Growth AND income: Getting the best of both worlds
Investors seeking income generally do so at the expense of growth. After all, a dollar returned in income, is a dollar not reinvested.
But the 'Fourth Industrial Revolution' offers opportunities not seen in other sectors. Whether it's investing in warehouses to enable e-commerce, or cell towers and internet infrastructure, the opportunity is there for investors to 'eat their cake and have it too.'
In this wire, two fund managers – Mark Mazzarella, Portfolio Manager of the APN Global REIT Income, and Jonathan Van Rooyen, Partner and Chief Investment Officer at Invest Unlisted – offer their insights into investing for income in property, outside the usual paddock.
The two approach this asset class from markedly different perspectives.
For Mazzarella, the search for income means looking offshore via real estate investment trusts (REITs). He says well-chosen assets of this type offer the best of both worlds: income plus growth.
Van Rooyen's patch is unlisted infrastructure, an asset class that offers exposure to government assets with risk control at the tight end of the spectrum. This stuff is at the heart of how society functions.
Both weigh up the risks of investing in today's environment and discuss specific opportunities for income investors.
Look outside the box
"The search for yield is a perennial one," Mazzarella says. "But in this environment, with rates at record lows, investors could be well rewarded to broaden their field of view."
Mazzarella says the spotlight is often on Australian real estate investment trusts, but growing income streams are easier to find offshore. "In the global REIT sector, businesses with exposure to e-commerce, mobile phone towers and data centres are our standout investments."
"At about 3.3% (GPR 250 REITs Index), some might consider the yields from global REITs low in absolute terms, and yet they are almost double the available yield on global equities at circa 1.65% (MSCI World Index).
"But what gets us really excited is the prospect of a competitive yield plus attractive growth."
Mazzarella says investors don't need to take an either/or approach to income and growth.
"This is not a departure from APN’s long-standing property-for-income philosophy, where we seek out attractive, regular, and growing income distributions from commercial real estate," he says. "This was the driver behind the launch of the APN Global REIT Income Fund in April 2020."
Bunnings isn't the only warehouse
Within the Australian sphere, Van Rooyen says many income investors are using Bunnings Warehouse facilities as a kind of benchmark of returns.
"Property investments are in strong demand from private capital seeking income," he says. "Each day we hear announcements of high-quality Australian property transactions being struck at yields of 3-5% per annum."
"Most prominent were 11 Bunnings Warehouse facilities that transacted for about $400 million. The annual yields of these trophy sites reportedly range from 4% over 10 years to 5.9% over 5 years."
Van Rooyen says a review of four unlisted property income funds raising more than $350 million in the last 12 months showed the underlying demand for yield.
"There is no shortage of options offering investment periods of 5-7 years, portfolios of 1-4 assets, targeting a levered internal rate of return of 7-8.2% (net of fees), and offering minimum investment thresholds of $10,000-$50,000," he says.
But Van Rooyen says there are other ways for private investors to access stable income streams and pandemic-proof their portfolios for the long term. How do the big kids do it?
Copy the institutions
"Australia’s largest investors, comprising the industry superannuation funds and the Future Fund, have an enviable history of early investment into income-generating assets such as unlisted infrastructure," Van Rooyen says.
"We can see it in their highly diversified portfolios, the sophisticated asset allocation, and the long-term results they have delivered.
"Investors get excited about a Bunnings Warehouse lease in regional NSW, but what if you could invest in a portfolio of long-term leases directly with the NSW Government through an availability payment model?"
This class includes high-yielding social infrastructure assets such as:
- Education facilities
- Water treatment
"These assets have revenue certainty via a long-term public-private partnership government-backed concession, typically over 25-30 years," Van Rooyen says.
"The availability payments are not exposed to demand or patronage risk, competition or sudden changes in economic activity such as the COVID pandemic. Government generally pays the revenue as long as the facility is available for use."
Disruption goes viral
While Van Rooyen's speciality of unlisted infrastructure offers COVID-proof protection, in Mazzarella's sphere, the pandemic has brought opportunity.
"The pandemic has changed the opportunity set," Mazzarella says. "While lockdown restrictions placed retail malls under pressure and working from home heralded renewed calls for greater flexibility in the office market, the opportunities in global REIT portfolios exposed two major trends that take us to the heart of the opportunity."
To put it simply, warehouses are pumping. More space is needed to support the growth of online retail and make supply chains more resilient.
"The pandemic has accelerated the need for more warehouse and distribution space, especially in North America, where the consumer shift to online was already ahead of most countries," Mazzarella says.
"Through the second quarter of 2019, a Digital Commerce 360 analysis of US Department of Commerce data estimated online retail penetration at 14.5%. The latest figures suggest this has since increased to 18.6%.
"The upshot? The pandemic has pulled forward future demand by several years and almost certainly bought a new audience of shoppers online. Supply chain resilience and efficiency in getting online shoppers what they ordered fast has made fulfilment a key battleground for logistics operators and retailers."
This growth trend has been good for industrial REITs the world over but is most pronounced in North America.
"Warehouse premises will benefit from the acceleration in demand and landlords are likely to enjoy higher rents over time," Mazzarella says.
"We expect industrial REITs to have close to the highest levels of earnings and dividend growth across the wide range of property sectors."
