Relative value in real assets

Read this article to understand:

• How our proprietary data reveals relative value across private markets
• Why private debt remains compelling on a relative value basis, and new analysis of sub-investment grade debt
• The repricing journey of equity and the resulting spectrum of opportunities across debt and equity.

“Data! Data! Data!”, cries the great detective Sherlock Holmes in Arthur Conan Doyle’s short story “The Copper Beeches”. “I can’t make bricks without clay.”

Investors in real assets know the feeling. A lack of transparent data can be a significant challenge for those participating in private markets. As part of our efforts to address this, Aviva Investors’ real assets research team has developed a methodology to compare risk and return across sectors on a consistent, forward-looking basis.

Using data alongside proprietary insights from within the business, we analyse the fundamentals in various sectors to understand the factors driving performance. We develop our insights through performing multiple simulations and collating the results, revealing where relative value can be found. The view for Q3 2024 is presented here.

This quarter, four new sub-investment grade (IG) debt models have been added to our sector analysis, including real estate and infrastructure debt for both the UK and Europe. As expected, sub-IG offers higher return potential, albeit with higher risk, compared with the IG sectors.

Our approach: measuring risk and return

A common obstacle for investors in private markets is the lack of a transparent pricing history to track risk and return and the factors driving them. Most firms keep transactional data private and buy supplementary market data from external providers who may not have a comprehensive view of the market. To address this, we have developed our own methodology to apply on a consistent, forward-looking basis (see boxed text, below).

This methodology allows us to compare risk and return at sector level using a cashflow profile approach. Moreover, because all the cashflows and simulations are contained within one framework, we are able to examine and quantify the underlying drivers of risk.

When considering risk in a relative value context, we take ex-ante risk (based on a forward-looking view) on the standard deviation of 5,000 internal rate of return (IRR) simulations to measure variation from the mean. As with any idiosyncratic asset class, manager skill and the specific characteristics of the investment strategy make a difference. When considered alongside mean returns from individual assets, these factors could result in outcomes significantly lower or higher than those modelled. Also, note that all the returns illustrated are unlevered. In spite of these qualifiers, we believe the approach allows a level of insight and transparency where nothing else similar currently exists.

With the depth the relative value model offers, we determine correlations between sectors. This information is then utilised to help us build portfolios and optimise capital allocation. We can interrogate these portfolios to understand how sectors contribute to overall risk or offer diversification benefits. These capabilities, coupled with a unique understanding of the individual risk drivers in each sector, enable us to identify new opportunities and unlock diversification potential.

We conduct our analysis on a five-year, ten-year and full-life basis, with the flexibility to analyse alternative investment horizons as well. For the purposes of this article, we focus on an investment horizon of five years, as this is aligned with the requirements of a large portion of investors.

Economic backdrop 

In the first six months of 2024, inflation has been trending down in the UK and Europe. Q1 2024 saw positive GDP growth in the UK following a contraction in H2 2023; Europe also reported positive GDP figures following flat growth in Q4 2023.

In June 2024, the European Central Bank (ECB) lowered interest rates by 25 basis points after nine months of stable rates, and the likelihood and possible timing of future rate cuts continues to be an important focus for market participants. On August 1, the Bank of England cut rates for the first time since March 2020, to five per cent.

While the economy has been slowly moving towards a more “normal” environment, the new normal is likely to be one with “higher-for-longer” interest rates, as it is anticipated that rates are unlikely to reach previous lows. This creates opportunities, particularly in the debt markets, which our relative value models have flagged for some time.

Equity sectors stabilise whilst debt also remains attractive on a relative value basis

Since our last relative value analysis was published in September 2023, absolute returns across the model have on average increased, while risk has fallen slightly. Given the more stable macroeconomic outlook, this is not surprising on balance, although the stories differ between asset classes.

Returns and volatility have stabilised for equity sectors and are screening attractively on an absolute return basis, having struggled over the past couple of years relative to debt. The debt sectors continue to remain attractive from a relative value perspective, based on return per unit of risk.

Infrastructure equity and real estate equity both offer attractive absolute returns (Figure 1). Infrastructure equity may have greater return potential than real estate equity; however, this opportunity comes with greater risk and lower risk-adjusted return.

In the debt sectors, return expectations are moderating as the market outlook stabilises, but a range of opportunities is expected to remain in a higher-for-longer environment. Real estate debt continues to offer more attractive returns than infrastructure debt, reflective of the nature of the opportunities.

Four new sub-IG sectors, two for real estate and two for infrastructure, have been introduced to the model in 2024 in response to the increasing number of opportunities available. Following the Global Financial Crisis, banks have become more restrictive with their lending as they have sought to reduce their exposure to risk-weighted assets. Alongside an increase in interest rates, the opportunity for private debt to be offered as an alternative source of funding has increased. The opportunity to obtain exposure to sub-IG sectors also enables a broader range of risk to be adopted within a portfolio.

On a geographical basis, the UK continues to offer greater absolute returns compared with European debt sectors, underpinned by the differential between the base rates of the Bank of England and the ECB. On a five-year basis, floating rate debt screens more attractively than fixed, although this is starting to change over the longer-term horizon. 

Real estate

UK real estate saw its first quarter of positive capital growth in June 2024 after seven consecutive quarters of decline. Europe’s repricing journey is slightly behind the UK, but opportunities remain. Despite this, we feel that the market at the headline level has turned a corner.  (A new chapter: Time to prepare for the next phase of the real estate cycle has more details.)

