While liquidity may be perceived as a barrier to investing in real assets, when managed appropriately at the portfolio level, they can deliver investors access to relatively defensive investments. This was one of the themes of discussion during the real assets webinar that was part of Channel Capital’s recent Asset Allocation Virtual Series.
Real assets are tangible assets investors can access via equity or asset-backed debt. They are often defensive in nature and provide stable cash flows, particularly if they are contracted and CPI-linked to offset inflation. They can be useful in an institutional portfolio because they can provide uncorrelated returns to equity and bonds and help mitigate volatility.
“Real assets can help mitigate overall volatility and provide stable cash flows when you’re trying to construct robust, resilient portfolios. This is especially true if cash flows are contracted to high-grade corporations or government.
The yields these cash flows create are also generally higher than investment-grade bonds whilst arguably offering lower credit risk,” explained moderator Phil Webb, Investment Director, Australian Impact Investments.
This was especially true during the market correction earlier this year, when bonds generated almost no yield, equity valuations plummeted and dividends vanished.
Explaining his approach to investing in real assets, Tim Short, Capital Dynamics’ Managing Director, Clean Energy Infrastructure, who is based in the US, said, “it's no longer good enough to sit at a desk in Manhattan and tell yourself that you can really generate above-market returns investing in renewables. You need capabilities that stretch much closer down to the asset level. That's how you find value in a dynamic environment right now, where assets and opportunities are diverse.”
Short explained renewable energy is the largest single sub-sector of all infrastructure globally by value and volume, and the US is the second-largest renewable market.
“We're moving towards a market-driven change towards renewable generation, driven by solar and storage. There is no greater accelerator than energy storage that allows clean energy to provide a traditional power product.”
The combination of natural gas and battery energy storage will together facilitate the integration of low cost renewables, while also driving out almost all baseload coal entirely. Over the coming decades, there will be a natural retirement of these natural gas facilities that corresponds well with the transition to cleaner alternatives.
“We're moving from a fossil fuel part of the base load to a more intermittent production profile, and like any transition stage, it can be problematic. We've got potential future supply issues and antiquated structures with significant bottlenecks on the east coast and an uncertain regulatory environment. But regardless of what politicians say, the market has decided renewables plus storage is the way forward. The reduction in the cost of storage is really helping to drive that movement,” he said.
Short unpacked the US market in comparison to Australia. “There are a lot of state-level drivers and renewable portfolio standards, with renewable targets set at the state level. Those have only increased over time. Each state has a requirement for utilities to procure a certain amount of clean energy. As the market has become more economic, that's reduced the boom-bust nature of the industry, which is what Australia has suffered from in the past, where there's only a couple of large states with large demand. If the incentives go away, the whole industry has to reshape itself,” he explained. Nonetheless, “there are still valuable investment opportunities in renewables in Australia, but you have to be very careful with your due diligence.”
In contrast, new targets are constantly being set in the US, creating a diverse set of opportunities where investors can create meaningful value. “That means that the industry has true scale. You also have an understanding that long-term contracts are important.”
Turning to the investment thesis for renewables, Short explained real assets fit well into portfolios because of their long-term contracts and stability of cash flows that are largely insulated from both macroeconomic shocks and movements in commodity prices. This has been largely evident during the Covid-19 crisis where renewable assets have continued to offer stability to investors via fixed price contracted cash flows and steady generation during a time of great volatility. “Aside from their uncorrelated returns, valuations are also stable.”
It’s also important to understand there’s a vast difference in investments across the real asset spectrum.
Matthew Tominc is the Chief Investment Officer of impact investors Conscious Investment Management, which focuses on earning a market-rate financial return as well as delivering tangible positive social and environmental benefits.
Tominc said as an impact investor, his business focuses on three things: environment and climate, health and education, and sustainable development. “Step one in our investment process is to address those challenges. Step two involves acquiring properties and other real assets, or funding programs and providing asset management rights to charities and socially-minded enterprises.”
The process of handing over asset management rights to a charity or social enterprise involves supporting them to operate an asset to have maximum additional and positive social impact. “Real assets and social infrastructure, correctly built, can have additional positive impact on society. It's why they can be so critical to portfolios.”
An example is specialist disability accommodation (SDA), which is one of Conscious Investment Management’s investments. “It’s an investment we love; we're the second-largest owner of SDA apartments in Australia. We focus on partnering with the best charities to supply properties they operate.
In Australia, a hidden problem is young people with disabilities living in inappropriate housing, often in residential aged care. To address this, the Australian government is encouraging investors and developers to build appropriate housing stock. It has developed an incentive scheme through which investors buy apartments or build houses focused on that cohort, giving them choice, control and appropriate housing.”
Says Tominc: “We don't take development risk. We own the apartments and we have them built to standards − that means the right people can live in the right homes. The properties are modified to include accessible kitchens, accessible bathrooms and hoists. The properties are operated under 20-year schemes through which they are let to the Commonwealth government.”
Assuming houses are let, Conscious Investment Management takes on Commonwealth government credit risk, earning high cash yield easily valued under a discounted cash flow model, just like a long-term power purchase agreement. Investors are exposed to vacancy risk, in the same way as other property investments.
Tominc explained not all real assets are created equally. “Stable cash flows are a key reason real assets fit into a portfolio. But it is important to be aware of issues like liquidity. So always make sure the assets suit your investment mandate.”
Stable cash flows are equally critical to Short and his team. “From a portfolio management perspective stability of cash flows doesn't just create the yield, it also feeds into the valuation, which is helpful in terms of overall portfolio volatility. You do have to be careful, but a provision towards these investments is helpful from an overall portfolio management perspective.”
Get our latest updates and investment manager performance reports