Phil Waller explains the thinking behind core real assets and what it means for investing in real estate, infrastructure and transportation.
So what are real assets and what do we mean by core? Real assets for J.P. Morgan’s JARA Trust correspond to the income-producing part of three categories: real estate, infrastructure and transportation. If we think about these real assets on a spectrum, core is at the high-quality end of the spectrum; so real assets that are in excellent locations, facing off against high-calibre counterparties. The majority of the return for these types of assets should be derived from income. Indeed, about two-thirds plus of the return profile should be income.
It’s not just the level of income that’s important; it’s also the predictability of that income. So it has to be high quality income, often coming from contracted sources. In the context of real estate, this would be a New York office building which has got Amazon as a tenant. You’re not going to buy that building and expect it to double in value, but you’ve got a pretty good tenant you expect to pay you on time.
At the other end of the spectrum, you’ve got opportunistic real assets. An example of that within real estate would be buying land, whereby you build a second-tier city on it and hope to sell it at a profit. This approach focuses much more on capital appreciation, which is a much higher risk. There’s no right or wrong way to play real assets. At different times in the cycle, different ones will be more appropriate for investors’ portfolios.
Real estate opportunities
In terms of real estate, the focus is on core key markets. In the US, these include gateway cities such as New York, San Francisco and Chicago, whereas the definition is more complex in Asia. Mainly as qualification as a core market requires liquidity; the right regulatory framework; and protection of ownership. For J.P. Morgan Asset Management that narrows the Asia Pacific region down to eight countries – including Japan, Australia, New Zealand, Singapore, Taiwan and South Korea – and 15 cities where we see that core return profile. However, with a developing region, more and more markets are more likely to open up to investors over time.
In addition, the US and the Asia Pacific side complement each other. The US is very developed real estate market; Asia, a much newer market. While Asia Pacific is now the largest real estate market globally; larger than Europe and the US, it has the largest investor underweight. This points to a rising tide of opportunities ahead.
Scale is also relevant. In real estate, larger properties tend to outperform, particularly on a volatility basis, as they attract more significant, higher quality counterparties that tend to pay on time. Also, larger tenants find it more difficult to move, and therefore your releasing risk is quite significantly reduced by playing in this part of the spectrum.
Infrastructure focus on mid-market
There’s been a lot of capital flow into the infrastructure space over the last ten years or so, and long-term projections of infrastructure look very good. Yet while there’s a lot of spending that needs to happen, care needs to be taken on chasing trophy assets. A more mid-market approach, with a preference for bolt-on acquisitions, is preferred.
For example, by working with existing solar farm operators to help them grow either organically or through acquisition, it allows them to write smaller cheque sizes and therefore avoid a lot of the competitive processes. This approach helps deploy capital more predictably, because if you’re chasing these trophy assets and you lose out on your bidding process that’s a lot of capital that you haven’t been able to deploy in that period. But also, smaller ticket sizes hopefully allow more efficient spending over time to maintain that all-important yield.
Transport behind the curve
Right now we’re probably seeing the best market dynamics on the transportation side. While a lot of capital has gone into real estate and infrastructure, transport is still five years behind in terms of its curve, particularly from a capital flow perspective.
There’s a real need for capital in transport right now, which is driven by the fact that firstly the main capital providers in the space have always been the banks, particularly European banks. Now it’s much more expensive for these banks to be equity owners of these assets, mainly driven by the fact that capital adequacy is much more punitive for them, so they have slowly withdrawn from the space.
If the traditional capital providers aren’t there, that space needs to be filled, particularly as a lot of the fleet of the world is ageing. Currently, 42% of the world’s fleet is now over 20 years old, which with the average useful life cycle of transport assets 25 to 35 years, it means they soon need to be replaced.
In many ways, the outlook is a very similar business model to real estate. In real estate, you own a building, and you put it on a lease, which can also happen in the transport space; you own a ship, and you put it on long-term leases. And because of the need for capital, it can offer a yield north of 8% net. In the medium term, it’s an attractive complement to the slightly lower-yielding infrastructure and real estate side of the market at present.
The outlook for returns
We are obviously in a period of considerable uncertainty. But looking ahead, while infrastructure is very much the golden child at the moment, we’d expect all our core real assets to produce, whether it’s real estate or transportation. Over the last ten years income of 4.5% to 5% yield, has been pretty much consistent quarter on quarter. Having a predictable income stream is essential, particularly looking back to 2009/2010. During this period of negative capital values, there was still the ability to derive a positive return from that asset class because of the consistent income stream coming through.
Often we think about the key risk for real assets as being something of a local risk; that can be political, it can be jurisdictional, it can be a range of different things. While taking a global investment approach can help diversify such risks, the predictability of income coming through is also a critical risk factor in our opinion, and of vital importance when we consider investing in real assets.
That said, all sectors, real assets included, are now facing enormous challenges as COVID-19 spreads globally. While it may be some time before we see the equity markets recover with any level of consistency, by sticking to the core principles of investing in real core assets – focusing on income; high-quality locations and counterparties – we can hopefully enjoy a more predictable return to normality when it eventually arrives.
Phil Waller is a product specialist at J.P. Morgan Asset Management.