Real opportunities in real assets
The word “real” is a broad term that has many different meanings, so it should perhaps come as no surprise that the term real assets can also be defined in different ways by investors.
real; adjective1. existing or occurring as fact;
2. being an actual thing, not imaginary;
4. (of money, income or the like) measured in purchasing power rather than in nominal value.
Our definition of real assets covers three main investment areas – agriculture, timber and water. There is a finite volume or quantity of land for each of these areas, but they are all self-replenishing through naturally occurring cycles. As such we can consider them to be organic, non-finite natural resources (therefore excluding extractive industries such as mining).
These real assets all share some similar investment characteristics but also exhibit some key differences.
Why should investors consider real assets?
The key benefit of investing in real assets is diversification. In most cases, returns from real asset strategies have a low or negative correlation to more traditional asset classes such as fixed income and equities. This means that real assets have the ability to deliver a positive investment return even at times when other asset classes are struggling.
Real assets have also proven resilient through different economic conditions and offer greater cash-generating potential than many other asset classes. They can produce an income return (typically linked to the annual crop, harvest or productivity of the underlying asset) and the prospect of long-term capital appreciation.
Part of this capital appreciation has historically been linked to inflation, which brings us back to the definitions of the word “real” in the introduction. Real assets have historically protected investors from inflation, by rising at a similar, or slightly higher pace than prices in the broader economy. This is why they can be considered “real” assets, as opposed to “nominal” assets such as many fixed interest securities, which cannot protect investors against inflation. At a time when many investors are becoming increasingly concerned about rising prices, the protective nature of real assets may be seen as a potential natural hedge against the risk of future inflation.
When considering real assets, investors should take a long-term view, perhaps even more so than for other alternative asset classes. Many timber and agriculture investment strategies encourage investors to invest for fifteen years or more to benefit fully from the attractive investment characteristics on offer.
Agriculture: grow your own performance
With such a long-term investment horizon, the economic fundamentals for most real assets look positive, but this is particularly the case for agriculture, which has a clear megatrend in its favour. According to the United Nations, approximately 385,000 babies are born every day, which means there are 140 million more mouths to feed every year. The world is experiencing increasing demand for food, but the amount of land available upon which to grow it is ultimately finite. Combined with the trend towards healthier lifestyles, changing diets and increasing awareness of the climate crisis, the long-term market fundamentals for agriculture assets look robust.
Historically, Australian agriculture has been dominated by family businesses, but that is beginning to change. Over the last decade, a considerable amount of institutional capital has started to flow into the sector, attracted by Australia’s transparent regulatory environment, strong legal system and relatively low levels of protection (in the US, for example, it is far harder for foreign investors to buy farmland in certain states). This wall of capital has driven prices gradually upwards, bringing Australia more into line with international agricultural land valuations.
There are two main ways to invest in agriculture.
- The first is known as cash-lease, where an investor buys the land and then leases it to an operator in return for an income stream. The advantage of this route is that returns are predictable and operational risk is outsourced to the operator.
- The alternative is an operational strategy whereby an investor buys the land and operates it too. This is a higher risk because the investor must embrace the operational risk and the volatility that naturally comes with the variability of harvests and productivity. Nevertheless, in the long run, the returns from this type of strategy should be higher, as the investor is capturing more of the profit margin.
In the US, the cash-lease model is well-established, but the family business legacy of the Australian agricultural industry means the owner-operator model is much more entrenched.
It perhaps goes without saying that investing in agriculture is not without risk. These include weather events such as droughts, wind and extreme rainfall. Insurance is expensive and sometimes unavailable for agriculture assets. Investors should therefore be prepared to embrace volatility in returns, reinforcing the need for a long-term investment horizon.
One area of agriculture that looks particularly interesting currently is the advent of sustainable greenhouses. These are industrial scale, state-of-the-art greenhouses that utilise resources as efficiently as possible by capturing and reusing energy and water from sustainable sources. They do not use fertilisers or other chemicals, and the entire environment is controlled to deliver an optimal blend of efficiency and yield. The greenhouses are leased to operators who pay an attractive rental income to the asset owners. They are already becoming popular in Europe and the US and we are aware of a few market players that are interested in bringing this innovative new growing system to Australia.
