• Real Assets

Quarterly update on drivers in real assets - Q3 2019

In our regular update on drivers in real assets, we assess the impacts of a possible downturn in the euro zone. We touch on cash generation, the valuation outlook and the significance of security and ranking in the capital structure.

Assessing impacts of a possible downturn in the euro zone on private assets

The European Central Bank’s decision to re-start asset purchases in September at €20 billion a month highlights more cautious sentiment in the euro zone. While our central scenario is for growth to moderate rather than decline sharply, we look at the impact of a possible downturn for holders of private assets, trying to anticipate the uneven impacts of slower economic growth.

Focus on cash flows

Long income real estate, infrastructure or corporate borrowers with contracted or regulated revenues are likely to see their cash flow generation relatively unaffected, while corporate borrowers in competitive sectors would be most exposed. Historically, corporate profits have been more volatile than rental yields. Cash flows derived from real estate vary with the economic cycle but to differing degrees. Parts of the market have short leases and tend to exhibit a strong correlation betweeen GDP growth and rental values (such as high street shops). These are exposed to a downturn. Other areas feature longer leases, with low correlation between GDP growth and rental values, and are therefore more defensive.

Figure 1.  Through the cycle: tracking the cash flow of corporate and property borrowers
 Through the cycle: tracking the cash flow of corporate and property borrowers
Shaded areas: years where GDP growth fell by more than 1% vs. previous year. Source: Investment Property Databank (IPD), European Central Bank, CBRE Global Investors. As of 2018

Valuation outlook

Secured lenders would benefit from additional protection. Infrastructure asset values are likely to be quite stable, with the exception of economic infrastructure with strong GDP linkages – e.g. ports, or those exposed to commodity prices. On the other hand, property values are more strongly correlated to economic cycles.

 Through the cycle: change in property value
Shaded areas: years where GDP growth fell by more than 1% vs. previous year. Source: UK Office for National Statistics, OECD, PMA, IPD, Aviva Investors. As of June 2019
Figure 2.  Through the cycle: change in property value

Importance of security and ranking in the capital structure

Senior secured creditors would be comparatively well placed. Institutional real estate loans extended at up to 60 per cent of property value can absorb a shock consistent with the average drop in property values experienced during the Global Financial Crisis. Unsecured lenders or second lien lenders are more exposed. The same holds true for corporate lending. Figure 3 compares average losses for various tranches of corporate debt compared to the average interest income for leveraged loans. The average spread is not substantially above the long-term average loss for unsecured creditors (in green), illustrating the value of security.

Figure 3.  Margins and credit losses
Margins and credit losses

Indicative spreads p.a.*

Indicative spreads p.a.
* Additional yield above comparable government bonds **High quality: unlevered infrastructure with largely predictable cash flow. Source: Aviva Investors (for illustrative purposes only). Data as at 30 June 2019. The future returns and opinions expressed are based on Aviva Investors internal forecasts and should not be relied upon as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature.

Key risks

Investment risk

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency exchange rates. Investors may not get back the original amount invested.

Illiquidity risk

Where funds are invested in illiquid private assets, investors may not be able to switch or cash in an investment when they want because private assets may not always be readily saleable. If this is the case, we may defer a request to switch or cash in shares or units. Investors should also bear in mind that the valuation of real estate is generally a matter of valuers’ opinion rather than fact.

Valuation risk

Certain assets held in the fund could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.

Related views

Important information

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