Freeths Real Estate Law Blog: Income Strip Leases

In these changing times, investors are looking for long term, lower risk investments and income strip investments increasingly fit the bill.

Put simply, an income strip structure involves:

• • granting a long lease (generally for between 30-50 years);
  • to a strong tenant covenant (often a public entity such as a local authority or government department);
  • an indexed rent review mechanism (often annually); and
  • a tenant option to acquire the asset at the end of the term for £1.

The lease is generally a triple net lease of whole, which allows the landlord to strip the income stream from the asset whilst the tenant is obliged to maintain (and often insure) the asset. In addition, the rent is frequently below market, allowing the tenant to sub-let at a profit. These structures are most often used either as forward funding arrangements by developers, as a way of financing an investment acquisition without using traditional debt, or to release equity in an investment (i.e. a form of sale and leaseback).

Why investors like them

• Creates long-term secured income;
• As the asset is of an amortising nature  (i.e. the value of the asset reduces over time), the investor's exposure to fluctuations in the asset's value reduces over time;
• The capital sum paid is generally smaller than on a traditional sale and leaseback, as the investor has no real permanent property rights;
• Given the £1 acquisition option, the tenant is incentivised (particularly towards the end of the term) to continue to meet its obligations, so it doesn't forfeit the option.

Typical parties to an income strip transaction

• Pension funds (as investor);

• Public bodies (i.e. local authorities, universities etc.) who are committed to certain locations and often need to “retain ownership”, but also require funds to acquire new sites or redevelop existing assets.

Issues to watch out for

• Insurance - this is often tricky as the parties' interests are not aligned. An investor wants to ensure income continuity and cares less about the property itself. Tenants will want to ensure that, insofar as they are able, the insurance protects them where the site is destroyed leaving them unable to fund the income strip rent by way of under-lettings;
• Forfeiture - similarly, given the long nature of this type of arrangement, a tenant will want to ensure that the lease contains robust tenant protection provisions, given forfeiture is likely to also terminate the option to acquire.

If you would like more information on this type of lease, whether you're a local authority, a developer, and investor or a would-be tenant, please contact Clive Pearce in our London office on 0345 050 3200.