Phil Kent, CEO of Gravis, makes the case for the enduring role of alternative real asset investments in investor’s portfolios.
For much of the last decade, alternative real assets such as infrastructure, real estate and asset-backed investments have provided investors with an attractive source of income in a world where more traditional yield generators remained stubbornly unattractive. That world has changed: public and private bonds now offer a return that is neither negative nor relies on at least one decimal point to register a reading. At the end of June, yields to maturity on 2-year and 10-year UK gilts were 5.2% and 4.4%, respectively. Investors have responded by buying into the sector at scale. Data published by Morningstar shows that short-term GBP money market funds saw a surge of interest during May, receiving estimated net inflows of £2bn taking year-to-date net inflows in these funds to £2.6bn and the Investment Association records that the short-term money market fund sector was the most popular in March and April.
The result has been a significant sell-off in alternative real assets but, in our view, this has been overdone. We observe many Real Estate Investment Trusts (REITs) trading at 30% discounts to net tangible assets, and core infrastructure and renewable energy companies trading at discounts to net asset values in the range of 15 to 20%. We believe this is an undervaluation; as is often the case, markets will overshoot by 20% when the mood is buoyant and undershoot by 20% when the mood turns and becomes more sombre.
Source: EPRA N
Where are we now?
Real assets have common characteristics that endure against a volatile and uncertain wider market backdrop, offering attractive diversification to corporate or government risk harnessing long-term, defensive, and often contracted income. We frequently talk about capital growth and capital protection; the last few months have tested that comment, reflected in the falling prices we have seen. Despite this, there is no doubt that asset valuations for companies within the sector have held up well. In effect, we are seeing a disconnect between value and price, presenting investors with an opportunity to lock in highly prized assets at deep discounts, big yields, and the potential for reversion to the mean.
Notwithstanding the market environment, there are regulatory challenges, which have created their own headwinds. It is encouraging to see these issues tackled head on by Baroness Bowles of Berkhamsted in the Lords, in which she has repeatedly challenged the artificial pricing model currently in use for Investment Trusts (which include Investment Companies and REITs). Her last speech can be read here. We understand she is engaged in an energetic campaign to over-turn guidance regarding synthetic pricing, which many investors and brokers cite as a significant driver of the share price declines experienced this year.
What’s on offer?
Real assets present investors today with a number of benefits their portfolios and society.
- Environmental – assets include a wide variety of projects from renewables to social housing,
- Social – often large and intended for the benefit of society as a whole,
- Governance – London Stock Exchange listing requires significant levels of corporate oversight and process,
- Non-correlated – such is the critical nature of the assets, returns are rarely linked to GDP,
- Inflation linkage – cashflows are often long dated and in many cases are linked to inflation,
- Low-interest rate sensitivity – limited cashflow exposure to short term interest rate movements
- Low volatility – real assets are illiquid in nature and values move slowly, making them defensive holdings for the long-term.
- Long-term – characterised by high upfront costs that are paid back over the long term they are often supported by public sector backed cashflows,
- Structural scarcity – often locally monopolistic and with high barriers to entry requiring planning and environmental consents.
Where are we now?
All asset investments need to be assessed on a case-by-case basis. At Gravis, we have a 13-year track record of understanding real assets and how they are monetised. We think the following are areas that investors should focus on to maximise the benefits described above, particularly in the current economic environment.
- It’s not all about discount rates: discount rates are a helpful guide to understand what level an asset would sell at today. However, if investors are holding real assets over the long-term, changes to discount rates only alter the timing of income recognition, not the actual returns. If I invest in a wind farm at an IRR of 8% and hold this for the life of the asset, all else being equal (in respect of which, see below), changing the discount rate at any point does not change the fact that I will get 8%. It does change when income is recognised in the P&L, with the difference amortised over the remaining life through a ’pull-to-par’. As such, investors should not focus too heavily on discount rates, but on the long-term return generated by an asset.
- Understand cash flow sensitivities: in the context of the above, the important question should be what might impact my IRR of 8%? In the context of real assets this could be, for example, exposure to volatile energy prices, inflation, interest rates on embedded leverage (where rates have not been swapped or fixed), occupancy and rental levels or issues with customer and supplier counterparties (such as default or insolvency). More defensive assets may benefit from government-backed or contractual income and costs with highly rated counterparties. In contrast, less defensive assets have limited certainty over long-term price and volume risks and therefore investors need to be more comfortable with the structural fundamentals underpinning demand for the goods and/or services generated by an asset.
- Stage of the asset and financing: we would be more wary in the current environment of exposure to projects in development or that rely on asset disposals and/or refinance assumptions to underwrite value. Increases in capital cost, driven by higher commodity and supply chain costs, compounded with increased financing costs, risks making projects in development unviable. Understanding the sensitivity to cost increases and focusing on operational assets with locked-in financing and ongoing capex costs, would be areas of focus for us.
The return of yield to traditional fixed income has provided welcome relief to many, as portfolios return to more traditional allocations with which investors and clients are familiar. However, the alternative real asset investments that have satisfied investors demand for income during the ten-year sabbatical of traditional sources, is being unfairly forgotten. Real assets have structural characteristics that endure over the long-term and provide an important, non-correlated, diversifier in investment portfolios. The all-time low pricing that has resulted from capital re-allocating away from these sectors represents an attractive entry point at the current time.