Real assets: A positive long-term story

By Jayson Forrest

As investments, real assets offer investors diverse opportunities to access a range of assets that can deliver income, inflation protection, and have a low correlation to equity markets. Mary Power (JANA Investment Advisers), Michael Sheffield (Dexus), and Campbell Ross (Octopus Investments) discuss real assets as a natural inclusion for portfolios.

As an asset class, real assets cover a diverse range of physical assets. They are generally categorised into three categories:

* Property: REITs, commercial, industrial, retail, and residential.
* Natural resources: energy, oil and gas, timber, agriculture, solar, mining, and commodities.
* Infrastructure: transportation (roads, airports, railroads), utilities, and telecommunications.

A characteristic of real assets is they usually have a contract attached to the asset, which helps deliver the total return from the asset — such as rental agreements in commercial property. These investments tend to be appealing to investors, as they generally deliver: high income, inflation protection, and have a low correlation to equity markets.

In an IMAP Specialist Webinar on ‘Real Assets’, Michael Sheffield — Executive Director at Dexus — acknowledges that while real estate and infrastructure are typically viewed separately, he believes there is a merging of these two categories. As an example, he points to airports, where up to 50 per cent (or more) of the asset might comprise of real estate, with the other component being aviation-related infrastructure and services.

“Where two asset categories crossover, there is a real opportunity to unlock potential in these types of assets,” says Michael.

Campbell Ross — Head of Wholesale at Octopus Investments — believes it’s important to consider renewables as part of any exposure to real assets when building portfolios. Looking at renewables, he says whilst investors were previously focused on late stage projects, this has changed, as investors are now looking at much earlier stages of projects, like solar and wind farms.

While the obvious drawback of investing in unlisted assets is the lack of liquidity and capital lock-up, Campbell believes the benefits of investing in real assets definitely outweighs the lack of liquidity, provided the risk-return objectives are properly understood by investors.

“Real assets are typically uncorrelated to market movements and that can be incredibly valuable,” says Campbell. “When you consider renewable energy assets, you’ve got a free and forecastable fuel source in the sun and wind. They have very attractive revenue profiles and relatively low operating costs.

“In terms of portfolio allocation, renewables have a low correlation to other asset classes and reliable income, because often these types of assets have long-term fixed priced inflation-linked power purchase agreements in place with investment-grade counterparties. This provides renewables with a natural inflation hedge.

“So, for their lack of liquidity, real assets do offer investors many benefits, provided they properly understand the risks and returns. When allocating to real assets, investors need to be comfortable  with illiquidity in order to enjoy the diversification benefits these assets bring to their portfolio.”   

Michael agrees that an attractive characteristic of the real assets sector is the secure income streams that investments can often deliver, with any volatility really coming from the valuation or trading price of an asset.

“Typical investments in equities are generally more volatile, as their income stream in not typically locked in. However, in a real estate asset that has potentially hundreds of different tenants paying rent, this asset delivers a stable source of income, as do infrastructure assets that are often backed-up by very secure contracts or income streams.

“The real asset space is characterised by very stable income streams. If you’re focused on income, then real assets are typically a very good way of getting that income, and they are often a very good inflation hedge. Therefore, depending on what an investor’s objectives are, real assets can be a great way of securing income with an inflation hedge.”

Michael adds there are also different types of risks within real assets that investors need to be aware of, which can happen at the asset level, the sector level, and even the geographical level. These types of risks, along with the diversification of assets within this market, can produce very different income steams for investors.

“This means you need to know what you’re trying to get out of the asset class and look at what investments are going to provide the risk-return that you’re after,” he says.

When considering real assets, Mary Power — Principal Consultant at JANA Investment Advisers — believes that diversification of investments is important because when it comes to asset allocation, “we’re never going to get it right all of the time”.

According to Mary, real assets have different drivers in different sub-markets. She cites the office sector as an example, where both Sydney and Brisbane have both been relatively strong markets, but not Melbourne.

“In the U.S., there are so many sub-markets across the 50 states and there are a lot of different drivers happening in those states. In the last 12 months, the U.S. has outperformed Australia, so we believe it’s beneficial to have some capital invested in real assets globally. But even within Australia, I think diversification — even at a sector level — is very important. At JANA, we aim to get whole-of-portfolio diversification by including some unlisted assets.”

According to Michael, the investments making up the real assets market are all very different, with some assets performing better than what their valuations would indicate. He says incentives (such as rents) in sectors like property are quite low, as growth continues to come through.

“If you look at the office space post-COVID, employers want their staff back in the office. Employers recognise the cost of labour (wages) is actually quite high, whereas the cost of rent is low. So, if employers can boost productivity by getting their employees back into the office, then that’s what they will do.”

