Volatility presents challenges and opportunities for investors. James Tarry and Luke Layfield discuss what’s next for real asset investors focused on the climate transition.

Read this article to understand:

  • How the recent turbulence has impacted real asset markets
  • Why the coming months could present significant buying opportunities for climate-focused real asset investors
  • The implications for investors of new policies on both sides of the Atlantic and other structural dynamics

After the challenges of last year, investors might have hoped for a less eventful opening to 2023. But the uncertainty that characterised much of the last 12 months or so has continued. Troubles in the banking sector in the US and Europe have highlighted how vulnerabilities to rising interest rates can spring up in all parts of the economy. 

The tough environment has weighed on real asset valuations, particularly in the property market – according to MSCI, no major market globally saw sharper falls than the UK in the second half of 2022. But while some investors have been forced into selling assets at steep discounts to raise liquidity, others with capital to deploy have been able to take advantage.

Meanwhile, the climate crisis continues to loom large over economies and markets. According to the UN Environmental Programme’s 2022 Global Status Report for Buildings and Construction, the release of which came during COP 27 in November 2022, emissions from construction and buildings hit a new high.

To make sense of what these short- and longer-term dynamics mean for climate-focused real asset owners, we sat down with James Tarry (JT) and Luke Layfield (LL), managers of the Aviva Investors Climate Transition Real Assets strategy.

How has recent volatility affected real estate asset markets, particularly from a climate transition perspective?

JT: Over the past six months, we've experienced a rapid rerating in real estate and the wider investment market. This was a consequence of structural shifts in interest rates, which caused sharp movements in real estate capital values. These were more marked in the UK (down 21 per cent as at the end of February), while they lagged in Europe (down ten per cent as at the end of December). We expect more to come in Europe over the following months as those markets catch up with the UK.

We focus on assets and sectors with solid fundamentals and clear net-zero alignment.  While they might experience volatility over the shorter term, we believe such assets will deliver strong and consistent performance over the medium term. On the occupational side, having the right assets in the right locations will support values and growth, especially in markets where there are supply constraints and limited development opportunities.

We focus on assets and sectors with solid fundamentals and clear net-zero alignment

Two examples in our portfolio are Curtain House, located in the technology cluster in Hoxton in London, and the FOZ building, located in the central business district in Amsterdam.1,2

Curtain House is a refurbishment of an existing Victorian warehouse office conversion and is emblematic of our transition strategy. FOZ is a recently built office and retail space. Both are best-in-class offices, with amenities and outstanding climate credentials in space-constrained markets.

In terms of new real estate opportunities, the coming months should offer the possibility to exploit mispricing as the market shakeout continues. This plays strongly to our multi-asset approach, as we can allocate to different sectors at different times. Currently, we are seeing good relative value in other asset classes and are in the process of allocating further to forestry and European infrastructure.

In which real estate sectors do we expect to see opportunities?

LL: On the residential side, the build-to-rent (BTR) sector is interesting. We focus on locations where demographics and affordability issues support strong rental growth. For example, in the UK, through our partnership with Packaged Living, we are developing single-family housing in suburban locations. In Europe, we are looking at multi-family BTR in major cities, such as Barcelona; this is an asset class with strong fundamentals.3

In logistics, the growth of online retail remains a structural tailwind for rental growth. The sector has been keenly repriced – yields fell sharply as people priced in rental growth and we have seen lots of development. On the flip side, as interest rates have moved, this has created attractive entry points.

Historically, the focus has been on big box logistics. An area that has been less exploited is last-mile delivery. Those sites are harder to find and need to be more connected to urban areas and customers.

Some operational sectors can be defensive in a recessionary environment

Some operational sectors can be defensive in a recessionary environment. Pressure in the residential sector, such as the densification of living space, creates demand for self-storage, making that sector resilient. Demographics are also favourable for student accommodation, particularly in the UK, where the number of 18-year-olds is projected to increase by 40 per cent over the next decade.

Other sectors are not out of bounds, but we will be opportunity-led, as with offices. While COVID-19 led to increased home working, in industries where creativity, collaboration and building trust is important, like the one we work in, there will be an ongoing need for office space. Demand will be for best-in-class assets, which offer amenities to attract staff and good connections to city centres. But we think there will be bifurcation in the office market. Out of town, secondary locations will struggle.

We also can’t emphasise enough the importance of climate alignment in asset selection. That reflects investor appetite and demand from tenants wanting energy efficient buildings to minimise costs and meet their own net-zero targets.

How is the US government’s Inflation Reduction Act (IRA) affecting the infrastructure market? Do you expect European policymakers to respond with their own incentives for green projects?

JT: It's a good question, one that will get more attention as people wake up to its implications over the coming years. The IRA is acting as a significant tailwind for climate tech in the US, providing about $370 billion of subsidies and tax breaks to industries focused on decarbonisation. But you only get these subsidies if you produce and assemble the tech in the US. It's protectionist, but a huge stimulus to those sectors and the US economy.

The European Union and the UK have fallen behind, risking a drain of green tech and jobs in newer technologies such as clean hydrogen, carbon capture and battery storage. Volkswagen and other European manufacturers could delay new battery factories in Europe and relocate them to the US. Similarly, Tesla paused plans on a German factory as only electric vehicles (EVs) manufactured in the US will qualify for a $7,500 IRA consumer subsidy.

