Quarterly update on drivers in real assets - Q2 2019

19 July 2019

In our regular update on drivers in real assets we assess how real assets could appreciate amid lower long-term rates, we look at how lower bond yields are likely to extend the real estate cycle in the UK, but note that lending at senior level has reduced interest rate sensitivity.

Long duration real assets could appreciate amid lower long-term rates

  • Fears of a potential global economic slowdown have put interest rate rises on hold.
  • Longer duration assets (infrastructure debt and equity, real estate long income) should capture the higher capital gain if long-term rates fall but are quite insensitive to short-term rates.
  • Despite higher leverage in infrastructure versus real estate, most borrowers have fixed rate long-term debt. Real estate borrowers should capture the benefit of lower rates on income return more quickly.
Figure 1: Asset Class Duration
Sources: EDHEC infrastructure, Bank of America Merrill Lynch, Aviva Investors, June 2019

UK forecast assumptions: lower bond yields to extend the real estate cycle

  • In late 2018, we expected interest rates to start rising and demand for real estate to be subdued. This narrative has changed in 2019, with expectations that central banks may be forced to keep rates on hold for longer or even cut again as economic growth slows.
  • Lower interest rates will extend the real estate cycle: even at current levels, real estate yields are significantly above government bond yields.
  • Real estate pricing is attractive compared to a host of other income-producing asset classes. With the outlook for interest rates now more supportive, investors can now find positive total returns in several areas across the UK.
Figure 2: 10 year Gilt vs. IPD All Property Yield
Sources: EDHEC infrastructure, Bank of America Merrill Lynch, Aviva Investors, June 2019

But conservative lending at senior level has reduced interest rate sensitivity

  • Over recent years, lower borrowing costs have not translated into higher profit for commercial property investors, due to yield compression and more conservative lending terms, i.e. lower loan-to-value ratios (LTV).
  • If senior LTVs had stayed unchanged in the last 10 years, the levered equity income return would be around 25 per cent higher today. Nevertheless, we expect leverage to continue to be used relatively conservatively. 
Figure 3: Borrowers’ Cost and Equity Income Return
Note: Leveraged equity income return calculated based on MSCI Yield and the Borrowers’ Cost from the CASS Commercial Real Estate Lending Report 2018. Corporate tax has been ignored. Source: CASS Commercial Real Estate Lending Survey, Aviva Investors, May 2019

Indicative spreads p.a.*

*Additional yield above comparable government bonds **High quality Unlevered Infrastructure Equity. Source: Aviva Investors (for illustrative purposes only). All data as at 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.

Important information

Important Information: Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 05 July 2019. Unless stated otherwise any views and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors). They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Issued by Aviva Investors Global Services Limited, registered in England № 1151805. Registered Office St Helens, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St Helens, 1 Undershaft, London, EC3P 3DQ. Telephone calls may be recorded for training and monitoring purposes. 

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