Uncertainties lie around the corner for road and rail infrastructure in the US. Christopher O’Dea reports
Road and rail assets in the US are expected to continue delivering positive performance based on stable, if modest, growth in underlying traffic and revenue. But the sector faces challenges stemming from potential changes in federal funding for transport infrastructure, despite President Donald Trump making rebuilding roads, bridges and railways a top priority.
Ultimately, the performance of road and rail assets hinges on economic growth, and while expectations are that Trump’s pro-business policies will help revive US growth, his protectionist stance on trade could have a negative impact on US roads and railways if his policies hinder global commerce.
There is no doubt that roads and railways have attracted the attention of institutional investors looking for long-term, secure income streams. Roads present the widest range of risk-reward profiles among the sub-sectors that comprise the transport allocation within an infrastructure portfolio. And the reach of railroads into institutional portfolios has increased over recent years, with both rail lines and rolling stock now being options for investors to consider. Inclusion of rolling stock expands the investment horizon in several unexpected ways, offering numerous combinations of tapping potential revenue streams from passenger and freight traffic.
While such considerations can give institutional investors justifiable cause for caution when deploying capital to the transport sector, some recent bright spots have emerged in the US toll road segment. The good news shows that when projects are financed with reasonable capital structures based on conservative traffic projections, they stand a good chance of delivering to investors the comfortable ride they expect from these essential assets.
Transport assets are “definitely a key part of a well-constructed infrastructure portfolio”, says Karen Dolenec, global head of real assets at Willis Towers Watson. But building the right exposure for any pension fund – that is, an allocation that provides secure cash flow without taking on undue risk – can be like threading a needle.
One of the key issues, Dolenec says, is that availability of transport assets can vary between countries, leading to geographic skew towards countries where private investment in transport infrastructure is more common. This can introduce incremental additional exposure to the economic prospects or regulatory regime of a particular country or region. In the US, few transport assets are available to investors due to the history of municipalities owning and operating roads, bridges and ports. This can lead to bidding contests for scarce assets.
It is easy to understand the attraction the sector holds for investors. Supported by the broadening economic recovery and sustained low fuel prices, US toll road performance in 2016 was robust, with revenue growth outpacing increases in traffic. Year-on-year traffic growth rates since 2012 ranged from 3% to 7%, Fitch Ratings reports, while revenue growth rates were between 4% and 8% during the period. With economic conditions improving and oil prices low, US consumers took to the roads during a mild winter in the Northeast and Midwest in 2016, producing exceptionally high year-on-year growth last February, with traffic and revenue up 13% and 14%, respectively.
Low fuel prices are expected to buoy transport infrastructure assets in 2017, with a particularly favourable effect on toll roads. Toll roads typically help lighten the load on toll-free routes, while improving economic conditions allow for toll rate increases. Fitch director Tanya Langman says: “Congestion relief and infrastructure renewal needs will continue to necessitate debt borrowing and investing by large transportation enterprises.”
This presents opportunities for investors, but given the link between underlying economic growth and transport-sector performance, they would be well advised to look both ways before moving into the fast lane. In fact, “we’re looking carefully at exposure”, says Dolenec. “It’s important to have some transport exposure because of that economic linkage in the event that things surprise to the upside. But our view is that, on the whole, we’re not in a significantly expansionary economic environment where you want to overweight it because the outlook is so exciting.”
Transport assets can fit into a wide range of investment strategies, and allocating capital within the transportation bucket poses challenges. “Transport is a tricky one because sub-sectors span quite a wide range of risk profiles,” Dolenec says. “We tend to think about the risk-reward spectrum.” In general, roads “span the widest possible range”, she adds. “You can have roads that are structured very much like social infrastructure projects which are availability-based. Or you can have toll roads which require the operator to assume all of the volume and pricing risk, as well as maintenance obligations.” From a risk-reward perspective, “that’s a very wide sector.”
The opportunity for private investors is that road networks in and around US cities that have experienced the most rapid growth over the past decade are now under severe strain, taxing both the financial and engineering ingenuity of authorities at the local, state and federal levels.
In Seattle, for example, where multi-family housing prices have been rising faster than in any other city, transit officials, companies and residents alike are carefully watching the progress of a new 17-mile toll lane. It is designed to relieve congestion along US Interstate 405, which connects the city to the suburb of Bellevue south of Seattle.
State data show 51,000 drivers use the single-toll lane each day, saving, on average, 11 minutes southbound and 14 minutes northbound during peak times. The average toll is $3, but it can reach $10 during the rush hour. The project has sparked controversy, illustrating the importance of strategic planning and accurate forecasting. While drivers using the entire 17-mile corridor save a few minutes on their journeys, the new toll lane has simply shifted traffic choke points without reducing overall congestion. This is because the state of Washington opted for only one toll lane by converting a free car pool lane, which has proven not to have the capacity to handle a rise in traffic resulting from Seattle’s strong job growth.
Most new capacity in the US in the near term is likely to be in the form of additional toll managed lanes, Fitch predicts, reflecting the need in already-congested urban corridors. While these projects “certainly entail risk, traffic demand patterns in the existing corridor are well understood”, Fitch says, and costly new right-of-way needs “should be more limited than for classic greenfield construction”. Perhaps most important, drivers use the toll lanes: “Performance data across the sector suggests an increasing acceptance of these facilities among the public.”
