Relative value in real assets: Q2 2023

Read this article to understand:

• Opportunities in real estate equity that are beginning to materialise
• How absolute returns for equity investments are beginning to match debt investments
• How rewards from European and UK markets are diverging

A common challenge for investors in real assets is the lack of a transparent pricing history to track risk, return and the factors driving them. Most firms keep transactional data private and buy supplementary data from external providers, who may not have a comprehensive view of the market. To address this, we have developed our own methodology to apply on a consistent, forward-looking basis (see Aviva Investors’ proprietary real assets relative-value framework).

Our approach allows us to make a quantitative assessment of the risk-adjusted attractiveness of each sector. We carry out five-year, ten-year and full-life analyses, and have the flexibility to assess alternative investment horizons as well. In this analysis, we use a five-year horizon to align with a large portion of investors.

As with any idiosyncratic asset class, manager skill and the specific characteristics of the investment strategy and individual assets mean returns could be significantly lower or higher than those presented. Nevertheless, we believe our approach brings new insights and transparency to the changing prospects in private markets.

Summary

Over the past six months, absolute returns across most sectors have improved.  While risks have varied, the overall risk environment has abated.

Debt markets have offered considerably better opportunities than equity markets for some time. However, this picture is changing gradually as some equity investments have begun to catch up with debt on an absolute return basis. This is a result of an improvement in outlook, notably within real estate.

Looking across markets through an absolute return lens, equity investments in the UK screen better than Europe, which is perhaps counterintuitive given the weaker growth outlook for the UK. However, when considered relative to prevailing risk-free rates, the positions reverse – which is perhaps more intuitive.

Despite these changes, debt remains compelling in our view. Elevated base rates across markets contribute to its appeal, and we do not expect this to subside materially in the near term.

In the UK, floating-rate debt is currently more attractive than fixed-rate in infrastructure and real estate (Figure 2). This is a function of the inverted yield curve where short-term yields are higher than long-term yields, so the starting point for floating-rate debt is from a higher base. This dovetails with our experience, where we are seeing investors willing to pay a higher all-in coupon for shorter-term debt rather than lock-in a longer-term fixed rate at current levels.

Debt markets react rapidly to changes in the rate environment. As such, they repriced quickly off the back of market movements. Equity markets, on the other hand, take time to reprice; broadly speaking, the repricing we have seen as a result of market turmoil has largely occurred.

Overall, markets have typically responded to the recent turmoil and negative news and, in the absence of further developments, are beginning to move on. Clearly risks remain, but all in all, the picture is broadly beginning to improve across the board.

Relative return across sectors

Real estate

Over the past 18 months, real estate has experienced material repricing, but the outlook is improving. A considerable amount of volatility has occurred alongside the revaluation of prices. Our models indicate this volatility is abating as the markets start to price in the end of the interest-rate-hiking cycle for many central banks.

In December 2022, real estate equity would have featured towards the lower-right in Figure 1, but has seen a significant improvement since then. There have been sizeable increases in expected absolute returns, with Europe offering greater increases than the UK combined with less volatility.

On an absolute return basis, the UK has more to offer than Europe, although the gap is closing slowly. Repricing in the UK has been rapid, in contrast to Europe, leaving the UK further ahead on this journey. However, as before, the differential in market risk-free rates must be considered.

Real estate debt continues to offer considerably greater returns per unit of risk than real estate equity, driven by higher government bond yields and illiquidity premia, and reflecting recent equity repricing (Figure 2). UK real estate debt offers higher returns than Europe, predominantly driven by higher gilt yields. However, the picture changes when adjusting for market risk-free rates.

Infrastructure

The infrastructure equity sectors we analyse fall into two buckets – renewables, such as wind and solar, and typically riskier sectors, such as fibre and energy-from-waste.

Over the past six months, renewables sectors have been relatively static. Each saw an increase in expected returns, but the levels of risk also increased, contributing to a mixed picture.

Absolute returns outside of renewables (for fibre and energy-from-waste are markedly higher, to reflect the risks implicit in greater operational challenges, competition and the volatility of returns. Both sectors appear in the top right in Figure 1, indicating a high level of risk and high absolute returns. These sectors experienced slight increases in returns in the first half of 2023, with fibre seeing a significant increase in risk due to greater competition in a more mature market.

Infrastructure debt continues to offer more attractive returns per unit of risk than infrastructure equity, with further increases over the past six months. Default rates, for now, remain low in this sector, which is reflected in the overall risk in our models.

Real estate long income (RELI)

Returns have increased in most sectors, and all have seen a reduction in risk, resulting in an improvement in the return per unit of risk across the board. Factors helping drive an improvement in some short-term returns include the recalibration of property yields alongside rental growth expectations, which are often inflation-linked.

When comparing UK and European long-lease assets, the UK is seen to have scope for greater improvements in return, which has resulted in a narrowing of the gap between the two markets’ expected returns. This is evident in Figure 2, where the return/risk bars now sit relatively close together.

RELI is inherently longer term in nature. The longer-term outlook has improved since the beginning of the year, with expectations of increased returns and reduced risk.

Private corporate debt

UK borrowing activity has reduced significantly in 2023, with activity predominantly focused on refinancing and some borrowers seeking shorter duration, floating-rate structures.

Taking a forward-looking view, UK private placements have seen a reduction in returns in the short term.

In contrast, returns from UK mid-market loans have increased, while Europe has seen little movement. This has caused the gap between mid-market loans in the two regions to widen in terms of returns and returns per unit of risk (Figure 2). The primary drivers are differentials in the market base rates, margin and upfront fees.

Key takeaways

• The outlook across the sectors we have modelled has typically been trending towards a more optimistic picture as some macroeconomic concerns have begun to abate.
• We are beginning to see prospects improve for equity markets, while debt markets have been holding steady as base rates remain elevated.
• All in all, we see continued improvement heading into 2024, in contrast to what has been a volatile and uncertain 2023.