Harvesting income from real assets: Globalise to stabilise
- In the last article in this series on inflation and real assets, we set out how real assets may be a better inflation risk mitigant than index-linked bonds, especially when appropriately diversified to reduce price volatility.
- In this latest article, we examine the ability of real assets to provide a stable, inflation-linked income stream, which is particularly vital in today’s ultra-low yield environment.
- We also look at how global diversification across real estate and infrastructure can help investors to maintain, or enhance, income from real assets while preserving long-term returns.
Stable income is the defining characteristic
A stable, long-term income stream is a defining characteristic of core real assets. Although there is no formal industry threshold, we generally define core real assets as having highly visible income streams that account for at least 75%-80% of expected overall returns. For example, income has accounted for over 85% of the total return from pan-European core real estate since 2004, and less than 15% of the total return volatility (Exhibit 1).
Typically, core real assets focus on “stabilised” relatively low risk assets with long leases and high quality tenants, or regulated income streams, and use low levels of leverage. As a result, core exposures offer bond-like characteristics, combined with some equity-like upside and inflation protection over the long term.
There’s also a broad range of global opportunities to capitalise on. For example, investors can access deep existing core real estate markets in the US and Europe, as well as maturing markets in Asia-Pacific real estate and global infrastructure. A more detailed discussion on these opportunities can be found in our recent white paper examining the case for diversified global property allocations in pension portfolios.
Exhibit 1: Real estate capital appreciation and income returns (March 2004-December 2020)
For pension investors, the stable income generated by core real assets provides significant diversification benefits and helps give these assets their “bond proxy” or “alternative safe haven” status, especially through periods of market turbulence. The stable income stream produced by real assets can also help more mature pension funds facing significant outgoings to service their cash flows more effectively.
Keep your eye on the price
Core real assets provide many benefits to pension funds in the current low yield environment, but there is the potential for price volatility to undermine their safe haven characteristics, particularly in periods of global crisis.
As can be seen in Exhibit 1, core real estate suffered deeply negative capital returns in the Global Financial Crisis, from 2007 to 2009. Clearly this was an exceptional period (the worst on record for real estate prices), and real assets have generally held up better than expected in the most recent Covid-19 crisis. Nevertheless, the pandemic did cause meaningful impairment to prices (and income) in some sections of the real assets market.
Mature pension funds, in particular, will have limited appetite for volatility as they generally seek to hold low volatility, low risk assets to stabilise their overall balance sheet. Fortunately, there are strategies that can help manage both the price and income volatility of real asset allocations.
“Supercore” or globalise
There are two key ways to manage real asset risks. The first is to “go supercore”, by seeking out higher quality core assets, such as those in better quality locations or in sectors with more stable demand, and with higher quality tenants or regulated revenues. Often supercore assets are associated with longer tenancies or visibility on long-term income.
Alternatively, investors can globalise, which means diversifying across all real asset regions and segments to reduce the impact of any individual asset, sector or geography on income and price.
Both approaches have their own advantages, but they also come with disadvantages that investors should be aware of (Exhibit 2). Supercore strategies, for example, are relatively simple to implement, can provide a higher quality income, and are able to preserve the link to local inflation in the income stream. However, supercore assets have a lower initial and ongoing yield, and expected long-term returns will be lower.
Globalised strategies, including global real estate and infrastructure, on the other hand, can reduce income and return volatility, and preserve yield and long-term return potential. However, the link to local inflation in income streams will be diluted, while globalised real asset portfolios can be more complex to implement.
Exhibit 2: Pros and cons of supercore and globalised real asset allocations
How do supercore and globalised strategies compare for European pensions?
We’ve analysed the supercore and globalised approaches to real assets to see how they may perform in practice. It is challenging to create robust quantitative comparisons because the supercore concept, while well understood, is not well-represented in the data - that is to say that the data does not classify assets in this way.
We have built prototype assumptions for supercore real estate, and to allow for the greater uncertainty given lack of data, we have also built a sensitivity analysis for supercore real estate (see “Supercore Assumptions Methodology” box for details). We’ve then compared the impact on portfolio efficiency to globalising existing core property exposure versus going supercore across a range of UK and European illustrative pension plans.
Supercore assumptions methodology
Our approach is based on the methodology used in our Long-Term Capital Market Assumptions and uses the same building blocks.
We adapt the initial yield to reflect the yield we are seeing on recent transactions for exceptionally high quality, long-lease properties across the various core real estate sectors in Europe. We then assume similar levels of leverage and fees as we assume for core real estate, and also assume that there is no difference in rental growth between core and supercore. Finally, we allow the yield differential to gradually reduce over time, as supercore incomes effectively “shorten” and the quality differential erodes to become more core-like in nature.
Overall, the main driver of the return differential comes from the initial yield. At the total market level, return expectations from supercore relative to core are reduced by 70 basis points for the UK and by 90 basis points for Europe.
For our risk assumptions, as a starting point we assume that volatility falls commensurately so that the Sharpe ratio for supercore assets is similar to core. We then apply two sensitivity tests, both representing improvements in the Sharpe ratio relative to core:
- A reduction in return relative to core of only half the magnitude of our base supercore assumption.
- A reduction in volatility, such that the Sharpe ratio for supercore is 10% higher than the Sharpe ratio for core.
The resulting base assumptions and sensitivities are then:
The results of our analysis suggest that going supercore is generally less efficient than globalising due to lower returns, even if we assume a more-than-commensurate reduction in volatility (Exhibit 3). We also note that, by definition, income is stable in all segments of the real asset universe, so it is reasonable to expect that income stability will be preserved when diversifying globally, assuming currency effects can be hedged out.
Exhibit 3: Impact on surplus sharpe ratio of changes to core property allocation for illustrative european plans
Finally, we note from our recent white paper, “Going Global in Core Real Estate: The case for diversified global property allocations in pension portfolios”, that the “beta to inflation” of the real asset portfolio to local inflation is actually maintained, or even improved, when taking a global approach—both empirically and on a forward-looking basis.
For example, we found that, historically, adding 50% global real estate to a UK core real estate portfolio could have increased inflation sensitivity from 69% to 77%, and globalising a Europe ex-UK core real estate portfolio would have at least maintained inflation sensitivity at 77%.
Therefore, as we discussed in our previous article in this series (“Mitigating Inflation Risk: Index-Linked Bonds Versus Core Real Estate”), while the local inflation linkage in the income stream may be diluted by globalised real estate portfolios, it seems that the stabilisation in price volatility more than offsets this dilution in inflation beta terms.
We have described and compared the two key options for pension investors looking to harvest the desirable characteristics of core real assets while reducing income and price volatility – either to “go supercore” or to globalise allocations.
While both options have pros and cons, they are, of course, not mutually exclusive. A robust overall strategy can be achieved by combining both approaches in accordance with available capacity and implementation capability.
In our next article, we will focus on the globalised approach and examine the structure of the global opportunity set in more detail.