Infrastructure & Property
One of the key defensive cornerstones of multi-asset and equities portfolios since the end of the GFC has been the use of property and infrastructure securities. The typical structure is a trust, holding assets or part ownership of assets, an optimal quantity of financial leverage, an delivering a stable and consistent income.
We will argue in this note that selectivity and a discerning eye will now be required in this asset class, with the use of ETFs for broad passive coverage now fraught with risks now we have entered a new market paradigm.
What characterises this paradigm and how does it differ from the traditional view of this asset class?
To answer that question requires us to consider what effectively a lockdown means for our assumptions of the stability and predictability of cashflows for these assets. What the lockdown highlights, is that cashflows are far from predictable or certain, when clients and customers are unwilling or unable to utilise the infrastructure once deemed “recession proof”.
Suddenly the utilisation of the asset, and hence the revenue stream, develops a level of risk, perhaps not associated with the business cycle, but more associated with government policy around pandemic risk, and our willingness even in the absence of a lockdown, to mingle freely with our fellow citizens in a workplace or a shopping centre, where there is no exacting requirement to do so.
Sell-side forecasts are already starting to reflect the uncertainties associated:
Figure 1: In the chart below the orange line (RANGE) is the spread of dividend estimates across sell-side analysts – as the line increases, analysts are more prone to disagreement.
The blue line (STAB) is the standard deviation of estimates, a different measure of uncertainty, which essentially confirms the same trend – analysts are increasingly uncertain as to the trajectory of dividends for these assets.
(Source: Refinitiv, Resonant Asset Management)
Why does this matter
Uncertainty never was the name of the game with these securities – investors use them specifically to provide a cushion during times of market turmoil.
In addition, providers of debt capital have not factored in the incremental risk we now see: even if the RBA target rate is at record lows, the cost of debt of these assets certainly is not.
In financial markets, perceptions matter as much as reality: perceptions have now shifted, at least semi-permanently; away from stable to unstable cashflows.
The stability of cashflows and cheap cost of debt is what permits the issuers of these securities to embed financial leverage:
Figure 2: Index weighted Debt to Equity ASX 200 Infrastructure and Property Stocks (source: Resonant Asset Management calculations, Refinitiv data)
The chart above is the weighted average Debt to Equity ratio of these stocks. The series is volatile because of the way the data is reported by specific companies – suffice to say, that over the last ten years, the trend is up – from around 60% net debt to equity to at least 80% and on the latest estimate, over 100%.
Debt in itself can be a good thing for equity holders as it enhances returns. But it also increases risks, risks that are latent, not apparent to investors until they are.
What happens now
A protracted and prolonged de-rating of these securities is inevitable, particularly for assets whose cashflows were assumed immune to uncertainty, and for whom reality is now setting in. As we crunch our asset allocations, what long term risk premiums would traditionally satisfy for this asset class?
Figure 3: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (source: Resonant Asset Management)
The chart above shows the return demanded by investors over cash to invest in the asset class: as you can see we have moved from a near 3% hurdle rate to invest, to near 6%, as uncertainty hits.
What is important, is how this compares to competing asset classes: and in our view, the gap between the risk premia for equities, and this asset class, is inevitably closing:
Figure 4: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (Blue) vs Broad Australian Equities (Orange) (source: Resonant Asset Management)
In fact we would argue that this should not be treated as a separate asset class any longer: it is quantitatively tantamount to equity risk, and offers no exceptional or structural defensiveness, that merits its exceptional treatment.
We advocate selectivity in the main across these assets, as there are securities within the complex that will continue to offer stable cashflows, but the dispersion in outcomes across the investible universe will be large, so passive investing is the least attractive approach at this point.
Resonant Asset Management Pty Ltd, ABN 41 619 513 076, trading as Resonant, AFSL No 511759.
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