A BALLAST IN UNCERTAIN MARKETS
Institutional investors have long turned to real assets for diversification and inflation hedging — and it’s an opportune time to do so today. Broadly defined as tangible or physical assets that have intrinsic value, real assets include infrastructure, real estate and other sectors. Allocators are parsing the specific benefits each segment can bring to their overall portfolio, particularly in light of uneven macroeconomic signals and greater market volatility.
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“Slowing growth combined with stubborn inflation makes certain real assets, such as infrastructure, real estate, natural resources and commodities, especially enticing,” said Vince Childers, head of real assets multi-strategy at Cohen & Steers. He sees three considerations driving increased interest in exposure to real assets: inflation sensitivity, portfolio diversification and risk/return trade-offs. “Our discussions with institutional investors center around ‘where and how’ to invest in real assets, versus ‘why.’”
Gregory Michaud, head of real estate finance at Voya Investment Management, sees real estate debt as being particularly interesting for allocators today. “We view real estate debt as an effective way to diversify across institutional fixed-income portfolios,” particularly commercial mortgage loans. While insurance companies have long maintained hefty allocations to commercial mortgage loans, pensions have been slower to move into the asset class, due to it offering the illiquidity of real estate equity but the yield and risk profile of fixed income. However, with the rise of liability-driven investing popularizing investment-grade private credit as a diversifier and yield enhancer, Michaud said an increasing number of pension funds are excited about commercial real estate’s ability to offer consistent returns at a premium to comparable investment grade bonds.
Proof of concept
The post-COVID inflation run-up has demonstrated the viability of investing in real assets.
“The post-COVID inflation spike did a whole lot of work in terms of proof of concept for real assets investing,” Childers said. “It convinced a number of investors who had not had that real world experience of how bonds and equities might perform when you had that kind of inflation shock come out of nowhere and catch everybody off guard.”
For instance, “at the end of the first and into the second quarter of 2022, inflation peaked around 9% and was generating large shocks relative to prior-year expectations, where surveys looking ahead had projected inflation numbers more like 3%,” Childers said. “By the time you looked in the rear-view mirror at the one-year returns, you had negative returns in Q2 in both stocks and bonds, and yet a diversified real assets portfolio was still delivering positive returns.”
Looking ahead, Childers’ team believes that markets are in the midst of a regime change. With its first rate cut in September, the Federal Reserve has signaled a bias toward supporting the U.S. labor market and that they’re not particularly concerned with inflation worries, he said, despite inflation staying somewhat sticky at around 3%. “What we’re really saying is that a Fed that’s very accommodative at this point may be creating upside inflation risks — but those risks look underpriced in the broader markets.”
As investors weigh that potential upside risk, “on the whole, it’s not a bad outcome for a lot of real assets, given their typical positive inflation sensitivity,” Childers said. “While we think about the direction of interest rates as part of our tactical views within the portfolio, history tells us there isn’t a whole lot of negative rate sensitivity across a broadly diversified real assets portfolio.”
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Finding relative value
Real estate valuations across several segments have continued to struggle following the post-COVID rate-hiking cycle. For instance, the large real estate platforms allocated to the Class A office buildings in markets like New York and San Francisco continue to see write-downs and impairments, said Michaud at Voya IM.
However, commercial mortgage lending tends to focus on longer-dated loans to the higher-quality borrowers with stable cash flows. Institutional clients such as pension funds are seeing “good relative value pickup that they can put in the illiquid portion of their fixed-income allocation and where spreads are relative to the comparable-rated bonds,” he said. Also, compared with traditional equities, “if we lend around 65% for real estate exposure, we’ve still got a 35% cushion ahead of us.”
“We don’t have the high exposure to legacy big office loans in the primary markets that many of our peers have. We like high-growth secondary markets, and our focus has always been more on retail, industrial and select multifamily,” Michaud said, which fit well in core and core-plus allocations for many institutional allocators.
With the Fed’s expected path to lower rates, Michaud cited two reasons that returns on commercial mortgage portfolios should remain robust. First, these deals tend to be fixed rate and provide 7% to 8% coupons. While residential mortgage refinancings tend to follow declining rates, it’s far less common on the commercial side due to high friction costs, he said. “It costs a lot of money to refinance a building, take out, pay for appraisals, attorneys, and so on.”