Mazzarella provides the North American example of Industrial Logistics Properties Trust (ILPT), held by the APN Global REIT Fund.
"It features an attractive portfolio of high-quality logistics premises and a well-covered distribution yield of 5.20%," he says. "Comparative REITs in Australia don’t get near this kind of figure."
"Even among the global REIT universe, ILPT offers an additional 1.9% distribution yield. With our focus on high quality yield, ILPT’s lease covenant strength is really appealing. About 15% of all rental income derives from tenants like Amazon and FedEx."
We're in the fourth industrial revolution
The fourth industrial revolution, driven by data, has been underway for some time. In many ways, the pandemic has accelerated it.
"Instead of physical goods, the movement of ones and zeros travelling across networks of optical fibre, data centres and mobile phone towers is providing income investors with some fantastic opportunities," Mazzarella says.
"Two positions in the APN Global REIT Income Fund – American Tower Corporation (AMT) and Equinix (EQIX) – offer exposure to global portfolios of mobile towers and data centres and are set to capitalise on this revolution."
Mazzarella says the revolution has just begun and mobile phone towers and data centres are at its core.
"A mobile phone tower usually supports multiple tenants," he says. "Tower space and portions of the land underneath are leased out to tenants, who cover the costs of installing additional antennas.
"From the towers, data is transmitted to data centres, where it is stored and processed.
"This is mission-critical real estate. Without it, the fourth industrial revolution grinds to a halt. The more data consumed, the better businesses data centre REITs and mobile tower REITs become."
Mazzarella says APN’s Global REIT Income Fund offers an excellent opportunity to invest in asset classes that are not available locally.
"Historically, because of their growth rates, dividend yields in this sector have lagged more established property types, such as retail and office," he says.
"But tower and data centre REITs have grown their dividends at twice the rate of the overall sector. This is just one of the reasons we’re so excited about them.
"Over the next three years, yields in this sector are expected to grow by an average of 11.2% a year.
"The price of a higher, growing future yield is a lower current yield as tower and data centre REITs invest in growing their asset bases.
"For long-term income investors, this is an alluring trade-off, as it offers the prospect of higher capital growth and higher yields down the track.
Staying out of danger
Van Rooyen warns that investors searching the investment markets for income need to be aware of the specific risks of unlisted property.
One risk relates to the marketing of opportunities during the pandemic. "There is evidence that the definition of 'essential service' is being stretched to include service stations, funeral homes, car dealerships, childcare, education service providers – and medical centres," he says.
Another relates to revenues falling short. "There is the counter-party or tenancy risk, namely the businesses delivering the cash flow stream critical to sustain these forecast yields. Not everyone is a Bunnings."
Management costs must also be considered. "Unwary investors seeking the promised yields need to be clear-eyed about the layers of fees that can be buried in an unlisted property trust's offer documents," Van Rooyen says.
"While entry and exit fees are (mostly) a thing of the past, there are still property acquisition fees, property divestment fees, management fees, performance fees, finance facility fees, and in some cases, expenses (typically capped as a percentage of the gross asset value of the fund). All these fees impact the future returns."
A short course in risk factors
Van Rooyen offers this list of specific risks for investors in property to consider and the related protections that come with availability-based unlisted investments:
Revenue risk. "Base revenue is generally fixed and paid to the investor for making the facilities available."
Pricing risk. "Inflation-linked income is matched to underlying expenses and debt service."
Volume risk. "The assets are predominantly availability-based, meaning much lower volatility of returns for investors."
Cost risk. "Costs are fixed and indexed or benchmarked, for example, over the life of a 25-year concession."
Counter-party risk. "What could be better than Bunnings, you ask? Well, in the case of our investment in the Sydney Desalination Plant, our counter-party is the great state of NSW."
Capital expenditure risk. "In the case of availability-based infrastructure, the whole-of-life capital-expenditure program is agreed and embedded in the asset returns. This results in lower volatility and more predictable, consistent cash yields for investors."
Financing risk. "Availability assets typically sustain higher gearing levels. Base rates are fully hedged for the life of the concession, with typical debt profiles of 5-7 years."
Operational risk. "Operational risk is sub-contracted to third parties with transparent performance criteria."
Valuation risk. "An important benefit of government-backed concessions is there is typically zero terminal-value risk."
Service delivery risk. "The obligation to deliver services is typically retained by the government counter-party."
After covering the risks and opportunities, what is there to take away?
Mazzarella sums up his case: "The APN Global REIT Income Fund delivers access to income returns from a world of commercial property, available to investors through an actively managed portfolio of global property REITs.
"Focused on the developed markets of North America, Europe and Asia Pacific, where local fundamentals and accelerating structural trends are strongest, the fund offers great prospects for sustained rental growth, attractive yields and long-term value creation through REITs like American Tower Corporation, Equinix and Industrial Logistics Properties Trust."
Van Rooyen likes the idea of unlisted infrastructure investment finally becoming democratic and admitting the average investor alongside big institutions.
"Like Australia’s Future Fund, mum and dad investors increasingly have opportunities to invest in highly diversified portfolios of unlisted infrastructure investments comprising availability-based models, supported by multi-year concessions with governments, with limited volume or pricing risk – and low correlation with other asset classes," he says.
"The result: consistent, stable income. It’s a turbocharged version of the Bunnings lease!"
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