The benefits of investing in real assets for retirement

Investing for retirement used to be straightforward.

As the end of your working life approached, you traditionally wound down the proportion of growth assets like equities in your portfolio and lifted the defensive assets like bonds and fixed income.

The aim was to eventually reach a 50:50 split between growth and defence that could fund a comfortable and stable income across a long and happy retirement.

Near zero interest rates changed that.

The traditional approach stopped working – bonds and fixed income are no longer capable of playing the role they once played in a retirement portfolio, leaving investors searching for income.

So, what can take their place? One option is real assets like property and infrastructure, which show some of the same characteristics that make fixed income attractive to retiring investors.


Changing needs

Investing near retirement is different from investing during the earlier parts of a working life. This is true for five main reasons:

• As retirement approaches, an investor’s ability to tolerate downturns in the market is reduced. This is known as sequencing risk and refers to the idea that younger people have more time to ride out market volatility.
• In retirement, most people rely on account-based pensions in superannuation and pay no income tax, raising the attractiveness of refundable franking dividends.
• Inflation risk plays a bigger role in retirement as consumption spending is subject to rising prices, but there are no longer inflation-linked wages to offset this. Financial markets call this an asset-liability mismatch.
• Liquidity is a bigger factor in retirement than during working life, as people need to be sure they can access funds rapidly in case of life events such as health emergencies
• Natural human behavioural biases often play a bigger role as people faced with market volatility and no wage income can be tempted to make decisions to switch away from growth assets, often at precisely the wrong time.

Most retirement planners handle these risks through reducing allocations to growth assets and lifting exposure to defensive assets.

But is there a better way? Is there an asset class that can provide the kind of stable, predictable income that retirees need, while also offering equity-like growth?

Real assets – an asset class encompassing real estate and infrastructure – may be the answer for many retirees.


Infrastructure

Institutional investors have long recognised the attraction of infrastructure as an asset class.

Infrastructure has some of the benefits that an investor in or nearing retirement might want, including stability, income, inflation protection and diversification, considering the risks of infrastructure investing including regulatory, liquidity and operational.

These features reflect that infrastructure assets often include essential services – water, power, schools, hospitals and roads.

This essential nature means they enjoy consistent levels of demand and are less susceptible to economic cycles.

Many infrastructure assets are also monopoly businesses, either through regulation or high barriers to entry in the marketplace.

They are free from the competitive pressures faced by many other businesses.

In terms of yield, a hallmark of many infrastructure assets is their consistent long-term income, with revenues often underpinned by regulation or long-term contracts.

That gives the investors a high level of visibility and certainty around future cash flows.

Many infrastructure assets offer a hedge against inflation, with revenues linked to inflation, which may occur through built-in price rises under contractual arrangements or a regulatory framework.

Diversification is also a feature of infrastructure, as most assets show little correlation to other asset classes.


Real estate

Real estate is another sector that shows little connection to other asset classes and can behave very differently throughout the cycle.

Not all real estate is the same. Commercial real estate performs very differently to the residential market.

In Australia, commercial real estate is further divided into three main sectors: office, industrial and retail. Each has its own unique characteristics and can perform differently in reaction to various economic factors.

Investing across different geographies can provide further diversification.

Commercial real estate historically offers a higher yield than residential, which can be useful for investors nearing or in retirement.

The commercial sector benefits from longer lease terms than residential. Generally, retail leases are between three and five years while office and industrial leases are longer than five years and sometimes longer than 10 years.

This provides certainty of income for investors. Leases are a contractual obligation between landlord and tenant and often come with annual increases that are linked to CPI, allowing income to keep pace with inflation. Income growth from real estate assets generally provide support for an asset’s value, considering the risks of investing, including regulatory, liquidity and operating risks.

A fourth class of commercial real estate is also emerging in Australia – grouped under the label alternative real estate and including multi-family, build-to-rent residential, and assets like medical and data centres. Alternatives are 55% of the US real estate investment markets but only around 5% in Australia¹, so there is opportunity for domestic growth in these sectors.


Economic impacts

So, what should investors watch out for when investing in real assets?

One of the most important things is understanding how different real assets behave in different economic conditions.

The COVID pandemic has been the biggest recent influence, with various illustrated asset effects.

Real assets that depend on patronage for revenue were badly affected. Airports and hotels saw a dramatic decline in people travelling during the pandemic. Shopping centres were also badly affected with many people under stay-at-home orders. Offices also clearly suffered.

But these are short-term effects. People began to travel again as lockdowns were lifted, and shopping centres are returning to pre-pandemic traffic levels.

Even in the short term, many assets performed well. Non-discretionary retail such as supermarkets, hardware and liquor stores performed strongly during the pandemic. The industrial logistics sector also did well, as people switched to online spending and tenants held increased inventory locally in response to global supply chain disruption.

This shows the different short and long-term outcomes. Infrastructure follows a similarly varied pattern.

While airports depend on patronage, public-private partnership assets like schools, hospitals and justice facilities often have availability-based revenues that are paid if the asset is available for use, regardless of the extent to which they are used.

Regulated assets like water and power companies are always in demand, regardless of economic conditions.

Meanwhile, communications infrastructure such as mobile phone towers and fibre optic networks saw booming demand during COVID with an increase in working from home and streaming services.

Investors seeking diversification should consider these different economic drivers as factors in their investment strategy.

<sup>References
1. NAREIT, AMP Capital. As at June 2020.</sup>