Both asset classes are ‘defenders’ in a portfolio. Cherry Reynard considers whether infrastructure is a straight swap for property.
Commercial property was once the dependable parent of the investment world. It brought in a regular income, delivering reliable capital growth and exhibited very little volatility. More recently, however, that same parent appears to be in the grip of a midlife crisis: its financial security and long-term income potential in jeopardy as it finds itself overtaken by a changing world.
It has been a perfect storm for the sector. Brexit created some wobbles, while e-commerce started to dent high street rents; then the pandemic saw off the office market as everyone decamped to their spare bedrooms. Rent collection has been unpredictable and in some cases, commercial property owners have been forced into spats with tenants over liability for payments. Open-ended funds have once again been forced to close to redemptions.
Its mantle has been seized by the infrastructure sector, which has shown its resilience in 2020. In contrast to commercial property, its income generation – usually government-backed and inflation-adjusted – has been steady and capital values have remained stable. Investors might draw the easy conclusion that infrastructure could provide the stability once provided by commercial property and a straight swap is appropriate.
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However, the first problem with this switch is valuations. Looking at the investment trust sector, commercial property funds are currently on huge discounts to net asset value (NAV). At the top end, the BMO Commercial Property (LSE:BCPT) trust is on a 40.3% discount to NAV (as at 26 March), 32% for the Schroder Real Estate Investment (LSE:SREI) trust, 25.3% for the Standard Life Investments Property Income (LSE:SLI) trust. Even the UK Commercial Property REIT (LSE:UKCM), which has delivered positive performance over the past 12 months, is trading on a 16.9% discount.
In contrast, infrastructure assets are in high demand. The behemoth 3i Infrastructure (LSE:3IN) trades at a 17.9% premium to NAV and a relatively low yield of 3.3%. International Public Partnerships (LSE:INPP) is on a 12.1% premium and for HICL Infrastructure (LSE:HICL) the premium is 7.1%. Infrastructure has to continue its strength, while commercial property needs to remain weak to be able to justify these valuations.
Funds versus trusts, which is the best structure?
It is a little different for infrastructure funds, where there isn’t the sentiment factor built in and yields still look attractive. For example, the Legg Mason IF ClearBridge Global Infrastructure Income fund features in the interactive investor Super 60. It is up 24.4% over the past 12 months, has a yield of 5.5% and is significantly invested in energy transition assets. Other open-ended infrastructure funds display similar characteristics. Investors are getting the true price of the underlying assets without the ‘hope’ factor.
For commercial property, however, the open-ended sector still looks problematic. Although funds revalue monthly, there are relatively few transactions in the market with only a few distressed sellers wanting to trade in an uncertain time. As such, valuations could still lurch lower when the property market opens up. The investment trusts reflect this with wide discounts, but the large open-ended property funds may not. Many are only down 10% to 15% from their highs, which looks optimistic given the stress the sector it is experiencing.
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This would suggest a scenario where commercial property investors should buy investment trusts and sell open-ended funds (where possible), and infrastructure investors should sell investment trusts and buy the open-ended funds. However, Jake Moeller, senior investment consultant at Square Mile, is wary about this approach. “This is a short-term arbitrage on two areas that should be long-term holdings.”
He is also clear that infrastructure isn’t a straight swap for commercial property. “Arguably, infrastructure assets are less homogeneous than commercial property assets. While it is relatively easy to understand office or retail property, infrastructure assets are a lot more project-specific and can be complex. Infrastructure presents more problems from a due diligence point of view. It is not a good idea to think of them as substitutes.”
Commercial property is at an inflection point
If short-term arbitrage isn’t the best idea, what are the longer-term prospects for each sector? Commercial property appears to be a tough sell. Of the three main strands – retail, industrial and offices – only industrials seem secure. Retail is suffering as e-commerce gains ground. Agile working is creating considerable uncertainty for the office market: HSBC’s chief executive recently said the group would reduce international office space by 40% and adopt a “very different style of working post-Covid”.
Of course, it is not all one way. Goldman Sachs has made it clear that it will be expecting its staff back in the office, with chief executive David Solomon calling home working an ‘aberration’. It may be that people will be tempted back to the office to grab a little extra face time with their boss, or to glad-hand with clients ahead of their competitors.
John Husselbee, head of multi-asset at Liontrust, is optimistic, believing commercial property is not dead, but at an inflection point. Landlords are seeking policy reform to help them adapt to changing consumer trends, demographics and technology. This includes a refining and simplification of planning permission to allow the alternative use of assets, which, he believes, should help asset values to bottom out.
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He says: “This alternative use case for property assets should be a prominent theme in future, with retail warehouses/parks converted into distribution warehouses for example. We should also see landlords and tenants moving to more co-operative relationships, whether shorter, more flexible lease lengths or the creation of flexible spaces that can be easily adapted, as well as more sustainable rent levels – with some sectors such as retail rebasing these entirely.”
Infrastructure is natural alternative, but not a panacea
Nevertheless, some multi-asset managers believe there are better opportunities elsewhere. Paul Green, portfolio manager on the multi-manager team at BMO Global Asset Management, says: “We’ve steered away from commercial property for a number of years, as even before the Covid-19 impact we felt that yields were unlikely to compress much further, meaning the total return was limited to the income paid.”
Infrastructure is the natural alternative, but investors should be wary of viewing it as a panacea. As Moeller says, it is a diverse asset class and may hold old economy-style assets such as toll roads or utilities, but also new economy assets such as digital infrastructure or renewables. These assets will behave differently in different economic climates.
Nevertheless, there is a lot of money moving into the infrastructure sector as governments across the world try to rebuild after the pandemic – the UK alone has committed to £100 billion in capital spending on infrastructure for 2020-21 and other governments have made similar commitments. Green believes this government spending should be positive for the infrastructure space and the group has exposure across its portfolios.
He adds: “Selection will be key as there tends to be a high correlation to government bonds. It is also important to look at the fund structure to ensure there is no mismatch in liquidity terms.” Infrastructure suffers from the same problem as commercial property in that the assets are generally illiquid and cannot be readily sold to meet redemptions. This isn’t a problem for funds that invest in the shares of infrastructure funds, such as the M&G Global Listed Infrastructure fund, but can be an issue if a daily-dealing fund invests directly in infrastructure assets.
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Husselbee believes that some of the characteristics of commercial property investments - low correlation to equity markets, long-dated income, and an efficient hedge against inflation - can be achieved via infrastructure, but also likes some of the property sub-sectors such as healthcare, logistics, offshore wind, battery storage and digital infrastructure. While some of these areas have risen a lot in 2020, many still offer a competitive income and stable capital growth prospects.
In conclusion, there is no perfect replacement for the stability once offered by previously dependable commercial property and there is an argument that investors should hold on because it may yet come good once it adapts to a new environment. Infrastructure merits a place in an investor’s portfolio but has its risks, particularly after a strong year of performance. It is a reminder that even the most stable investments can wobble.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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