James Tarry and Luke Layfield from our multi-asset real assets portfolio management team discuss the outlook for real estate and infrastructure and how shifts in UK climate policy may affect the push for net zero.
Read this article to understand:
- Relative value in real assets across markets and geographies
- Opportunities in “brown-to-green” real estate
- How UK policy may affect investment in real assets
The investment landscape in real assets has shifted significantly over the course of 2023. As inflation has soared, central banks have tightened monetary policy and assets have repriced at different speeds, affecting relative value across sectors, countries and deal structures.1
Although the pace of rate hikes has slowed in recent months, uncertainty continues to cloud the future path of interest rates and potential economic impact. As well as the short-term risks and tactical opportunities emerging in this environment, investors in real assets also need to monitor longer-term thematic trends, from consumer behaviour and demographic changes to the status of the energy transition.
Policy interventions are also influencing real-asset markets. In the UK, the government’s Mansion House Reforms, designed to encourage defined-contribution (DC) pension schemes to increase investments in private markets, could unlock significant new capital into real assets over the coming years.2
Meanwhile, Prime Minister Rishi Sunak’s announcement on September 20 that certain climate policies will be postponed or scrapped3 has prompted concerns the country may struggle to meet its net-zero targets. This is despite growing private-sector momentum and strong investor appetite for real assets aligned to the energy transition, including low-carbon property, renewable-energy facilities, fibre broadband and electric-vehicle charging networks.
James Tarry (JT), senior real assets portfolio manager, and Luke Layfield (LL), real assets portfolio manager, are part of Aviva Investors’ multi-asset real assets team and also co-manage the Climate Transition Real Assets strategy. They sat down with AIQ to discuss their outlook.
How is continued uncertainty about inflation and monetary tightening influencing real assets?
LL: Inflation is proving sticky and there are concerns about a possible wage-price spiral in some economies. As a result, rates are likely to remain higher for longer. Over recent weeks we have seen tentative signs of inflation coming down, and a pause in rate hikes in the UK and the US. But inflation may not abate as quickly as policymakers hope. On the other side, there is also the risk of central banks overshooting and keeping rates too high for too long, with a negative impact on growth.
While strong assets in sectors with good fundamentals will perform best, we are also focused on repositioning secondary assets in the right sectors and locations
Our base case is that there will be a “K”-shaped recovery in real estate, with prime assets first to recover. Secondary or tertiary assets will struggle and, in some cases, become functionally obsolete.
While strong assets in sectors with good fundamentals will perform best, we are also focused on repositioning secondary assets in the right sectors and locations, where we can add value by upgrading their performance and ensuring they are aligned with the climate transition.
The repricing currently occurring across UK and European markets has opened opportunities to acquire such assets at a discount. There are risks – not least due to high inflation pushing up construction costs – so we are undertaking this work on a selective basis and maintaining discipline in our underwriting. On the plus side, there is less competition for these kinds of assets currently, as fewer investors are willing to put in the kind of work and capital expenditure required.
Where do you see relative value across real estate sectors and strategies?
JT: We see a strong cyclical opportunity in real estate debt. On the supply side, lenders are retrenching, while at the same time borrowers need to refinance as loans mature. Since the market has been rebasing over the past 12 months from a valuation perspective, the downside for debt should be relatively limited given we are nearing the bottom of the cycle.
Industrial assets are underpinned by strong fundamentals thanks to the continued growth of online retail and a structural undersupply of logistics space
Conversely, while there are interesting real estate equity opportunities, transaction volumes have fallen, probably because owners are waiting for a more opportune time to sell. Where we are allocating capital here, we are looking for assets where pricing reflects the risk and offers strong relative value compared with debt.
As for our sector outlook, industrial assets are underpinned by strong fundamentals thanks to the continued growth of online retail and a structural undersupply of logistics space across the UK and parts of Europe. The sector has repriced quickly and represents reasonable value. The living sector has similarly strong fundamentals and is supported by favourable long-term demographics, but it has been slower to reprice.
You previously argued geographical distinctions are becoming less important than specific asset-class dynamics across real estate and infrastructure.4 Is that still the case?
LL: It remains true that the structural trends are broadly the same across geographies. As James mentioned, logistics and living have the best fundamentals in real estate. Operational sectors such as hotels, student accommodation and care also look strong. The office sector is bifurcated between prime, best-in-class space and secondary assets that are much more challenged. In infrastructure, renewable energy and digital sectors aligned to the transition, such as fibre broadband and EV charging, are buoyed by longer-term thematics. All of this applies across geographies.
A diversified approach can smooth investors’ journey through periods of varying performance across economies and sectors
However, the macro backdrop is creating cyclical differences. Inflation varies across countries and rates are rising at different speeds. The UK has been among the worst-hit countries by inflation, partly because of Brexit, and has a structurally higher level of interest rates than Europe. The UK therefore offers higher levels of absolute return for real asset investors and markets there have also been quicker to reprice than most European markets. While this is likely to normalise over the coming months, the UK currently looks to offer better relative value than Europe.
That said, investors should consider a diversified approach, as this can smooth the journey through periods of varying performance across economies and sectors. Structural trends across sectors will play out differently in different countries depending on relative GDP growth. And countries have different regulatory regimes and areas of strength – for example, Spain has far more solar-power generation facilities than the UK, where offshore wind is more prevalent.
