Get real with income-producing real assets

We have seen demand for real assets grow dramatically in recent years, and we expect it will advance further as investors better understand the positive attributes of the asset class. Real assets offer the opportunity for diversification, inflation hedging and competitive total returns. Real assets may also serve as a nontraditional source of income, a feature that investors frequently overlook.

What are real assets?

Broadly, real assets provide the framework and resources to facilitate everyday activity in the world economy. While numerous types of investments could be considered real assets, our definition includes:

• Real estate, including real estate investment trusts (REITs). Land and commercial properties including apartments, offices, warehouses, malls, etc.
• Infrastructure. Assets and networks used to transport, store and distribute goods, energy, people and information, such as toll roads, pipelines, airports and cellphone towers.
• Commodities. Basic goods such as oil, natural gas, precious metals, gold, corn and soybeans.

Unlike conventional stocks and bonds, the value of listed real asset investments comes from the physical nature of their underlying assets. This direct link to hard assets means real assets often store long-term value better than more traditional investments. Their intrinsic value may also increase due to higher utilization, greater demand or scarcity of supply.

The inherent characteristics of each real asset can vary, but they have several features in common.

Diversification benefits

Real assets have historically exhibited a lower correlation to a wide variety of investment alternatives, as well as other real assets. The performance drivers for real assets are fundamentally different from other types of securities. By expanding into asset classes with lower correlations, investors may potentially benefit from greater diversification.

Inflation hedging ability

Real assets have historically exhibited greater ability to hedge inflation than the broader equity and fixed income markets. Real assets have generally offered stronger returns during periods when inflation is rising.

In general, inflation increases as economic activity accelerates. In such an environment, commodity prices tend to rise in conjunction with inflation, as demand for goods increases with gains in consumption and building activity. Infrastructure and real estate also tend to have a positive correlation with inflation. When the prices for goods and labor costs increase, the replacement costs for these types of assets also increase. Additionally, many infrastructure assets have a direct tie to inflation measures such as the Consumer Price Index (CPI) in their contracts or concessions.

Real estate companies often structure leases with rent escalators that increase the rent over the life of the lease. In both cases, these structures are used to grow cash flows in an attempt to account for the potential effects of inflation.

Competitive total return potential

Infrastructure and global real estate investments have shown competitive performance with most other equity groups over the last 20 years.

In addition, infrastructure has also offered a higher return with similar or less risk. And while global real estate has demonstrated more risk than broader non-U.S. equities, it has provided more return per unit of risk than the broader set.

Overall, infrastructure and global real estate equities have provided competitive risk-adjusted returns compared to U.S. equities and stronger risk-adjusted returns than non-U.S. equities.

Commodity returns have trended higher recently, but have remained low overall throughout the last 20 years. The asset class has been in a bear market that has persisted since the financial crisis in part due to supply and demand imbalances.

Nontraditional source of income

We believe real asset investments that offer a stable yield supported by contractual cash flows are especially attractive. These investments have assets that tend to be monopolistic, providing a strong and consistent income stream usually derived from their fee-for-use nature.

Infrastructure and real estate exemplify these types of income-producing real assets. These companies commonly own or operate location-specific hard assets that garner a fee for use through long-term contracts, concessions or leases. Commodities rely solely on capital appreciation and offer no income component. Infrastructure and real estate have the potential to produce attractive yields compared to other commonly held investments.

These alternative income sources may also prove particularly advantageous for investors in low interest rate environments where more traditional yield options are anchored by lower rates, much like we’ve seen globally for the past several years.

Moreover, these steady income streams may help cushion total returns in times of volatility, potentially providing for added downside risk management.

Emphasizing the most mature companies within infrastructure and real estate with fewer growth expectations allows for stable cash flow, and may result in a less volatile return stream.

Consider income-producing real assets

Historically, income producing real assets such as infrastructure and real estate have supplied competitive total return and positive inflation hedging effects, with lower correlations to more traditional stocks and bonds. These asset classes have also provided convincing yields, helping investors diversify their income sources. Additional benefits to investors include enhanced total returns and cushioned performance during volatile periods. For these reasons, we feel income-producing assets should be an important part of a balanced portfolio.