Timber: seeing the wood for the trees
The global timber investment industry is dominated by North America, which accounts for approximately 70% of institutional investable timberland. The attractions of this part of the asset class are perhaps best summarised by the old market adage, “share prices may fall, but the trees will still be standing”.
Like agriculture, timber is well-placed to benefit from some established global megatrends, including the drive to rely on more sustainable raw materials as a result of the climate crisis. Timber has, of course, been a key material for the housing industry for centuries, and this does mean that there is a relatively strong correlation between timber prices and the broader economy through construction demand. This means that income returns from timber can be more correlated to mainstream asset classes than other parts of the real asset universe. The capital value of timberland is much more stable, offering excellent downside protection during periods of broader financial market turmoil.
Despite some very positive investment characteristics, timber is still seen as an emerging investment opportunity. It is also a highly specialised asset class because it requires a combination of global scale and local expertise. Scale is required to build an appropriate level of diversity by geography, climate zone and species and local expertise is needed to effectively manage risk within each asset. Bushfires, for example, represent an obvious risk and, although modern technology is starting to play a greater role (drones are taking over from the traditional watchtower approach, for example), it tends to pay to have an experienced local property management team in place.
All of these things combine to make successful timber investment difficult and expensive. There are only a handful of providers that do it properly, but the long-term returns that can be delivered when it is done well are impressive.
Water rights: the ultimate liquid investment
Australia has one of the most transparent and regulated water markets in the world. Water rights form an important part of this market structure, providing the holder of the entitlements with a specified volume storage of water from a particular source for consumptive use. Entitlements vary by State jurisdiction, but they are all transferable and can be valued at the market by observable traded prices.
The traditional owners of these water rights have been farmers, who need reliable access to water to maximise their annual productivity. Prior to 2012, water rights were not really considered an investable asset but, since then, they have been attracting increasing attention from institutional investors. In part, this has been driven by progressive market reforms, which have improved market efficiency and made it easier for institutions to invest.
Additionally, farmers have been keen to rationalise their balance sheets. It is expensive to hold water rights as an asset, and many farmers have looked to sell their water rights, and instead pay annually for access to the same source of water. Institutional investors have facilitated this transition by buying the assets, attracted to the consistent, highly regulated income stream and the prospect of long-term capital appreciation.
Historically, returns from water rights have been approximately 10%-15% per annum, driven by a combination of the regular income stream and steady capital appreciation. The capital value of the underlying asset has benefited from the additional institutional demand, alongside an ongoing shift in water use from lower-value crops to higher-value permanent produce such as almonds, citrus and grapes.
The trends that have seen water rights emerge as a nascent asset class remain in place, and we would expect institutional demand to continue to increase. The prospect of further capital gains is perhaps more modest than it was ten years ago, though the outlook for long-term returns from water rights remains attractive.
What is the outlook for Australian investors in real assets?
As we have outlined, the real asset opportunity set for Australian investors is deep and diverse. Accessing it is not straightforward for private investors, though. Investing directly in real asset projects requires multi-million-dollar ticket sizes that prevent most investors from participating.
Pooled fund opportunities represent a cheaper and more accessible route and, although there aren’t many options to select from, it makes sense to have an experienced fund manager forming partnerships with specialist investors that have expertise and experience in particular parts of the asset class.
Within a broadly positive opportunity set, it is important to be selective and invest in the right geographic areas and an appropriate combination of different assets to deliver the most appealing blend of risk/return characteristics.
With respect to inflation, we cannot know more than anyone else about whether the current bout of rising prices will prove more enduring. However, real assets represent an attractive route for anyone wishing to hedge against the risk of future inflation.
Finally, in a world of change, risks cannot be ignored. Some of the risks that face real asset investors may be amplified as a result of the climate crisis, but other megatrends, such as demographics and the increasing global demand for food, play firmly to its strengths. As a result, the long-term potential from real assets looks attractive – and differentiated.
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WAM Alternative Assets provides retail investors with exposure to a portfolio of real assets, private equity and real estate. The company aims to expand into new asset classes such as private debt and infrastructure.
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Dania joined Wilson Asset Management in 2020 and is the Portfolio Manager for WAM Alternative Assets. Dania has held senior investment roles in Australia, the US, Europe and the UK throughout her career of almost 20 years and most recently held...