In this month’s instalment of our visual series on topical themes, we look at some of the key recent trends in the real asset universe.
Read this article to understand:
- How risk and returns in real assets changed in the first half of 2022
- Why adding leverage doesn’t necessarily lead to additional returns
- How occupancy rates in office markets have changed since the pandemic
- The potential of residential property, fibre and net-zero technologies
A risk worth taking?
In the first half of 2022, inflation surged, central banks increased rates to counter it, and public bond and equity markets saw significant valuation declines. By contrast, real asset markets have been slower to react to these external pressures; as recently as the end of March, values were still climbing in real estate and infrastructure.
However, Figure 1 shows forward-looking five-year returns across real asset equity sectors declined in the first half of 2022. We expect yields and discount rates to increase, negatively impacting capital values. In contrast, nominal returns available from all real asset debt markets have risen due to higher policy rates and government bond yields.
Figure 1: Five-year risk versus returns (per cent)
Source: Aviva Investors. Data as of March 2022
The uncertain economic outlook could weaken the appetite for leverage among investors. Figure 2 shows the impact of leverage on risk-adjusted returns (a steeper upward gradient suggests a strong increase in risk-adjusted returns from adding leverage).
As the cost of debt has risen, the benefits of levering real assets have declined. In some cases, the cost of debt is now higher than unlevered expected returns, making leverage dilutive to returns.
Figure 2: Five-year unlevered versus levered expected returns (per cent)
Note: Sector-level returns levered at 50% LTV
Source: Aviva Investors. Data as of 30 March 2022
While there has been some compression in illiquidity premia this year, this varies by sector and the specific nature of a transaction. Figure 3 shows infrastructure debt and private spreads have remained stable during a period when public spreads have widened significantly, causing the illiquidity premium to decline.
For more detailed analysis on how illiquidity premia in real assets are changing, read Illiquidity premia in real assets: Q2 2022.
Figure 3: Illiquidity premia in real assets
Note: Illiquidity premium required for private real estate equity transactions reflects the time it takes to sell and achieve a fair value. Indicative time period: 3 months.
Source: ICE BoA Merrill Lynch, Bloomberg, Aviva Investors. Data as of June 30, 2022
Residential rentals: an untapped opportunity?
The UK residential sector is larger than the commercial real estate sector. To date, however, there has been a noticeable lack of institutional investment, with a significant proportion of stock owned by individuals and small scale buy-to-let landlords.
Figure 4 shows that, historically, only three per cent of the investment in the private residential rental sector has been institutional, which could provide opportunities to invest while the market is still at an early stage of maturity.
Generally, with low levels of maturity comes higher relative yields; investing in the UK single-family housing sector with favourable structural dynamics could lead to greater resilience against the upward movement in government bond yields and interest rates.
Figure 4: Institutional investment - commercial versus residential property (stock value £bn)
Source: Packaged Living, April 20211
Figure 5 illustrates the UK residential sector is expected to remain the most resilient against rising inflation. It is forecast to see average rental growth of 3.6 per cent between 2021–2026, while industrials and offices are forecasted to witness three per cent and 1.7 per cent growth respectively.
Figure 5: Estimated rental value growth: residential, offices, industrial
Source: Aviva Investors and PMA, August 2022
One of the key reasons for the expected growth in the rental market is that buying a property is becoming even less affordable, as Figure 6 shows. Rising interest rates feed into higher mortgage repayments, meaning an increasing number of individuals and families are being priced out of markets (assuming house prices don’t fall).
Figure 6: Monthly mortgage repayments and mortgage-to-income rate
Source: Oxford Economics, PMA, ECB, The Global Economy and Aviva Investors. Data as of June 2022
Hybrid working is here to stay
Office occupancy has slowly increased after the steep decline experienced during the first wave of COVID-19. Nevertheless, occupancy rates are still far off pre-pandemic levels despite the removal of social distancing rules, suggesting the hybrid working model will be a lasting legacy.
Figure 7: European average office occupancy rates (per cent)
Note: Historic data reflects Republic of Ireland and UK.
Source: Savills, August 20222
And with hybrid working, there is a clear pattern emerging about which days of the week people like to be in the office – at least in London. As Figure 8 demonstrates, Thursday is the new Friday.
Figure 8: London office occupancy by weekday (per cent)
Source: Savills. Data as of June 2022
One of the most interesting trends is that cities with the lowest transport costs have, on average, higher office occupancy rates (see Figure 9). London is at the bottom of the list – food for thought perhaps for those running and regulating the city’s vast, but pricey, transport network.
Figure 9: Office occupancy rates versus public transport costs
Source: Savills. Data as of June 2022
At what carbon price will the various types of carbon removal solutions become financially viable?
According to our latest analysis, nature-based carbon removal solutions will remain the most cost-effective option for the foreseeable future, as Figure 10 illustrates. It hypothesises the carbon price at which a variety of carbon removal solutions become financially feasible.
There is a growing case for increased investment in both technology and nature-based carbon removal solutions
There are huge unknowns when analysing these scenarios, such as carbon price movements, engineered solutions’ learning curves, climate impacts (floods, wildfires) on nature-based solutions and future government incentives.
With demand for voluntary carbon market credits expected to increase fifteen-fold by 2030, there is a growing case for increased investment in both technology and nature-based carbon removal solutions.
Figure 10: Technology versus nature-based carbon removals
Note: NGFS Climate Scenarios, Greenhouse gas removal methods and their potential UK deployment, Element Energy and UK Centre for Ecology & Hydrology, October 2021 ad NGFS carbon scenarios.
Source: Aviva Investors, August 2022
Over the next few years, a large portion of carbon removal will be reliant on afforestation, second only to bioenergy with carbon capture and storage by 2030 (see Figure 11). In the following two decades, additional solutions scale up but nature-based solutions should remain a sizeable contributor to the UK’s absorbed emissions.
Figure 11: Scale of removal required in the UK
Note: Greenhouse gas removal methods and their potential UK deployment, Element Energy and UK Centre for Ecology & Hydrology, October 2021 ad NGFS Climate Scenarios.
Source: Aviva Investors, August 2022
Infrastructure: Acceleration in renewables, fibre
As the focus on net-zero intensifies, other technologies are likely to see an exponential increase in capacity. Renewable energy is a case in point; it is expected to account for almost 95 per cent of the increase in global power capacity through 2026, as shown in Figure 12.
Figure 12: Annual renewable electricity capacity
Source: International Energy Agency, 20223
Another market expected to accelerate is fibre broadband. According to the Fibre to the Home Council, the total number of homes and buildings passed with fibre broadband in the EU group of countries reached 198.4 million in September 2021, compared with 176.3 million a year earlier.
It estimates that figure will hit 309 million in 2027, with France (31.1 million), the UK (30.1 million) and Germany (26.9 million) the top three markets.