Producing income from real assets
Scott Crowe (pictured), Chief Investment Strategist at CentreSquare Investment Management outlines the case for income producing real assets.
Over the past 20 years, the size of allocation and illiquidity associated with investing directly in to real estate and infrastructure tended to put off institutional investors. But as Scott Crowe, Chief Investment Strategist, CentreSquare Investment Management, points out, the growth of the global listed real estate investment trust (REIT) market – a far more liquid and accessible marketplace – has attracted institutions and found its way into their portfolios; firstly into the ‘alternatives’ bucket, but more recently into the ‘real assets’ bucket.
However, as Crowe is keen to emphasise in a recent white paper he authored entitled The Case for Income Producing Real Assets, by including global listed infrastructure as part of an holistic allocation to income producing real assets, investors can achieve more attractive risk-adjusted returns and income generation.
“When you think about what has happened over the last 10 years, prior to the financial crash in ’08 most people used a 60:40 equity/bond allocation as the foundation for their allocation approach. Following the crash, there was an understanding of the need to have better diversification in the portfolio and this led to a growth in allocation into alternative assets; hedge funds, commodities, real estate, private equity.
“What we’ve noticed in our client base over the last three years is that there’s been a defined allocation to what is termed ‘real assets’. These are defined as any asset that derives its value from tangibility and permanence. That definition, though, was, in our view, too broad and failed the primary objective of why investors were investing in real assets in the first place,” says Crowe.
That goal was to reduce volatility and increase income. The most important real assets that help achieve this are income producing real assets that have a cash flow attached to them.
A real asset such as a lump of coal, has high volatility and low, or even negative, income, whereas infrastructure and real estate share the benefits of being economically necessary – both are an intrinsic part of how we live our lives – and derive their value from long-term identifiable cash flows, Crowe says.
“We’ve been talking about this idea (of income producing real assets) a lot with investors. The paper was based on a presentation we had been using with investors six months prior to writing it. Our intention was to re-define the conversation around real assets.
“Investors were basically throwing everything into their real assets bucket that was tangible and permanent. As a result, they owned a lot of commodities and commodity-related equities and if you look at the performance of these investments, it hasn’t delivered. We didn’t think they were actually geared to achieving what they were investing in real assets for, which was income and low volatility,” explains Crowe.
Together, listed real estate and infrastructure represent a USD5.3 trillion market capitalisation. Rather than focus on REITs, investors that include listed infrastructure have the opportunity to enjoy not only a wider universe of investments, which improves diversification and lowers volatility, but also to improve the income generating potential of their real asset bucket.
In a world where safe haven assets such as US 10-year Treasuries are yielding 1.73 per cent, pension plans are not able to meet their long-term liabilities, says Crowe. “What you have right now is an investor community that is searching for a replacement to these safe haven assets and it strikes us that infrastructure and real estate, within the real asset bucket, are able to meet a lot of those needs.”
Listed infrastructure enjoys a substantial existing investable universe with significant growth potential as governments look to privatise existing infrastructure assets, and as the private sector increasingly undertakes new infrastructure investment.
Crowe says that the pace of structural development reminds CentreSquare of the REIT market from 10 or 20 years ago.
“The unlisted infrastructure market is very illiquid and is only suitable for the very largest SWFs and pension funds, but that is now changing with the growth of listed infrastructure as a distinct asset class. If you look at returns in listed infrastructure, they’ve been very attractive. The FTSE Developed Core Infrastructure Index has returned 15.4 per cent YTD, for example. It provides income and low levels of volatility but also tremendously low levels of down market capture; half that of global equities,” explains Crowe.
While there are other asset classes such as timber and agriculture that could also form part of an IPRA approach, the listed markets are not yet evolved enough for those other asset classes.
Just to underscore how much potential there is for listed infrastructure, according to RARE Infrastructure Limited, 75 per cent of the USD20 trillion in global infrastructure assets was still government-owned as at 31 October 2012. But a 2014 estimate by Cohen and Steers suggests that new infrastructure investments in developed and emerging economies could total an additional USD40 trillion by 2030 (FTSE Insight Newsletter, April 2015).
“The returns that infrastructure companies enjoy are multiples of the 10-year bond yield. There is, in my view, a tremendous growth story here. I suspect we will see huge amounts being invested in infrastructure over the next few decades. Many of the companies that we invest in our listed infrastructure strategy are going to be the conduits of this investment.
“In the US, a lot of projects recently have tended to be related to the energy complex but you haven’t really seen a large-scale privatisation move in the US. In Europe and Australia, the infrastructure markets are ahead of the curve with respect to privatisation.
A lot of big energy assets in Europe sit within the regulated utility space. These are starting to be sold, however, such as energy grids in the Nordics owned by Vattenfall and Fortum, although the former is still largely owned by the Swedish government at present.
As more European regulated assets are privatised, going forward, the easier it will be, from a legal and regulatory perspective, to commit to greenfield projects that can be backed with private investment. In the aviation space, European airports such as Toulouse, Nice and Lyon have all been privatised (or are currently in the process), not to mention Budapest airport.
“It’s more than just a government cashing in its assets. What you tend to find is that when these assets are privatised the consumer enjoys a better experience because they are run with a consumer focus. All you have to do is compare Heathrow Airport to LaGuardia Airport. It doesn’t take long ascertaining which one is government-owned,” remarks Crowe.
One of the main attractions of holding listed real estate and infrastructure within an IPRA allocation, is the attractive income generating potential they offer compared to other assets. As CentreSquare shows in its white paper, as of 31 March 2016, 10-Year Treasuries yielded 1.8 per cent, US equities yielded 2.2 per cent, global equities yielded 2.7 per cent, whereas income producing real assets (so both REITS and listed infrastructure) yielded 3.5 per cent.
“We are used to thinking of yields of 3.5 per cent from an income producing real asset bucket as too low but the fact is that is more than two times the yield you get from a bond allocation. You would need to hold 2.3 times more bonds in the portfolio to produce the equivalent yield and that is the conundrum facing institutional investors today,” suggests Crowe.
When included in a portfolio of traditional assets, the IPRA component (for simplicity CentreSquare assumed a 50:50 split) led to improved risk-adjusted returns over a 20-year period: a 7.18 per cent return and a current yield of 2.60 per cent compared to a standard 60:40 portfolio that generated a 5.66 return and a current yield of 2.34 per cent.
Crowe explains that one of the things that REITs do when included in a portfolio is to provide a slightly better growth component.
“If you think about real assets in terms of the equity, bond continuum, infrastructure tends to be a little more bond-like and real estate a little more equity-like. When it comes to including IPRA in the portfolio, it really depends on the investor’s risk appetite and whether they want more of an equity or bond-like outcome from their allocation.
“What we recommend to clients is that as an initial starting point, they take 25 per cent of their real estate allocation and assign it to listed infrastructure,” says Crowe.
If one was to run current government and corporate bond yields through a long-term liability model, based on a classic 60:40 portfolio, one would need to assume that equities are going to deliver low teens returns, which is very aggressive at this point in the economic cycle, says Crowe.
“Are you therefore better off replacing some of that allocation with assets that offer higher yields but not necessarily higher risks? We would argue ‘yes’.
“The bigger picture,” he says, “is that inflation is low, growth is elusive and there’s not much on the horizon that is going to change the overall low-level interest rate environment. If you look at IPRA, and the yields on offer, I think we will see more and more assets flow in to this market as investors look for a bond alternative.