This week, Reporter Kaitlyn Mitchell spoke with institutional investment consultants and managers on how they are advising their institutional clients to invest in real assets. Experts consulted include pros from Aon, Hamilton Lane and Wilshire Associates, and Polsinelli law firm.
Many Facets to the Class
“The way we define real assets is anything that has a contractual income stream. This could include any [investment] that has a physical presence, from real estate to infrastructure to agriculture to timber,” said Prashant Tewari, head of investment strategy for real assets, including real estate at Aon’s Townsend Group, a professional services firm providing risk, retirement and health solutions. Notably, Aon excludes commodities and energy from its real assets category. By comparison Hamilton Lane includes energy. The asset supply could range from real estate inventory, agricultural crops and infrastructure projects to oil and energy pipelines, said Radhika Cobb, a v.p. of real assets investments at the consultant/manager, which has approximately $57 billion in asset under management and $414 billion in assets under advisement (See related story here).
Why Real Assets Now?
Real-assets strategies have benefited from positive market dynamics in recent years, as new asset supply has been constrained and lessons learned during the downturn have been successfully implemented, Cobb said. Within real assets, investors are seeking lower-risk alternatives to listed equities, Tewari said. “Volatility on the listed equities side continues to be high. Over the long term, on the alternative investing side, returns have been equity-like.” That said, Tewari believes that institutional investors are still at an early stages of creating allocation for real assets outside of real estate.
Even before investors’ post-crisis renewed interest in the asset class, asset manager Wilshire Private Markets was a proponent of real assets from a return standpoint, according to Shawn Quinn, a v.p. at the firm, “Institutional clients should have a full weight towards real assets in their portfolios, in the range of 10% to 20% invested in real assets,” he proposed.
Hamilton Lane advocates maintaining consistent investment pacing over time rather than attempting to time the market. The manager seeks strategies that will outperform in varying market cycles that produce a component of immediate current income, and only cautiously uses leverage, Cobb told IA.
Over the past 10 years, agriculture has performed well overall, Tewari said. “More recently, returns from row crops like corn and soy have moderated, while permanent crops like blueberries, pistachios, hazelnuts and avocados have done really well,” he said. “Select institutional investors are willing to pay a higher price for row crop assets because of the value-add potential to enhance returns—investors are seeking good-quality low-risk assets to provide good returns.”
Fertile land available for agriculture is naturally constrained, Tewari noted. “However, the space remains highly fragmented and continues to be institutionalized, with ownership changing from mom-and-pop situations where one farmer manages…to institutions managing multiple farms,” he said. “Fresh institutional capital needs to come into the sector. Underperforming land is now being better managed and value-add opportunities in agriculture are growing. Despite short-term setbacks driven by trends from the commodities side and trade tariffs, I continue to see more capital come into this sector,” he said.
Investing internationally in agriculture and timber tends to be a sensitive area with lots of political considerations, Tewari noted. “In an emerging market like India, there’s lots of sensitivity towards foreign capital coming into the sector, while Brazil is more open for agricultural investing,” he emphasized.
Underperforming land is now being better managed and value-add opportunities in agriculture are growing.
Recent news that the California Public Employees Retirement System (CalPERS) lost some $500 million on its forestland portfolio may deter some institutions from entering the asset class anytime soon, but for the patient long-term thinker, timber may be a safe bet, consultants agreed. Hamilton Lane advocates diversifying exposure within real assets to include thoughtful allocations to smaller and emerging sub-asset classes such as timber and agriculture, Cobb said.
“Frustration on the timber side stems from investors not understanding what these assets can and cannot do—timber is very low-risk, and has very low-to-no leverage at all,” Tewari argued. “The current return profile of timber is lower than what it had been historically; there were outsized returns early on, when the asset class hadn’t been discovered and it was a high-risk, new asset class back then,” he added. “Now, it’s better understood and returns have normalized, but expectations haven’t. Investors should expect higher returns when the new house construction activity picks up.”
New projects are being developed and more and more infrastructure assets are changing ownership from public to private, Tewari said. “Public entities with stressed balance sheets have attracted lots of institutional capital interest for acquiring their infrastructure assets.”
For infrastructure fundraising, there has been a substantial amount of private capital raised recently but it still does not meet the long term capital needs of the asset class, Quinn pointed out. “The private equity component improves the value of infrastructure assets, and investment is needed across the infrastructure space, both in the U.S. and globally—the amount of fundraising pales in comparison to the amount of capital needed,” he added.