A second reason is that commercial mortgage loans are yield maintenance protected over the life of the deal, or they have exit fees. “Investors will still be clipping nice coupons for the next 18, perhaps 24, months while rates are dropping,” he said. “Eventually, these loans will get paid off. They’ll get marked to market. But rate drops don’t necessarily mean you’re going to see vast payoffs,” he added, “and investors will continue to benefit from their commercial mortgage portfolios that were built over the recent term.”
Source: Pensions & Investments' Top 1,000 U.S. Plan Sponsor annual survey.
Support in era of scarcity
For investors considering the breadth of real assets segments today, it’s important to incorporate their longer-term market outlook. “We characterize this period as representing the potential for more of an era of scarcity in the decade ahead versus what we’ve characterized as an era of abundance from the great financial crisis up until COVID,” when the positive-supply shocks and disinflationary forces were not as supportive of real assets, said Childers at Cohen & Steers. The current era represents “a lot more risk in the decade ahead. We may be looking at the possibility of more negative-supply shocks and greater risk of recurrent stagflationary bouts” that can slow global economies. “All of those risks will not manifest in 2025, but we’re keeping an eye on them, as they would likely support real assets for the long run,” he said.
A CUSTOM PATH FOR REAL ESTATE
Amid blaring headlines about half-empty offices and loan delinquencies, many investors have “the misconception that commercial real estate is the same across the board. But unlike residential real estate, which is relatively generic, commercial real estate is very specific,” said Michaud at Voya Investment Management. “It’s market specific, asset specific. Even within office, which makes up only $740 billion of the U.S. total $4.7 trillion in commercial mortgage debt outstanding, there is a world of difference between the prospects for an aging landmark building in New York City versus a smaller floor plate suburban office. The latter is seeing leasing growth in many markets, and where it isn’t, residential conversion is a viable option. Meanwhile, the retail market is seeing its lowest vacancy rate in 20 years. But when you just go by the headlines, it’s like throwing out the baby with the bathwater.”
With regional banks having largely exited the commercial financing market, as well as tighter Fannie Mae and Freddie Mac lending criteria, private lenders can source a wider range of increasingly attractive debt deals, he said. Voya IM’s commercial mortgage lending team is able to customize institutional portfolios based on individual client needs, such as duration, credit risk, leverage and capital. It takes a layered and customized approach, building diversified portfolios that originate mortgage loans across borrowers, tenants, locations and property types across the U.S.
Commercial mortgage loans “have structural advantages that play out over the course of market cycles, including direct access to borrowers and the ability to negotiate directly with property owners during periods of volatility,” Michaud said. Both help to drive the workout and recovery process.
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Opportune areas
Michaud said he sees significant opportunities in office, retail and industrial — and, with some caveats, multifamily.
Office: Office must reinvent itself to succeed, and that’s currently happening in the smaller — under $75 million — sector in secondary markets, driven primarily through mixed-use conversions that blend residential and commercial spaces. “Offices, especially in the suburban market, are going to be more mixed-use with the ‘live-work-play concept’” in order to secure much-needed funding, he said. While mixed-use conversions come with various challenges, including high costs and zoning and regulatory constraints, these properties are likely to see greater success over the longer term. Since hitting bottom in the smaller office space, “we’re starting to see positive upward changes in both leasing and sales,” he said.
In contrast, the larger $100-million-and-above office sector in primary markets is still struggling. “We’ve also hit bottom in this segment, but there’s no liquidity in sight. Many larger deals have been marked down by 70% and could face the prospect of greater cuts,” he said. Also, shorter five-year leases are in demand versus the 10- to 15-year leasing terms that were the norm pre-COVID. “It’s a real challenge for office owners because they’re going to have a harder time amortizing that over a certain period of time and getting a decent net effective rent.”
Industrial and retail: More opportunity, given greater liquidity, exists in the smaller 50,000- to 75,000-square-foot — and even the 30,000-square-foot — space versus the larger Class A deals of a million square feet and above, Michaud said. Regarding the latter, “we’re still a little worried that there might be a little overbuilding going on, making it harder to find big tenants.” In the smaller spaces, “we’re seeing a lot of older, smaller industrial properties get a second life due to distributors trying to solve the last-mile problem.” In retail, lower-quality retail space has been washed out of the system by being redeveloped, which has improved supply-demand dynamics.
