital, for example for a pension fund, low to no interest rates make your job quite difficult; you are starved of the yield you require.

Warren Buffett once said that interest rates act like gravity on asset prices; the higher the interest rate, the lower the asset value. The reason for this is that the higher the rate at which future expected cash-flows are discounted back to the present day, the lower the present value of those cash flows and by extension the lower the value of the asset that generates them. The reverse is also true: if future cash-flows are being discounted back to present value at almost 0% interest rates, asset values soar. That is what we have seen in global stock markets over the past decade. As more asset managers piled into equities driven from the paltry returns and increasing risk of the bond market, they became more than fairly valued with only downside potential in the medium term as companies struggled to generate the level of profit required to justify these extreme valuations. As lenders chased yields, the underwriting standards of corporate debt plummeted as companies, that in normal times, would not be deemed creditworthy, received large sums of cash via bond issuance. Covenants were relaxed, payment terms extended and rates were low.

As asset managers scoured the investment vista, opportunities to make stable returns seemed non-existent. Managers who can’t put money to work will ultimately have to return it and won’t be allocated any more funds. Warren Buffett has come under increasing pressure over the last number of years for his inability to make investments and on the investments that he has already made, he hasn’t outperformed the market for many years at this point. This has led to a situation where the world’s most famous investor is now sitting on close to $150,000,000,000 of cash. The famed investor simply cannot see any value anywhere so his “dry powder” builds and builds and builds. Buffett should by right return this money to investors by means of a dividend as he can’t spend it; alas he prefers to hoard the cash in the hope that opportunities will emerge. While he waits, increasing inflation will eat away at his buying power i.e. he will soon be generating a negative real return on this cash as inflation rates start to tick up from historic lows.

It is against this backdrop that some international and domestic funds felt the Irish residential property market was as good a place as any to put their money to work. Systemic under-supply and steadily increasing demand owing to a growing population & net migration gave investors comfort that this was an asset class that offered safe, reliable returns.

But tenants come and go, boilers break, complaints are made about neighbours in the middle of the night etc. The more astute funds quickly realised that they could buy certain properties and rent them at slightly below market rent to the local Council. Local Councils don’t have the funds or the manpower to build so often prefer to enter into off-balance-sheet long term (25 year), self-repairing leases. Throughout the lease term, the Council is responsible for repairing and managing the asset and when the lease expires, ownership remains with the investor. It really is hard to understand how a Government can be this economically illiterate in that it would be cheaper to build the property themselves or buy it but instead they rent it, maintain it and deliver it back to the owner in 25 years to sell at a profit. Many articles have been written in mainstream publications highlighting this absurdity but the practice continues to this day. Investors can have their asset and rent it. This got investors' attention and they came en masse with cash to put to work.

To ensure that there is no chance of downside, funds often bring the relevant Council out to view the property to confirm that they will indeed rent it, and at what price, before they will buy it. For those successful in buying a property and renting to a Council on a 25 year, self-repairing lease at let’s say a 6.5% yield, they have in essence created an Irish Government bond yielding 6.5% i.e. a hands-off risk-free return of 6.5%. Actual Irish Government bonds yield a fraction of that and are close to 0%.

Irish Government Bonds are yielding close to 0% at present.

With a Government bond, on maturity, you receive back the amount you invested, having collected the interest payments along the way. But with a 25 year, risk-free, self-repairing Local Authority lease, not only do you get the yield over the years but you also get full exposure to the expected capital appreciation in the asset for the duration of the lease, without the work or expense of maintaining the asset. The rent is inflation adjusted also for good measure which a bond isn’t.

Arbitrage is when the same asset is priced differently in different markets. Here we have two 25 year, risk free cash-flows underwritten by the Irish Government. One cash-flow yields almost 0% while the other is over 6% with the kicker being that the holder of the “bond” also can expect at least low single digit capital appreciation on the asset over the period and the rent is inflation adjusted.

Let’s suppose an investor could put €100m to work with a 6.5% yield. As property is being purchased, it would be reasonable to assume that some leverage would be used. So of the €100m, let’s assume a reasonable 40% is equity with the remainder in debt. This €100m will generate risk-free rents of €6.5m per annum. This “bond” could be marketed to yield starved pension funds at an attractive risk-free rate of say 4.5%; this would value the “bond” at €144m. So an equity investment of €40m generates a profit of circa €44m or a return on invested capital of over 100%. There is of course work involved in sourcing the properties and doing the deals with the Councils but once a portfolio of these deals is assembled, they are very valuable indeed. Here’s what such a deal looks like when presented to the market: https://www.irishtimes.com/business/commercial-property/dublin-social-housing-portfolio-guiding-at-21m-1.4549153

Has Stamp Duty Spoiled the Party

It had looked like the 10% stamp duty for those buying more than 10 residential units per annum would bring an end to the party. However, properties bought in order to rent to Councils on long term leases are exempt from the higher rate.

Conclusion

The Irish Government has presented investors with an offer they can’t refuse and so they don’t; one can’t blame investment funds for availing of this incredible opportunity to generate such massive returns. With many funds competing for these deals alongside owner occupiers, it is certainly a great time to be bringing a property to the market.

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