There are important differences between real estate and infrastructure for allocators to consider, writes Derek Williams
Real assets – specifically real estate and infrastructure – are in much demand. Asset allocators are demanding more durable yield alternatives in a world of uncertainty. Tangible, hard real assets are in vogue for pension funds, insurance companies, sovereign wealth funds and family offices alike.
Some in the market, however, are finding it increasingly difficult to underwrite transactions to a credible internal rate of return (IRR). Too much competition for certain deals is causing some alarm at the low level of yield on prime assets, with the backdrop of increasing interest rates and an uncertain geopolitical environment that is having a negative impact on listed asset classes. Real assets will not be immune to all of these and yet allocations keep on coming.
While bfinance views that a credible real asset strategy (real estate and infrastructure, debt and equity) can be created to provide durable income, to do so one has to appreciate the risks in the market.
Many investors new to real estate and infrastructure talk about the two asset classes in the same breath. In our experience, the competition for capital starts at this early stage when an institutional investor weighs up its allocations and can easily swivel from a real estate to an infrastructure allocation and vice versa, this being done with or without expert guidance.
This is surprising, given that, as an asset class, infrastructure is a fraction of the size of real estate as measured by assets under management, number of funds and the sheer variety on offer. Even in recent years, typically three times as many real estate funds are raised versus infrastructure funds, with two to three times as much AUM.
Clearly, infrastructure is a relatively small, growing asset class that is punching above its weight. But based on the current opportunity set and sizing, real estate should typically have a higher weighting than infrastructure. This is particularly true if an investor is focused on core investment.
It seems somewhat counter to the accepted norm that real assets are illiquid and therefore any allocation should allow for this in comparison with the listed alternative. But it is worth noting that real estate has more liquid characteristics than infrastructure. Real estate is a widely brokered market, has scale, relative transparency in pricing and, for core properties, takes just a matter months to sell into the open market to a third-party buyer.
In contrast, with infrastructure there is a smaller pool of assets with a narrower set of buyers/sellers. There is also high complexity in infrastructure projects versus real estate, and often the best buyer will be the one that knows the asset (perhaps is it might be the consortium involved in the project or a former owner of has owned the asset before). Somewhat related to this, we would argue that a core infrastructure asset needs much more active management than a core real estate asset. On this count, asset allocators should demand a higher illiquidity premium from infrastructure versus real estate.
For core assets held by an institutional fund, leverage is typically 20-35% loan-to-value (LTV) in real estate, which contrasts with 60-80% loan-to-enterprise-value in their infrastructure counterparts. It would be disingenuous to suggest that real estate is therefore a safer proposition (after time spent unpicking an infrastructure deal one can appreciate the lower risk versus its property equivalent) but, rightly or wrongly, these higher levels of leverage in infrastructure are a cause for concern for some allocators.
Real estate debt is an attractive and a useful ‘add on’ to a real asset portfolio. Given the size of the underlying asset class, there are a range of strategies from senior to stretched senior to whole loans that are interesting to those investors looking for a decent real return over the medium term. Added to this, real estate debt is a small asset class with strong borrower demand, which means that the best-in-breed investors (lenders) with superior deal flow are well placed to deliver.
In bfinance’s experience, the biggest competition for capital for a real estate debt manager raising capital is a direct lending strategy – that is, a manager raising capital to lend to companies. Infrastructure debt offers very low margins resulting in IRRs in the 2-3% range, which most pension funds will find too low, but for insurance companies looking for a margin pick-up over investment grade corporate bonds it will almost certainly warrant a closer look.
Where infrastructure equity does score highly is that it is very different and intuitively will be a good diversifier. Many of the infrastructure core funds held up very well in the 2008-10 financial crisis years with NAVs declining by 10-15% peak to trough. Core real estate declined 30-45% in most established markets. Some of this difference is due to very different appraisal/valuation processes in each asset class but, at the end of the day, this is seen as a benefit by asset allocators looking at infrastructure.
The mantra amongst real estate managers and their investors is that realised performance is key to understanding the tangible performance of a manager. Top core and opportunity fund managers have bought and sold tens of billions over a market cycle – what better proof to establish your understanding of the market and total return performance? Given the long-term nature of infrastructure projects and ‘newness’ of both the asset class and institutional quality managers, realised performance is less available in infrastructure. This is fine – one can analyse unrealised performance – but this difference between real estate and infrastructure should be noted prior to an allocation.
While the above looks negative on infrastructure versus real estate, bfinance believes there are strong durable income options in both real estate and infrastructure, despite their being very different asset classes. Having helped clients deploy around $5bn in real estate and infrastructure over the last three years, we can say that the above factors have all been discussed at the highest levels at pension funds, insurance companies and other institutional investors we have worked with.
Investors are primarily concerned about the current pricing in the real estate and infrastructure markets, and the other points mentioned above. But on a risk-adjusted basis, by examining the other available options, asset class by asset class, one can envisage 2016 being another strong year, given the relative value to be found in many parts of real estate and infrastructure.
Derek Williams is MD of private markets at Bfinance