Real Assets

The amount of global institutional capital allocated to the real asset sector continues to increase. We believe this trend will continue as investors have increasing concerns with macro-economic and global events, including: extremely low interest rates, expansive monetary policies (possibly leading to increased inflation), increased volatilities in many markets, and increased correlations among asset classes during times of crises. These factors create a need for investors to further diversify their portfolios, seeking assets with a history of preserving capital, producing steady income, and having low correlations with other assets. Real assets have these favorable investment characteristics.

• In a recent study, Towers Watson¹ reported that institutional pension fund assets (comprising 16 major countries) reached US$36 trillion as of 2014. This study also reported a 10-year compound annual growth rate of 8.1% in pension fund assets (as expressed in local currencies). In addition, the asset allocation of the pension funds continues its shift away from stocks and bonds and into alternative assets (of which real assets is a large component). Towers Watson states that “Since 1995 bonds, equities and cash allocation have been reduced to a varying degree while allocation to other (alternative assets) have increased from 5% to 25%”.

• A September 2014 survey by the Economist Intelligence Unit of over 200 executives from institutional investment organizations concluded that “real assets have a significant and growing presence in institutional portfolios” and that the “median allocation to real assets was 11% of the total portfolio, a percentage that will rise further if the respondents maintain their current course”. Reasons cited for owning real assets included: concerns with macro-economic events, a need to increase returns, enhance income, address long-duration liabilities, increase diversification, and protect from inflation.

In addition, various investment models support the investment rational for including real assets in a portfolio. For example:

• Russell Investments ² “found that a portfolio that also has a 15% allocation to our [Russell’s] real assets model shows improved portfolio returns and volatility”.

• The investment consulting firm NEPC, in a 2009 report ³, recommended a 5% to 15% strategic allocation to real assets.

There remain significant investment opportunities in the real asset sector. This results from a variety of factors, including:

• The real asset sector grows in tandem with increased global GDP and population; all of which creates a growing demand for real assets, including:

  • Natural resources for consumption;

  • Energy for production of goods and household and professional consumption;

  • Infrastructure for distribution of goods and transportation of individuals;

  • Land/property for the investment base that underlies all real assets.

• Emerging and frontier markets continue to mature over time, thus increasing the assets contained within the ‘investable universe’.

• Consolidation opportunities remain as many real assets sectors are fragmented, with many owners lacking sufficient capital, technology, or management skills to own and operate efficiently.

However, real assets can be much more complex to buy, sell, and manage than financial assets. Most real asset investments have a land component, requiring specialized real estate knowledge to perform due diligence. In addition, real assets require skilled, local management to operate the assets efficiently and minimize operating risks.

Timberland

Timberland, as a real asset investment, traditionally refers to ownership or lease of forests and the underlying land for commercial timber production. The forest types can be divided between natural forests (mostly uncultivated) and plantations (cultivated). Institutional investors have primarily focused on investing in plantations (as opposed to natural forests). Trees are primarily grown for use as sawtimber, pulp, veneer, charcoal, or bio-mass (for energy production). Some investors take a more expansive view of the timber investment space to include manufacturing of wood products (sawmill, veneer mills, etc). Arcterra is focused on the underlying asset as opposed to production facilities, but has experience working with projects that combine the two.

Institutional private equity investing in timber began in the U.S. in the late 1980s, growing exponentially from about US$2 billion in 1980, to US$25 billion by 2006 ⁴, and (as reported by Newforests ⁵) to US$65 billion by 2015 on a global basis (with approximately an additional US$35 billion more invested in REITS). In their report, NewForests estimates the investable timber universe to be approximately US$200 billion (this figure excludes Europe); however, a 2010 report by Callan Associates ⁶ estimates the investable timber universe at nearly US$300 billion, while a 2005 study ⁷ estimates the investable total to be US$480 billion. Much of this difference in estimates involves the authors’ differences of opinion (and their difficulty) in deciding what constitutes ‘investable timber’. Also, these estimates vary significantly in the amount of investable timber by geography. However, the ranking of the investible timber based on percentages of total value is more uniform. The U.S. is always ranked #1 by a wide margin, usually followed by South America #2, Australia/New Zealand #3; with Europe, Canada, Southeast Asia, Africa and other geographies comprising the balance. Arcterra believes a reasonable estimate by value would be the U.S. comprises 60% of the investable timber, South America 20%, Australia/New Zealand 10%, with other countries at 10%. This allocation of course is very dependent on the risk tolerance of the investor and what he/she considers investable.

The U.S. market for timberland is considered mature, with much of the investable timberland in the U.S. having been previously purchased by institutional investors. Most of the larger transactions are now occurring between institutional owners (and/or REITS). Concomitant with the increase in institutional capital invested in U.S. timberland has been a compression of the cap rate. Therefore, many institutions are seeking higher risk adjusted returns for their portfolios by expanding into ex-U.S. geographies. Arcterra is of the opinion that this investment trend into ex-U.S geographies will continue.

Agriculture

Agriculture, as a real asset investment, traditionally refers to ownership or lease of farmland for production. Broadly speaking, the production types can be divided among annual row crops (e.g. soybeans, corn, wheat, and cotton), permanent row crops (e.g. fruits and nuts), and livestock (e.g. beef and dairy). However, some investors are taking a more expansive view of the investment space to include processing, storage, and distribution. In a 2010 paper by HighQuest Partners ⁸, they report the results of an interview with 54 funds/companies that invest in farmland or agricultural infrastructure, with the vast majority investing (by hectares) in row crops (83%), followed by livestock (13%), and permanent crops or other uses (4%).

One estimate is that the total agricultural land value is over US$8 trillion ⁹. Of that total, only US$1 trillion is estimated to be investable, of which only US$35 billion represents investments by institutions (as of 2012). This low penetration rate (3.5%) of the investable agricultural universe by institutional investors is partly due to high fragmentation, with many single parcels owned by family owner/operators. Further investment opportunity exists for institutions, especially into ex-US geographies. Of particular interest to Arcterra and its clients is that while approximately 60% of the investible universe is considered to be in the US, much of the ex-US investable farmland is situated in Brazil, Argentina, Chile, and Uruguay. These four countries comprise about 25% of the investable universe. Therefore, if an investor is looking to invest in ex-US farmland, these four South American countries represent a significant portion of the ex-US investment opportunities.

Many of the previously cited researchers and authors have concluded that real assets, including timber ¹⁰ and agricultural ¹¹ assets, can offer diversification, inflation protection and attractive total returns over the long term. Of particular interest to many investors is the correlation of real asset returns to inflation. One study of the correlation of inflation and timberland returns states that “While correlations among asset classes can change over time, we have noticed that timberland has tended to remain strongly correlated with inflation” ¹². Much of the published research supporting this and other statements involving timber and farmland relies on return data from the NCREIF Timberland Index and the NCREIF Farmland Index.

In general, the U.S. data as provided by these indexes show that timberland and agriculture have higher risk adjusted returns, low correlations, and inflation protection as compared to most other asset classes. This data suggests that similar diversification, inflation protection, and attractive total returns can be attained in ex-U.S. geographies. However, we caution that the underlying data is from the U.S. only and may not be entirely representative of international markets, especially when other investment factors such as country risk, currency risk, and expected risk adjusted returns are considered when constructing a well-diversified portfolio.