Looking at the office market in Sydney, he says the CBD is constrained, the cost of construction is increasing, and the city continues to experience very strong population growth. If you put these three factors together, Michael says you can expect to see growth in white-collar employment in the CBDs, which is positive for the office sector.

“To justify new development, what I look at is the economic rent. The rent that can justify the cost of constructing a building, which has increased significantly over recent years, is generally higher than what people are currently paying. That means we can expect to see a period where rental growth will actually catch up, which will be a definite opportunity for this sector.”

Despite rising construction costs and a number of builders exiting the market recently — leading to a shortage of residential housing and infrastructure developments across the country — Michael remains bullish on real assets.

“I believe the outlook for both the commercial and retail markets is quite positive,” says Michael. “Although there was a move to online shopping during COVID, we are currently seeing growth in retail assets. We expect this trend to continue, due to strong population growth. Retail assets located in catchments will perform particularly well because of this population growth, and the fact that additional development will be required in those areas to support this trend, like offices, hospitals, and schools.”

He adds: “This thematic around population growth will also be positive for industrial and infrastructure. So, if you look at the outlook for real assets, it’s a positive long-term story.”  

It’s a view shared by Mary, who adds that in sectors like commercial, there is bifurcation in assets between those that have strong ESG credentials and those that don’t.

“Alongside this difficulty in building new stock, supply will also be reduced when you overlay ESG, which not every building can actually rank highly on. So, the incentive levels (like rents) for the office towers that rank really well, will be a lot lower than other assets that can’t meet this ESG criteria,” says Mary. 

Mary believes real assets provide investors with good investment opportunities, which will help to deliver greater diversification to their portfolios. She also likes the living sector, like student accomodation and retirement living, where there is growing demand but a global shortage of stock.

“Remember, when it comes to real assets, when there’s a lot of noise and negativity (about sectors) that’s where you should be looking,” she says. “When looking at sectors and assets, ensure you put a big emphasis on the asset’s underwriting, cashflow, rents, and tenant demand.”

However, Mary is less confident about the ‘built-to-rent’ (large-scale, purpose-built rental housing that is held in single ownership and professionally managed) space in Australia, given the low yields in this particularly sector. 

“This is a highly developed market in the U.S. that has been functioning well for many years. However, as a market, Australia is much smaller compared to the United States,” says Mary.

Considering Australia’s strong population growth and the current housing crisis, Mary believes there is a need for ‘built-to-rent’ housing, although she acknowledges there has been a reluctance by developers to embrace this market, due to valuations and regulation.

Michael agrees: “In the U.S., the ‘built-to-rent’ market is tried and tested. However, in Australia, it’s relatively new. So, to put the investment in, you’re taking a higher risk. That’s because you don’t know what the demand in the market is going to be, how regulation will play out, and what it’s going to cost to manage the asset. Effectively, you’re taking on all these risks that you wouldn’t be in an overseas investment.  

“It’s going to take time for people to really understand what the risk-return profile is that they’re getting themselves into by investing in ‘built-to-rent’.”

The return of a Trump Presidency to the White House will inevitably have a number of wider implications for markets, ranging from trade tariffs through to inflation, which still have to play out.

“Trump is known for his ‘art of the deal’. No doubt, he will put forward a position which he may not necessarily follow through on, because he is looking to enhance his negotiating position,” says Michael.

“Trump is talking about 60 per cent tariffs with China and 20 per cent with the rest of the world. Will that happen? I don’t know but it’s likely that tariffs will increase, which will increase inflation. This will lead to interest rates remaining higher than anticipated. So, Trump’s policies will impact markets but until the policies are in place, it’s very hard to know what the impacts will be.”

It’s a view shared by Mary, who accepts that some of Trump’s proposed initiatives will be pro inflationary. “There will be disruption of trade. Over the last couple of years, there has been a lot of onshoring in the U.S., which has driven a lot of industrial returns. I believe that will definitely continue.”

While Campbell acknowledges that Trump is not generally pro renewables, he says from a global perspective, it will be interesting to see what he does in terms of supporting renewables, particularly considering Elon Musk’s support of them.

“I expect we’ll hear some noise coming out of the U.S. around renewables and there will probably be a slowdown in the development of renewables globally. But in Australia, the Government will continue to rollout its renewables program, which will provide investors with plenty of opportunities to invest in this sector.”

Mary Power is Principal Consultant at JANA Investment Advisers;

Michael Sheffield is Executive Director at Dexus; and

Campbell Ross is Head of Wholesale at Octopus Investments.

They were part of an IMAP webinar panel discussion on ‘Earning the illiquidity premium: Obtaining the diversification benefits — Real assets’.

The session was moderated by Adam Myers — Executive Director at Pengana Capital.