Chris Palmer, Head of Illiquid Assets Origination, Phoenix Group, discusses investment opportunities, integration of ESG and how COVID-19 has impacted the return expectations for real assets.
How has COVID-19 and the ongoing crisis impacted the return expectations for different types of real assets?
The crisis has certainly impacted our return expectations. It is now much more important to examine the credit resilience of many of the transactions we look at with a more critical eye than pre-COVID. Some of the assets and sectors that were previously considered to be robust and resilient – such as airports, hotels – have suddenly found themselves struggling and therefore need re-evaluating.
We are now slightly more pessimistic on outlooks for ratings. There has been a raft of downgrades already and we expect that to continue, especially in the UK once the fiscal stimulus such as the furlough scheme is removed. We will need higher returns in the future to take on the increased investment risk.
What types of real asset investments are currently attractively priced? And which look expensive?
Real estate is an interesting asset class at the moment. It is split between either great opportunities or assets you want to avoid, depending on the sector or tenant. The retail sector has had a huge shake up since the outbreak of the pandemic, accelerating existing trends and undergoing perhaps five years’ worth of change in the space of six months. Aside from grocers, retail assets therefore look unappealing in the current market.
On the flipside, we continue to favour logistics businesses, such as Amazon warehouses and equivalents, and multi-family residential assets. We are doing a lot more residential lending, including more lending to local authorities for social and affordable housing in local boroughs, which form part of our sustainable investment ambitions.
From a regional perspective, we like countries with a robust legal framework, so we prefer assets in the Anglo-Saxon jurisdictions of the UK, the US and in North Western Europe, where possible. And with market spreads moving wider you can make good returns in the ‘boring’, safer assets, such as German utilities, availability infrastructure et cetera. Given the environment, ‘boring’ assets are good for us right now.
How much consideration are you giving to the macroeconomic backdrop currently given the levels of monetary and fiscal stimulus globally?
A lot – you cannot avoid it at the moment. We need to manage our assets through the crisis and continue to examine underlying fundamentals, but we also need to manage our assets over the long-term and consider the longer-term trends. For example, you cannot ignore the shift to remote working and the potential impact that will have on society globally: it may be good for video platforms and technology companies, but it will have a negative impact on real estate and particularly on demand for office space.
Our view is that we are not through the worst of the crisis yet
We also have enormous central bank intervention that is keeping the economy alive, meaning asset prices have held up much more than they would have based purely on their fundamentals. Our view is that we are not through the worst of the crisis yet and there is a second wave of corporate downgrades to come, particularly following the removal of fiscal stimulus packages in leading markets such as the UK, Europe and the US.
Are there enough suitable real asset investment opportunities, and how do you think this will change in the next one to two years?
This is a great time for investors in real assets. Valuations and pricing have started to move back in favour of investors as people are more risk adverse. Covenants and structures are also going back in investors’ favour.
However, you still need to exercise caution when picking your sector and borrower. A weak name has a high potential to collapse and fail, but a strong name will survive through multiple market cycles. Our bias is therefore to buy resilient and robust businesses.
How do you integrate ESG into your processes when evaluating real asset investment opportunities?
ESG is a core part of the investment appraisal and is baked into our processes when assessing potential assets. Some of the transactions we’re looking at currently will score well from an ESG perspective, including renewable energy assets and socially-beneficial investments such as affordable housing.
We are finding a greater range of opportunities targeting social issues in particular
We are finding a greater range of opportunities targeting social issues in particular – for example, we recently funded an investment in the Midlands of social housing specifically aimed at black, Asian, and Middle Eastern tenants, which we think is a great initiative and something we’re very pleased to be involved with.
We have avoided opportunities with questionable environmental credentials for some time, e.g. hydrocarbon exploration. However, the ‘G’ in ESG is the more difficult aspect, as assessing good governance of assets can be tricky at times, particularly when you are engaging with small companies where the management are the owners as well. In these scenarios, the governance can get quite blurry and we have to be more careful, in a different way to larger companies, where there is usually better disclosure and separation of responsibilities.