Unified supply chains
While roads present a wide risk-reward spectrum, rail is “probably be more akin to what people think of as core infrastructure”, says Dolenec. But rail brings its own risk considerations. “You have a range of issues with government and regulation, and those can be quite significant,” she says. Rail infrastructure encompasses both tracks, and more recently, rolling stock.
“In certain jurisdictions rolling stock as an asset class is well-recognised within the infrastructure space. The rationale for rolling stock being an infrastructure asset is that, even though your contracts are with operators who might not seem like the best credit, the fact of the matter is that rolling stock is running on those tracks, and it is running a particular route.”
That certainty creates the security of revenue that institutional investors look for in infrastructure assets. “That route has to be run by somebody,” she adds, “so whether it’s run by a particular operator, or the government replaces that operator, the government is not going to let passenger routes not be run, so you essentially have a kind of government back-stop.”
The implicit backing of passenger service can create problems where freight and passenger cars share the same rail infrastructure, Dolenec says. “The rail infrastructure operator then needs to work out how much of their fees are being covered by passengers and how much will be covered by freight,” she says.
It is a critical calculation. “I think what that means is that you effectively have almost a cap on the returns that you take on the freight side, because to the extent that an operator starts making too much money on the freight side, there will be pressure to re-adjust the access charges.” The reason is simple, she says: “Passengers are the voters.”
In the US, analysts say some infrastructure managers have started pointing to shorter rail lines that feed major trunk routes as the next opportunity in a sector consolidating regional capacity into a nationwide network. The trend is gathering pace from an increase in intermodal shipping, in which containers are transferred directly from ocean freighters to rail for rapid movement around the US.
The practice “takes advantage of the best potentials of all the modes of transportation”, says Anthony Hatch, an independent transportation analyst. “It gives shippers the flexibility of trucks, the economy of scale of freight rail and the global reach of maritime.”
Intermodal shipping is transforming US rail transportation from a business of hauling single commodities like grain or coal, to one based on precision scheduling in which trucks and trains are part of unified supply chain. That is making railroads a competitive option for shorter freight journeys that used to be the sole domain of trucks travelling on congested highways, in turn raising the value of shorter rail lines that extend from seaports to auto plants and industrial parks far inland.
The new approach promises to bind the performance of both road and rail assets more closely to economic growth than ever before. “In today’s global economy,” says Hatch, “improvements like these can make or break a business, and they have a major influence on consumers’ choices.”
Uncertainty facing US transportation assets in 2017 revolves around political risks. The Trump administration has made infrastructure investment a priority, but the timing of any federal stimulus package is unclear. “A detailed plan for infrastructure spending from the new administration, coupled with concrete legislative proposals, could provide longer-term clarity regarding federal funding,” according to Fitch.
But most road and rail projects ultimately need funding and regulatory approval at the state and local level before they can move ahead. “A lot of the opportunity in the US transport sector is going to be at the state level,” Dolenec says. The administration’s request for potential projects from governors of US states “gives us good information about where the administration’s priorities lie”.
Trade tensions are running high as well. Several bridge systems represent major gateways for commercial traffic between the US and Mexico under the North American Free Trade Agreement. The potential for increased border security could make border crossings less attractive, says Fitch. Significant traffic and revenue declines could adversely affect credit quality of assets such as the Laredo, Cameron County and McAllen International Toll Bridge Systems – although at present these systems “demonstrate significantly stronger financial flexibility than peers at their respective rating levels”.
The urgent need for capital to build better US roads and railways was on full display during the inauguration. By tradition, the president-elect crosses the Potomac to lay a wreath at the Tomb of the Unknowns at Arlington National Cemetery in Virginia. This year the Trump motorcade took an alternate route from Washington DC because Arlington Memorial Bridge was closed to traffic to prevent further damage to it.
Houston, we have takeoff
As if hosting a record-setting Super Bowl game was not enough, Houston is aiming for an even tougher target – operating a financially robust toll road. With a highway system taxed by population growth, The Grand Parkway Transportation Corporation (GPTC) in 2013 issued $2.9bn (€2.7bn) of toll revenue bonds to finance the design and construction of major sections of a third ring road around Houston.
Greenfield toll roads globally have historically struggled to meet projections, but the Grand Parkway “is well on track to meet expectations relative to its original finance plan”, says a recent Fitch Ratings note. Since opening, traffic on Grand Parkway outperformed not only the Fitch base case, but transactions also exceeded the sponsor’s forecast by 42% through May 2016.
The system reached “substantial completion” on 29 March 2016. That was approximately six months behind the original schedule, Fitch says. But it was within budget – and full-system traffic and revenue levels through eight months of operation indicate that the tally for the first full year will be substantially greater than originally forecast.
The positive performance marks a departure from the long-term trend of toll roads falling short of projections. The North Carolina Turnpike Triangle Expressway, Central Texas Turnpike System, and the Grand Parkway have all operated “at or close to original projections”, Fitch says. The bright spot includes the less-proven area of managed lanes, where most of the toll corridors opened in the past two years have performed close to initial forecasts.
Those results mean “greater conservatism is being incorporated to address opening year and facility ramp up risks”, Fitch says. It is a good sign for investors, but still too early to be called a meaningful shift in the standards and quality of forecasts. “Only success on new projects over a period of a decade or more will provide greater confidence that forecasting techniques and input assumptions are more reliable and that this performance may in fact be sustainable.” Only time will tell, but the road looks brighter ahead than behind.