Where are the key opportunities in infrastructure across the UK and Europe?
JT: One intriguing development over the last 12 months has been the dislocation between the pricing of debt and equity for some core-plus infrastructure assets. The strong thematic tailwinds for renewables and digital assets, along with the weight of demand for these sectors, has kept equity pricing high. But that may be starting to change and we expect pricing to moderate over the coming months. Meanwhile, infrastructure debt has been quicker to reprice in line with interest rates and looks attractive due to a history of low defaults and strong recovery rates.
We continue to favour growth investments in sectors aligned with the climate transition, such as fibre broadband and EV charging, which are less correlated with interest rates. In these sectors it is also possible to invest through hybrid structures to capture the equity upside while mitigating downside risk, such as via convertible loan notes which maintain share ownership even if valuations prove volatile.
How is client appetite for real assets being impacted by the attractive risk-free rates currently on offer?
LL: We continue to see strong client demand, particularly from investors that had been underweight the asset class and are now starting to recognise the benefits. There are different solutions for different objectives. For cashflow and liability-driven investors, debt can be more attractive; for investors targeting growth, equity or higher-risk debt investments are often a better fit.
DC schemes are showing increasing interest in real assets, as they see an opportunity to boost returns and improve diversification
A year on from the liability-driven investment crisis in September 2022, and subsequent continued rise in interest rates, many defined-benefit pension schemes are now better funded than they were. Having made significant investments in real assets in in the past, these schemes now have less tolerance for illiquidity and are targeting buyouts in many cases. As a result, there has been some selling of real assets from that investor base.
On the other hand, insurers are buying those liabilities. Demand for real asset debt – especially debt structured to be matching-adjustment eligible, which therefore has favourable capital treatment under Solvency II regulation – is particularly strong, as it offers insurers the potential for attractive risk-adjusted returns. DC schemes are also showing increasing interest in real assets, as they see an opportunity to boost returns and improve diversification while also delivering broader environmental, social and governance (ESG) outcomes.
On that, the UK government is trying to encourage DC pension schemes to invest in private markets. What do you see as the potential impact?
LL: The Mansion House Reforms announced by the chancellor in July aim to encourage DC pension schemes to invest five per cent of their assets in unlisted equities by 2030, which the government says could unlock £75 billion of additional capital. The dual aim is to create better investor outcomes while also supporting economic growth (although investments will not be limited to the UK).
We think this is a positive development for real assets. The focus of the initiative is venture capital at this stage, but it shows the direction of travel and an attempt to broaden the types of investments DC schemes make.
Historically, DC schemes have been reluctant to invest in real assets, partly due to concerns around liquidity – which can be addressed through certain investment structures – but also cost. The Mansion House Reforms include a “Value for Money Framework”, which states investment decisions should be based not purely on cost, but also on long-term returns. Investing in real assets offers a way for these schemes to obtain better risk-adjusted returns through accessing illiquidity premia, as well as gaining diversification benefits thanks to the low correlation between real assets and public markets.
Infrastructure investors have repeatedly raised frustrations over the time it takes to obtain approval for new projects in Europe and particularly the UK. Are these delays causing challenges from a multi-asset perspective?
JT: The planning stage of infrastructure projects, and also some real estate projects, takes too long. According to the government’s own figures, the timespan for getting Development Consent Orders for UK infrastructure deals nearly doubled from 2.6 to 4.2 years between 2012 and 2021.5 It can also take more than five years for a new renewable-energy project to get a connection to the grid, which is a significant obstacle in the way of the UK’s ambition to fully decarbonise the grid by 2035.
The planning stage of infrastructure projects, and also some real estate projects, takes too long
More specifically, we have encountered issues with the administration of the Local Electric Vehicle Infrastructure funding scheme, which threatens to impede the wider take-up of EVs. We have also run up against grid limitations for new residential real estate developments that feature low-carbon ground-source heat pumps.
In his speech on September 20, the prime minister addressed the challenges posed by planning delays and acknowledged these bottlenecks need to be fixed to allow the country to meet its net-zero targets.
The cornerstone of the speech was the postponement on the ban on sales of new internal combustion engine (ICE) cars from 2030 to 2035. What did you make of this?
JT: As well as the ICE delay, there was also a change to the government’s policy on gas boilers; an exemption will now apply to 20 per cent of homes, which will not need to replace their boilers with heat pumps.
We don’t believe watering down net-zero policies is the correct course. The UK should be more ambitious than that
From an investment perspective, any kind of policy inconsistency is unhelpful – investors would be better served by having a clearer agenda from government – but it also sends the wrong signal on the broader climate transition. While the UK has made a lot of progress in decarbonising over the last 30 years, there is plenty still to do. We don’t believe watering down net-zero policies is the correct course. The UK should be more ambitious than that.
Nevertheless, reasonably strong climate targets remain in place and some of them apply before 2035. For example, there is a stipulation that 80 per cent of new car sales should be EVs by 2030, with quotas for producers to boost the proportion of EVs they sell. This is likely to move the cost of the transition from the consumer to the producer, which could help speed up adoption. But our view is that this clearly won’t be enough on its own and EV take up needs to be incentivised in this country by building out charging infrastructure.6
The UK’s legally binding 2050 net-zero target is still in place. Logically, this simply means other parts of the economy are going to have to decarbonise faster if the country is to meet this goal. Overall, this should support the investment case for real assets aligned to the climate transition.