Multifamily: This sector was hit especially hard in the past few years by rate increases, inflation driving up costs and overbuilding. Liquidity has started to flow as capitalization rates have stabilized, and owners have begun marking to market to adjust down rents, Michaud said. “We think the Class A multifamily sector should do quite well in the next 12 to 18 months, as the category bottoms out and rents start to increase.” Multifamily should return to more of a supply-demand equilibrium, especially as construction has stalled, which bodes well for future performance. Lower interest rates may also bring additional liquidity to the sector, he said, though “it’ll take time for lower rates to get reflected in the market and provide support to property values.” Michaud cautioned that major expense increases have hit multifamily the hardest with, for example, insurance premiums having risen by two to four times in popular markets.
Listed real estate
Listed real estate represents one of four core real asset categories within Cohen & Steers’ multistrategy approach, one that is currently in an underweight position, Childers said. While listed real estate has endured significant repricing post-COVID, it is seeing a more conservative use of leverage than in previous cycles as companies do a better job of deleveraging and staggering debt maturities, he noted. As a result, many more companies are in a better position to deploy a more attractive cost of capital to acquire assets and grow.
Cohen & Steers’ multi-strategy team explores secular forces, such as technology and demographics, that underpin their strategic allocation views in listed real estate and infrastructure. Data centers and towers provide services that are “the backbone of the entire modern communications infrastructure, and increasingly, AI themes,” Childers said. On the demographic side, demand drivers that underpin real estate include the senior housing needs of baby boomers aging into retirement and the single-family rentals by millennials who can’t afford to purchase a home.
A HOLISTIC ALLOCATION APPROACH
As institutional allocators turn to real assets to achieve varied objectives, it’s important to remember that each segment has distinct drivers of risk and return — and each responds differently during market cycles. “Investors should think about the non-inflation-related drivers of risk and return, ultimately taking advantage of the lower correlations within, and among, real assets,” said Childers at Cohen & Steers.
To help maximize the benefits of a real assets portfolio, “we do not recommend over-concentration in just one, or even two, real asset categories. Instead, we believe an actively managed, multistrategy approach across specific core asset classes — global listed infrastructure, natural resource equities, commodity futures and global real estate securities — can provide investors with a holistic approach to real assets allocation,” Childers said.
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Cohen & Steers’ multistrategy is overweight global listed infrastructure because of its attractive valuations and more defensive risk attributes. “We like to focus on infrastructure companies that have strong balance sheets, with limited near-term maturities and manageable refinancing schedules,” Childers said.
This segment has a number of favorable dynamics. First, lower rates have historically been favorable for infrastructure assets, especially for higher cost-of-capital businesses such as data towers and utilities. Second, a slowing growth environment that could be ahead, “has historically benefited infrastructure that has more defensive characteristics than most of the other real assets,” he said. A third dynamic is tied to the exponential demand for power, which underpins a long-term secular opportunity. “Global data center power demand is poised to more than double by 2030, given strong demand for cloud computing and, increasingly, artificial intelligence,” Childers said.
Marine ports are another secular infrastructure theme, given that “upwards of 90% of global trade relies on ocean freight, with a large number of very busy ports in the world, especially in emerging markets,” he said. Solid fundamentals are combined with relatively positive pricing power for many marine port businesses in the listed markets.
Compelling segments
Childers sees compelling value across natural resource equities in natural gas, agribusiness and metals and mining — another overweight in Cohen & Steers’ multistrategy portfolio. These companies are kicking off enormous free-cash-flow yields that are very attractive, he said, despite the markets being “skeptical over natural resource companies’ ability to generate long-term cash flows, as well as the willingness to distribute them.”
While U.S. natural gas prices dropped significantly this year, Childers expects 2025 prices to rise with increased demand from liquified natural gas and power projects. Several natural gas exploration and production companies have lower costs and the ability to generate free cash flow, he noted.
Within agribusiness, bearish sentiment continues, especially as a grain oversupply has made investors wary. But the pessimism could be an overreaction, Childers said, in light of improving grain prices and policies supportive of sustainable agriculture practices helping drive future opportunities. Another depressed sector has been metals and mining, following the far-reaching impacts from China’s economic slowdown. But the major Chinese stimulus package in September could signal the start of, “a nascent global manufacturing recovery along with supply-side disruptions on the metals and mining side, which means base metals may be poised to outperform.”
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