The European Union and the UK have fallen behind. The EU is not providing anything comparable to the US

The EU is not providing anything comparable to the US. Recently European policymakers brought in the Net Zero Industry Act, which seeks to incentivise clean tech through regulatory change rather than putting money in people's pockets.

There are also temporary subsidies for sectors such as battery, solar, wind and carbon capture through a temporary “crisis and transition framework”, which runs until 2025. The Invest EU Fund is about a tenth of the size of the IRA.  It seems unlikely current EU or UK subsidies will be sufficient to drive the behavioural changes we need to hit net-zero targets.

That said, this won’t directly impact our investment into renewables projects, EV-charging and fibre broadband. We will see more of the products they need to roll out business plans imported from overseas.

Lastly, although our investments are European focused, we gain the benefits of the IRA through the private equity allocation in our climate transition strategy. We recently closed a small commitment to a US venture capital fund focused on clean tech, where underlying portfolio companies are actively benefitting from subsidies.    

The UK government has promised to make planning for Nationally Significant Infrastructure “better, faster, greener, fairer, and more resilient”. Will this change the infra landscape?4

LL: The planning stage of infra projects is time consuming and inefficient, impacting the pipeline of investable opportunities coming through. Infrastructure planning needs to improve, as increasing demands on the system means the time to get development consent orders has increased from 2.6 to 4.2 years since 2012. To meet our net-zero target, this needs to improve; proposed reforms to increase planning capacity and reduce bureaucracy recognise this and are welcome.

Other policy support is needed to enable sufficient UK infrastructure investment

Other policy support is also needed to enable sufficient UK infrastructure investment. On the renewables side, one example is that it takes more than five years to get a connection to the grid. The government has a target to fully decarbonise the grid by 2035. If it takes more than five years to get a connection for a renewables project, that is not going to happen.

Are there still opportunities in digital infrastructure?

JT: We have made investments into EV-charging and fibre broadband networks, sectors with strong structural tailwinds and climate alignment.

Fibre is an enabling technology for the transition – avoiding carbon through remote working and providing the data needs for climate solutions such as smart meters and smart buildings, and it does this much more efficiently than copper from an energy standpoint.

This is not a new opportunity; it is an area many investors are interested in, and it has been a race to meet this demand with significant growth of alt-nets. We have invested selectively in companies with a first-mover advantage in rural areas; given the cost of building these networks, it is unlikely those first movers will face much competition.

People are prepared to pay for a reliable and fast internet connection

We haven’t seen the cost-of-living crisis affecting the take-up of new connections. People are prepared to pay for a reliable and fast internet connection. It’s becoming a utility people expect to have at their property.

On EV charging, we invested in a company called Connected Kerb. It builds and operates EV-charging networks for long dwell destinations and habitual users, rather than focusing on rapid en-route charging. Its business model is to install charging networks on the back of 15–25-year contracts with local authorities, which we view as very positive given its contractual similarity to other infrastructure asset classes.

As part of the climate transition real assets strategy, we invest in private equity to gain exposure to early-stage companies developing low-carbon technologies. Are we seeing any opportunities in this area?

LL: We recently closed our second investment. Both investments are in venture capital funds with a focus on clean tech, so companies creating technologies to avoid, reduce and remove carbon, which are exactly what will enable net zero.

Companies creating technologies to avoid, reduce and remove carbon will enable net zero

Some investments within these funds include smart EV chargers, where you can essentially use the battery in your EV to charge it up with energy when it's cheaper at night and then use it to power your home. Another portfolio company manufactures solar panels that can produce drinking water from the atmosphere. It is equivalent to bottled water with a much lower carbon footprint.

Those are exciting developments, which provide interesting return and diversification benefits, as well as giving us early sight of technologies of the future. Their performance is less correlated with other financial markets, as they have strong structural tailwinds behind them.

What are some of the social outcomes we are looking to achieve?

LL: We use a social value framework that looks at how, through our investment activity, we can improve social outcomes in three areas – access to employment, occupier well-being and supporting local communities.

We perform a local needs analysis for each investment

We perform a local needs analysis for each investment, looking at factors such as income, employment, access to services and green space. That gives us a social baseline, from which we can think about interventions to improve social outcomes through our investment.

For example, the analysis for Curtain House flagged a lack of green space in the area and challenges around employment opportunities. We are considering how we can open up the roof garden of the building, invest in apprenticeships in retrofitting listed buildings and source furniture from local tradespeople, as East London has a strong heritage of furniture restoration. That is an example of how we can integrate social objectives.

Some economists believe we have entered a new macroeconomic regime, characterised by higher interest rates and inflation. What are the implications for real assets investors with a climate transition focus?

JT: Cheap money is a thing of the past and we are instead seeing a normalisation of interest rates. Higher short-term rates will eventually subside, though to a higher level than has been the case for the past ten to 15 years, accompanied by the likelihood of higher trend inflation.

We need to focus on real estate sectors and assets with strong fundamentals

In terms of the implications for us, we need to focus on real estate sectors and assets with strong fundamentals where higher inflation can be reflected in rental growth.

Persistently high inflation works well in infrastructure because many sectors have a natural inflation linkage. Going back to fibre broadband, costs will increase, but inflation will be passed through to the end consumer.

As we said, climate alignment is increasingly central to fundamentals, which will drive demand and support value in the medium to long term. Another near-term consideration is weaker growth – again, assets with stronger fundamentals and climate alignment should be less volatile and more resilient to market movements.

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