Investment Actions

Targeting outcomes in the real world

Dec 6, 2016
By BlackRock

Recent strong investment flows into real estate and infrastructure show no signs of abating in today’s climate of ultralow bond yields and lofty equity valuations. As these and other alternative assets come to play a larger role in many institutional portfolios, investors are naturally focused on getting the most out of them.


 

Some of the largest pension funds have moved to group their allocations to real estate and infrastructure (as well as holdings in sectors such as timber, farmland and shipping) in a single real assets category. This makes sense. These assets have much in common, from their underlying physicality to the skill sets and resources needed to invest in them, to the ways they are affected by long-term trends such as urbanisation, technological change and economic growth. Infrastructure and real estate are especially close, with certain investments, such as student housing, even straddling the line between the two.

A real assets grouping is just a first step, however. Further optimising a real assets allocation means looking beyond immediate efficiencies and identifying commonalities on a deeper level. Along with all the potential benefits investors seek in real assets, they also present significant hurdles. A deeper view of the whole real assets opportunity setone that employs a common language of risk and return – may help investors overcome these hurdles.

Perhaps the most obvious hurdle real-assets investors face is the imbalance between strong demand and constrained supply, especially in infrastructure. At the end of 2015, according to Preqin, average institutional target allocations to real estate and infrastructure were 9.8% and 5.7%, respectively, compared with actual allocations of 8.5% for real estate and 4.3% for infrastructure. This imbalance, and a related pressure to put capital to work, may also exacerbate another common problem in real assets investing – a tendency to ask, in isolation: is this a good investment, yes or no?

The right questions

In our view, investors should replace this single question with two new ones. First, what is the goal for this investment? Real assets have progressed to the point where it’s possible to focus more tightly on one or more of the potential benefits investors have traditionally sought, from predictable long-term income to capital appreciation, portfolio diversification and inflation protection. Real estate, long a mainstay in institutional portfolios, has paved the way here, with investment strategies ranging along a risk-return spectrum from senior debt to opportunistic equity. Now infrastructure is following suit. See the chart below.

A common language of risk

The spectrum of real asset strategies

A common language of risk Source: BlackRock, September 2016. For illustrative purposes only. There is no guarantee that these asset classes will be profitable.

The second key question is this: given the objective, where – looking across the entire real assets spectrum – is the best place to try to achieve it at this point in time? If the primary goal is, for example, income, there could be several potential choices spanning both infrastructure and real estate, and both debt and equity, that are worth considering.

Each of these questions, to be sure, opens the door to a more complex set of considerations. Objectives are rarely one-dimensional; investors typically have multiple goals. Similarly, a judgement about where to seek an investment targeting a particular goal must take into account not just relative valuations but also the trade-offs an investor is willing to make. For example, what are the liquidity requirements? How much economic risk can be added to the portfolio? Finally, there remains the issue of access to deal flow, without which none of the prior steps can be taken.

More data, better tools

These are not trivial issues, but as the field of real asset investing develops, it’s increasingly possible to address them. A global perspective combined with strong relationships and local knowledge in different geographies may both extend the opportunity set and deepen understanding of individual projects. On the analytical front, broader data availability and the application of modelling techniques ranging from traditional mean-variance optimisation to more sophisticated factor-based models are helping to support decision-making. What’s relevant for alternatives investment hasn’t changed, but what is possible is changing rapidly.

The idea that two real estate investments may have very different risk-return characteristics is unsurprising. No one would confuse a senior debt exposure to a leased up property in Boston or Frankfurt with a value-add equity investment in a Shenzhen office tower slated for refurbishing and repositioning. Yet even in real estate, investors may still have less than perfect clarity on some of the risks they may be taking on, such as sovereign risk, currency risk, or concentrated exposure to a particular industry. Without this insight, it’s harder to be confident that risk, price, and desired objectives are fully aligned.

In infrastructure the picture grows still more complex. Renewable power, among the most active infrastructure sectors in terms of deal flow, offers investments that potentially target a range of outcomes. An investor seeking stable cash flows may choose to invest in established domestic projects. Another, searching for a blend of income and capital appreciation, might find better value from an investment in the construction phase. Going further out into the risk spectrum, investors might be willing to venture into emerging or even frontier markets, where higher total returns may be possible. But none of these paths is really viable without some visibility on the underlying risks involved, many of which are similar to the ones a real estate investor might face.

When investing in traditional asset classes, where data and the technology to harness it abound, the alignment of risk, price and goals is comparatively straightforward. Unfortunately, traditional asset classes appear unlikely to enable investors to meet their objectives in the years to come. The good news is that real assets, one of the main alternatives investors have embraced, are evolving to help fill the gap. The ability to decompose the risk and return characteristics of infrastructure, real estate and other real assets may help investors target their objectives with greater clarity. In an exceptionally uncertain investment climate, that is no small thing.

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