Real estate equity sectors have struggled over the past few years to offer the return premium typically expected of this asset class. During this time, relative value for real estate equity was in short supply as capital markets repriced off the higher-rate environment and a considerable amount of risk passed through. This yield expansion has now slowed, with inward or flat movement mostly anticipated for the remainder of 2024 in the UK and Europe. The return outlook has now stabilised, and the possibility of a recovery is in sight. This has led to the equity sectors screening attractively from an absolute return basis.

The recovery in real estate sectors is not without challenges, and stock selection will be key as we expect bifurcation in a “K”-shaped recovery. For real estate equity, the UK typically screens more attractively than Europe on an absolute basis, although opportunities persist within Europe, especially when the market risk-free rate is considered. The residential and industrial sectors both screen positively in the UK and Europe on an absolute return and a return-per unit-of-risk basis.

Elevated rates continue to support opportunities in real estate debt, although there has been some pullback from recent highs. Several key themes have been playing out over the past six months: notably, bifurcation, refinancing, and ongoing price discovery, with financing available for borrowers in the upper half of the K-shaped recovery.

A large number of real estate debt loans are expected to mature in 2024 and there is a continued focus on the refinancing gap. In addition, floating rate debt continues to screen more attractively than fixed, a phenomenon that is expected to normalise as rates start to decline.

Our new analyses of UK and European sub-IG debt reveal both have greater return potential than comparable IG sectors, with a slight increase in associated risk. In addition, these sectors have a slightly different risk profile to IG, offering diversification benefits.

When considering the attractiveness of the real estate sectors based on return per unit of risk, debt is screening favourably relative to equity, driven by higher government bond yields and private debt illiquidity premia (Figure 2). This however masks the opportunity that equity provides for upside potential.

Over time, as interest rates normalise, we expect the attractiveness of equity will improve when compared to debt, with return per unit of risk normalising in turn.

Infrastructure

The infrastructure equity sectors we analyse in our relative value models can be considered in two buckets – renewables (such as wind and solar), and greenfield sectors (including greenfield fibre and energy from waste).

Return expectations have increased in renewables sectors as uncertainty in the market has reduced. This, coupled with a slight reduction in the levels of risk, has resulted in an attractive increase for the infrastructure equity sectors from both an absolute return and return-per-unit-of-risk basis (Figure 2).

The story is slightly different in the greenfield sectors. These sectors are riskier than renewables during their first five years given the operational challenges of buildout, levels of competition, and the volatility of returns. This can result in higher absolute returns but is coupled with a higher level of risk. These factors account for energy from waste sitting in the top right quadrant of Figure 1.

Greenfield fibre has experienced a drop in five-year expected return alongside an increase in risk since our last relative value view. This reflects the view that greater network coverage is being achieved across the UK and competition is increasing. The likelihood is that fibre will move towards being a stabilised asset investment opportunity, away from being a development opportunity.

Infrastructure debt sectors continue to offer an attractive opportunity based on return per unit of risk (Figure 2). Floating rate infrastructure debt continues to screen more attractively than fixed, as rates remain elevated. This is particularly evident on a five-year basis in the UK, although signs are emerging that this is starting to reverse over the Full Life analysis horizon.

Our new analyses of UK and European sub-IG debt both reveal greater return opportunities, with a slight increase to the associated risk when compared to IG. And, like real estate, these sectors have a slightly different risk profile to IG, offering diversification benefits.

When comparing infrastructure equity and debt, debt continues to offer a more attractive return per unit of risk than equity. Infrastructure equity has, however, seen an increase in absolute returns since September 2023 and may offer greater upside potential.

Real estate long income (RELI)

Real estate long income (RELI) sectors screen attractively on an absolute return basis, as the sectors have repriced to higher risk-free rates and the real estate cycle has stabilised. On a short-term analysis basis, the general trend for the RELI sectors has been a slight reduction in risk over a five-year horizon, with an increase in expected returns.

The gap between UK and Europe has been narrowing as the real estate cycle stabilises and the UK sector captures less outward yield shift (Figure 2).

Private corporate debt

As the macroeconomic outlook has stabilised, private corporate debt (PCD) sectors have seen both public and private credit spreads tighten. This, coupled with a reduction in market inflation expectations, has resulted in a slight decrease in expected returns. Given that PCD reprices quickly to public debt markets, this is not surprising; nevertheless, it is still possible to find attractive returns for the associated level of risk.

Private placements have seen the greatest contraction in margin and upfront fees, as demand for IG corporate risk outstrips supply. This has resulted in the sector experiencing a dip in expected returns, albeit from a high level.

UK mid-market loans continue to screen more attractively than European mid-market loans (Figure 1). The difference in return expectations is driven by the differential in base rates for each market and the margins being priced in. When considering both sectors on a return-per-unit-of-risk basis, the same story prevails (Figure 2).

Conclusion

The macroeconomic environment has begun to stabilise and as we move towards a “new normal”; the path ahead looks clearer. While the outlook remains attractive across a number of sectors, asset selection will be key, as the K-shaped recovery evolves. With rates elevated, opportunities remain in the debt markets; there are increasing opportunities in equity sectors too as we enter a new chapter in the cycle.