Institutional investors have increased their exposure to real assets in recent years, but can their interest survive the coronavirus crisis? Catherine Lafferty takes a look.
The real deal
At a time when economies are contracting into their sharpest depressions for centuries and markets are bouncing with volatility, investors will be on the lookout for safer assets. Real assets, which are anchored in the physical world, such as property and infrastructure, could provide a haven for pension schemes buffeted by the gales of the Coronavirus crisis.
It is a sign of the maturation of the defined contribution (DC) market that real assets are increasingly on schemes’ menu of asset options. Until relatively recently, many DC schemes faced an insuperable obstacle in accessing the asset class: they were simply too small to justify including them in their funds. As schemes grow, however, and their scale increases, it is expected that there will be more of those types of assets being used within DC plans.
Strong and stable
Devotees of these long-term assets like the way they do not have the same volatile reactions as others do, while institutional investors, such as pension schemes, had been showing increasing interest in real assets before the crisis hit, attracted by their inflation-proofing abilities.
Yet this is by no means the extent of their attractions. According to Justin “Biff” Ourso, director and head of real assets at Nuveen, schemes’ increased interest in the class is driven by a number of factors, including diversification within their portfolios. He says that the income component is also interesting as global rates have continued to stay low to negative in certain markets and that it produces attractive total returns.
Chetan Ghosh, chief investment officer at the Centrica Pension Schemes, points out that the linkage to UK inflation is stronger and is the key advantage over equities.
“You also don’t tend to suffer as much price volatility as equities; the income you expect to get is much more reliant on the contractual income rather than capital appreciation so you start to plan with more certainty,” Ghosh says.
For all of the increased interest in real assets by DC schemes, crises have a way of upsetting the strongest trends. However, Mark Hedges, chief investment officer of Nationwide Pension Fund, suspects the trend towards increased exposure will continue as pension funds will look at how they can generate value that matches their liabilities.
But that is not to say that infrastructure comes without risks. Here, Hedges sounds a cautionary note. “What you should always remember is that infrastructure equity has two words to it and it still has equity risk,” he says.
While it may well be that on average equity risk is a lower beta than market beta, and it may be, therefore, less volatile than certain assets, for example, airports, have been marked down more severely and have experienced more volatility than the market in this particular crisis.
The Nationwide Pension Fund has exposure to property and infrastructure amounting to around 17% of its fund, with exposure split over three parts. It has return-seeking assets, in which it includes infrastructure and core property; long lease property; and ground rent property, which it sees as a matching asset, so it is run in a separate portfolio and within that portfolio it has a target of a 10% allocation to real assets.
It was marginally increasing its exposure to real assets before the crisis and currently has 8% of the fund in the asset class, but the intention is to increase its exposure through affordable housing. It already has one commitment to such a scheme and is on the hunt for another.
The Nationwide Pension Scheme has a little over £1bn in real assets, most of which is in long-lease property. Yet Hedges says that he does not see the long-term strategy changing because of the crisis.
“We are long-term investors,” Hedges says, adding: “We might occasionally take tactical decisions but primarily they are about rebalancing the portfolio if it becomes underweight or overweight.”
Similarly, Centrica’s pension schemes have exposure to renewable infrastructure and property. Before Covid it had just over 5% in UK bricks and mortar and almost 5% exposure to domestic renewable infrastructure assets, amounting to around a 10% exposure to the asset class in total. Chetan Ghosh says there is no particular intention to increase or decrease its exposure here. He cites its long-dated contracted inflation income at better yields than gilts as attractions, noting that they are the only other alternative for sourcing an asset with UK inflation. He also likes its diversification benefits and relatively low-price volatility.
Real assets are far from being a homogenous asset class and while they may have characteristics that make them resilient, its sub-classes include those that have been hardest hit by the Covid-19 crisis. Along with the scores of grounded aircraft that have brought a sharp stop to cashflow for airport companies, the strange sight of shuttered pubs, restaurants and hotels the length and breadth of the country bears mute witness to the crushing losses the hospitality sector has experienced as the crisis has swept the globe. The losses suffered by hospitality are upstream from those suffered by the property in which they have tenancies.
The example of a simple coffee shop on one of the premises owned by the Nationwide Pension Fund is illustrative of the decisions which are having to be made in a sector under lockdown.
“We decided that for three months we are going to write-off the rent because we’ll never get it back,” Hedges says.
“What we’re hoping is when this is over they’ll be back up and running and pay the rent from that point but they’re never going to be able to catch up,” he adds. “It is a low margin business. It’s not big and most of the arrangements will be the bigger enterprises.”
The Centrica Pension Fund uses the contractual income from property for liability matching. A lot of its property is in the traditional long-lease market where well-known supermarket, hotel and local authority tenants.
Hotels, which have slumped to zero revenue but still have fixed costs that need paying, have been hit sharply by the crisis. They are doing what they can to get rent holidays and there are varying degrees to which landlords have been accommodating, whether it’s a holiday or it just gets added on later, but these different treatments are effectively holding positions.
What is unknown is how quickly occupancy can return to normal in hotels; that could take many months and the problem is that the rent deferrals or rent holidays stop. Then there are questions about the viability of the tenant. They can no longer match the decrease in revenue with the decrease in rent they have to pay.
Valuations in the sector need to be more reflective of the uncertainty, we have not seen much change in this quarter but would expect more in the following one, Chetan Ghosh explains, noting that even when hotels reopen that full occupancy will not resume immediately. “With Covid there is a lot of price uncertainty around these types of assets,” he adds. “The other thing is that there’s quite a long holding period for these assets as well which means you are more exposed to that price uncertainty. For us it just makes sense to let the dust settle and see if any attractive pricing emerges.”
Ghosh anticipates that stabilisation on valuations and price in the real estate market could take upwards of 12 months and notes that some have painted scenarios in which the worst outcome could be a 40% to 50% drop in commercial property values.
A drop of at least 10% in commercial property values is expected in the near term, while a drop of between 15% and 20% is considered a good scenario. A correction will not be seen instantly as a feature of the property industry, as valuations move quite slowly. Price changes will fully feed through within 12 to 18 months.
Infrastructure seems to have weathered Covid-19 more robustly than mainstream liquid assets. The challenge it faces is that while it has not sold off its rivals are altering its relative pricing attractiveness.
Ghosh believes renewables and commodities should weather the storm but cautions that commodities will be more dependent on the speed with which economies get back up and running and if there’s a bad economic restart then commodities may continue to struggle.
Everyone agrees that the longer the crisis lasts the more difficult it will be for pension funds to recover lost value.
There are some success stories filtering out of the crisis which seem counterintuitive. A shopping mall in Spain, one of the countries hardest hit by Covid-19 and with one of the toughest lockdowns in Europe, is in one of the Nationwide Pension Scheme’s portfolios. But while it’s closed and is generating no income, it has sufficient cash to service its debt until March 2021 by which time it is expected to start getting some of its income back from its retail shops.
The Covid-19 crisis has hit some sectors in the real assets universe with a vengeance but despite the whirlwind of damage it has caused, Mark Hedges thinks businesses have learned the lessons of the last recession. “The sense I get is the underlying businesses seem to be better prepared with the cash they have and the length of their cashflow runway than they were in 2007,” he says. “So whilst there will be losses and businesses go under and there will be opportunities for potential buyers, I suspect there may not be as many as there were in the great financial crisis.
“This is a different sort of crisis and the sense is some businesses are better prepared for it,” he adds.