While central banks may have confidence that they are managing the inflationary cycle well, growing economic uncertainty, coupled with what we see as persistent inflationary forces, paint a difficult picture.
We think that listed Real Assets, particularly those that are the ‘every day-use’ building blocks of the economy, make for an interesting tactical play in this inflationary environment. The Real Assets that we invest in generally have a lower sensitivity to economic cycles as they are more driven by population growth and people’s everyday life activities. In-built inflation protection and pricing power, and exposure to Covid-19 re-opening, shifting work habits, demographic change and sustainability trends are strong tailwinds in this environment.
Let us explore several compelling investment opportunities that we think can manage the risk of rising inflation against their income streams through these five interconnected tailwinds.
INFLATION & PRICING POWER WINNERS
As toll road operator Transurban Group’s CEO simply put it when talking to their recent results, “inflation is good for business”.
In previous articles we have highlighted companies such as Transurban and Atlas Arteria with their inflation-linked toll regimes, but Real Asset inflation winners are not just limited to infrastructure; we also see pricing power in select property and utility stocks.
Affordability to pass through
Childcare property owner Arena REIT has over 80% of their rent reviews at a rate of CPI or higher, allowing them to accelerate their income in this higher inflation environment. Importantly our concept of pricing power goes further than simply looking at whether CPI is written into a lease.
The ‘tenant’s’ ability to pay is also critical, and when looking at affordability, some Real Assets are better placed than others. In the case of Arena REIT, the rent it charges relative to childcare tenant cashflows is at historic lows. This means that as new leases are struck, expiring rents can be reset at a higher rate. Another important factor in childcare tenant health is the new Labor Government’s commitment to make childcare more accessible; all this means that Arena is well placed to enjoy strong pricing power.
Long, and low debt
A related and equally important aspect, which the market often underappreciates, is that Real Assets typically have very long-tenured debt, so recent rises in the cash rate have a muted impact on ensuing finance costs.
In fact, some Real Assets have expensive legacy debt tranches that would see absolute debt costs fall were they to be refinanced at today’s higher rates. For example, Transurban stated at its April 2022 investor day that the “majority of upcoming term debt maturities are above average cost of debt, potentially creating a near-term net interest benefit from upcoming refinances.”
This is a powerful combination – cash flows get the kicker from CPI+ escalators and debt costs remain relatively stable – so profit growth accelerates and so to do dividends. APA Group is another example on the utility side in this sweet spot of long tenor debt and inflation linked revenues; going forward we expect APA to deliver strong cashflows and dividend growth.
The Real Assets that we focus on are the tangible economic building blocks used daily by society. Due to their essential ‘every-day’ use nature, demand for Real Assets is typically inelastic and grows with population growth. There is no escaping that Covid-19 lockdowns were bad for Real Assets as people were prevented from going about their usual everyday activities.
Rebounding activity levels
What we see now is that the bounce back in activity as restrictions eased has been very strong and activity levels are mostly back to pre-Covid levels. For example, tenant sales for shopping centres are continuing to grow as the reopening theme plays out. We expect to see cash flows continuing to recover, stronger earnings and double-digit dividend growth from REITs such as Scentre Group and Vicinity Centres, once we have experienced a full fiscal year without lockdowns clouding results.
Focus on the suburbs
The reopening theme is also stronger in the suburbs than the CBDs, just look to where people are going about their day with the ongoing working from home (WFH) thematic having an impact. We are being more selective in REITs with CBD exposures, favouring suburban property owners with defensive everyday needs tenants as foot traffic, tenant sales and leasing demand have recovered more quickly. REITs in this space includeSCA Property Group, Charter Hall Retail REIT, and HomeCo Daily Needs REIT.
TECHNOLOGY DRIVEN CHANGE
Covid-19 had highlighted another interesting theme of increased data demand. We had seen a general strong uptrend in demand for data pre-Covid, but the ongoing WFH thematic is fuelling inflation-protected income opportunities for data and network providers.
Greater demand, sunk costs
As the NBN of New Zealand, Chorus is a beneficiary of this increasing data demand per capita that supercharges the ongoing population growth mega trend in New Zealand. Having built out of their fibre network across the country, cashflow previously directed towards capex is now available for dividends.
The regulatory framework provides inflation upside and the transition of customers from copper to fibre offers operational efficiencies and economies of scale. Additionally, we see a strong valuation signal supported by our view that Chorus can deliver outperformance on regulatory assumptions and a higher multiple is warranted.
We often talk about why population growth is so good for Real Assets, the more a population grows the higher the volume of demand leveraged to everyday needs. Within this population growth mega trend thematic we also see growth opportunities as Australia’s demographic population mix ages.
A boomer ‘boom’
An example of a winner from growth shifts within the population is land lease landlord Ingenia Communities Group which has over 10,000 residential tenants in their lifestyle communities. Their cashflows are seeing robust growth from inflation-linked rents, with a large proportion of these cash flows underpinned by the Government through pension-related rental assistance.
Accelerating demand from the ageing baby-boomer population super sizes this outlook. Ingenia’s model also has a strong sustainability pathway, providing a solution to housing for retirees by addressing supply and affordability constraints that at the same time frees empty nest established homes back into the market.
What’s happening to Australia’s population growth?
Clients often ask about the impact of Australia’s Covid-stalled immigration program on the fundamental story for Australian Real Assets.
We are confident that this short-term issue will catch up to the previous upward trend. Tight labour conditions are making Australia an attractive market for employment-led immigration. However, a key issue will be for the Federal Government to address extremely long visa application lead-times (now up to 6-8 months from the prior 2-4 weeks) that have recently emerged, and the need to match skilled migration intake to actual economic needs. Failure here will elevate the risks that Australia falls behind other immigrant demand markets such as Canada and New Zealand.
A second issue weighing on our minds is a potential delayed impact (or looming air pocket) on demand for housing starts. With immigrants a key source of demand for new housing, they typically need two-three years on the ground to establish the employment and income history to access credit. While current build pipelines are still strong from Covid stimulus and prior strong population momentum, this will be an issue that needs addressing.
TRANSITION TO SUSTAINABILITY
Investment in renewable energy-based generation is set to rise materially. Australia and New Zealand’s net zero emissions targets and ongoing population growth are driving stronger power demand. However, increasing market and community pressures, as well as ageing legacy assets, mean that investments in coal-fired power generation are insufficient to meet the growing energy requirements. This is contributing to a persistent energy transition driven inflation, evidenced by higher electricity and gas pricing we see today.
Opportunities for renewables
Listed Real Assets such as Contact Energy, Meridian Energy and APA Group are well-positioned here. They stand to be benefit from both the increased capital deployment that renewables opportunities brings and improved returns on their existing portfolios from the higher inflationary environment that is feeding higher prices.
THE MCA REAL INCOME STRATEGY IN AN INFLATIONARY WORLD1
The Martin Currie Australia Real Income strategy focuses on growing the long-term dollar value of its income stream. Owning the right Real Assets can deliver benefits from inflation, while being well-shielded from the growing clouds on the economic horizon.
On a forward-looking basis, we expect the strategy to provide a dividend yield of 5.4% over the next 12 months, with forward income growth exceeding the latest inflation peak. This compares very attractively to the 4.4% S&P/ASX 200 expected yield and S&P/ASX 300 A-REIT yield of 4.4%.
Our positive absolute return over the last 12 months despite the falling broader S&P/ASX 200 market, relatively low absolute risk and low correlation to other asset classes, is also strong evidence of the merit in our approach2.