For institutional investors, over 60% of total returns of their core real estate assets have come from income, Tewari said. “Most investors start in real estate—I believe that over the next five-to-ten years we’ll see more well-rounded real estate portfolios extending to include infrastructure and agriculture assets,” he added.
Management-intensive properties are not preferred by institutional holders. “Our portfolios include core and core-plus strategies, which require minimal heavy-lifting, as well as value-add and select opportunistic strategies, where value creation and operational efficiencies are pursued at the asset level in order to position the asset for sale to a core buyer,” added Cobb.
Core and core-plus strategies require minimal heavy-lifting.
A major cause of supply constraint in the real estate asset class, currently, is the escalation of construction costs, exceeding inflation in general, which has been at historical lows since the financial crisis. “With the inflation that the economy has witnessed and land price escalation, most new construction taking place requires a really high rent to justify it,” Tewari said. “Consequently rents for existing core assets have a lot of room to grow relative to new supply in the market. Additionally, core assets generate stable income returns through good and bad times and are, therefore, very desirable.”
In terms of specific strategies within the real estate category, retail is not dead; rather, retail re-positioned to include e-commerce strategies are flourishing, according to Cobb. “We have been selective in office and hotel, but one area of focus has been certain retail strategies which are positioned to thrive alongside internet retail, last-mile industrial and technologically driven strategies,” Cobb said. “We’ve also been focused on demographically driven strategies like Class-B multifamily and senior housing.”
“Year after year, the annual Global Alternatives Surveys consistently rank real estate managers with the largest share of alternative investment assets under management,” said Debbie Klis, an attorney at Polsinelli in Washington, D.C., who is a co-practice chair of the firm’s EB-5 Program, as well as fund, real estate and investor services.
“In 2017, real estate managers managed more than 35% of all alternative investments, with $1.4 trillion of assets under management, followed by private equity fund managers with 18% and $695 billion, hedge funds with 17% and $675 billion, private equity funds of funds with 12% and $492 billion, and hedge funds with 6% and $228 billion, respectively.”
Energy, Oil and Commodities
Natural resources are undersupplied, and the risk is hard to underwrite—this has wreaked havoc with commodity prices across the energy spectrum, Quinn said. “Energy saw a steep decline in the primary years of the oil decline, but that only lasted two years,” he added. “The opportunity is there—we have a systematic need for a shift in the way that energy, oil and natural gas are harvested; this includes the execution of new, horizontal drilling techniques and cost reduction in piping, refineries and storage.”
The U.S. is becoming a leading provider of metals and mining commodities globally, continued Quinn. “Despite the lack of investment, we’re bullish overall—we encourage investors to take advantage of situational opportunities,” he said. “Though it has been an unusual cycle for commodity-based investment, there’s an opportunity given the preceding trough in commodity prices and a healthy economic environment.”
The lack of investment in water historically has led to interesting opportunities, Quinn said. “Historically, there’s been a lack of devoted managers in the space, and investors dipping their toe into the space must understand that manager underwriting is critical,” he added. “We do not have a good quantitative measurement of capital invested, but historically, there has been a lack of institutional capital focused on water-related investment, which makes finding the right manager paramount.”
Though it has been an unusual cycle for commodity-based investment, there’s an opportunity given the preceding trough in commodity prices and a healthy economic environment.
Location, location, location
Certain big U.S. markets in which institutions tend to invest are becoming saturated, such as New York, San Francisco, Los Angeles and D.C., Klis noted. “Investors would be wise to focus on tertiary markets like Houston, Austin, Seattle, Raleigh-Durham, Charlotte and Philadelphia to get better deals,” she said.
The U.S. real estate market is benefiting from the trends toward alternative investments, Klis continued. “The U.S.’s popularity has grown significantly among domestic and global investors alike. According a 2018 Urban Law Institute article, the U.S. is still the number-one destination in the world for real estate investment.”
Hamilton Lane invests on a global basis with a heavy weight towards the U.S. and Europe, noted Cobb. “[Clients’] portfolios are diversified with exposure to gateway cities and secondary markets; however, in recent years, we have found transactions in select gateway cities to be overpriced, while secondary markets have often provided interesting opportunities for outperformance,” she added. “We are currently overweight U.S. and Europe and are closely tracking ‘rest of world’ (ROW) opportunities,” Cobb continued. “As of today, on the real assets side, we see limited return premium for the enhanced risk in some ROW markets, particularly as it relates to foreign exchange and regulatory factors.”