'REAL' APPEAL: AUSTRALIAN INFRASTRUCTURE AND REAL ESTATE IN A LOWER FOR LONGER REGIME

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1 'REAL' APPEAL: AUSTRALIAN INFRASTRUCTURE AND REAL ESTATE IN A LOWER FOR LONGER REGIME KEY POINTS > The persistent weak growth environment means that investors globally are facing a lower for longer outlook for investment returns. This paper explores the opportunities that direct infrastructure and commercial (non-residential) real estate present for investors in a lower for longer return regime. The discussion is focussed on Australian assets. Australia s proximity to relatively high growth in the Asia-Pacific region provides opportunities for leveraging to both these asset classes, with commercial real estate, in particular, being the beneficiary of direct investment from China. Predicting rain doesn t count. Building arks does. Warren Buffett, American business magnate, investor and philanthropist. > Demand for direct infrastructure and real estate assets has been robust, driven by investor appetite for consistent returns, their low correlations with other asset classes, and the potential for inflation protection. > In the current environment where bond yields are low and equity markets are likely to experience episodes of short-term volatility, demand for real assets is likely to remain strong. > The lower for longer environment has extended the real estate cycle, and commercial real estate yields will remain relatively high versus most other asset classes. We are mindful that as bond yields appear to be bottoming out, this may moderate future valuation increases in real estate. > By contrast, high demand for infrastructure suggests there is still significant growth opportunity. Large cap and high yielding assets appear more fully priced than mid cap growth assets and these represent the best value. INSIGHTS.IDEAS.RESULTS. CONTRIBUTING AUTHORS MICHAEL CUMMINGS AMP Capital Head of Australia and NZ Funds, Infrastructure Equity > The US Federal Reserve will be cautious in lifting interest rates, given generally weaker global growth and the fragility of markets post the GFC. Consequently, the lower for longer environment is likely to persist globally. GREG MACLEAN AMP Capital Head of Research Infrastructure MICHAEL KINGCOTT, AMP Capital Head of Property Investment Strategy and Research TIM NATION AMP Capital Head of Real Estate Capital JEFF ROGERS CIO ipac and Head of Investment Solutions Multi-Asset Group PERSPECTIVES insights.ideas.results. 1

2 Investors globally are facing a 'lower for longer' environment for investment returns. This weak return environment is largely due to the lack of sustainable economic growth in OECD economies. Policy makers in general have struggled to reignite economic growth in the period since the Global Financial Crisis (GFC), a task that has proved harder than anyone anticipated. Stimulatory measures, including aggressive quantitative easing have left developed economies awash with liquidity. Despite record low interest rates in the United States (US), data from the US Bureau of Labour Statistics suggests that the required return on investment for capital assets is now at its highest level in 75 years. In short, very little of the stimulatory measures appears to be invested into generating economic growth. In the absence of a marked shift in policy making, we anticipate that this situation is likely to persist for the foreseeable future. 2 PERSPECTIVES vol 02

3 INVESTORS TURN TO REAL ASSETS FOR INCOME AND CAPITAL STABILITY Investment in direct real assets can offer investors equivalent returns to listed markets and more predictable returns at much lower levels of volatility. Of equal importance is the low correlation of direct asset valuations to listed markets. This provides an efficient means of diversifying portfolio risk. Consequently, investors are increasingly turning to real assets such as direct infrastructure and property, particularly, commercial (non-residential) property to meet their investment needs. According to the 2016 Preqin Investor Outlook Alternative Assets H1 2016, institutional investors expect to allocate more capital to both infrastructure and real estate in the longer term. Figure 1: Allocations to property and infrastructure are on the rise % OF INSTITUTIONAL INVESTORS PLANNING ASSET CLASS TO INCREASE THEIR ALLOCATIONS Infrastructure 52% Real Estate 29% According to Jeff Rogers, CIO of ipac funds, long-term investors generally favour direct infrastructure and commercial real estate for the stability they can provide within a diversified investment portfolio and the visibility of the income streams they generate. In a low interest rate environment where the outlook for total return appears compressed, asset classes that exhibit defensive characteristics with a stable and rising income profile are obvious candidates for a long-term investment strategy. In addition, investors worried about an inflation surprise arising from the unconventional monetary policy implemented by major central banks post GFC are attracted to the tangible nature of real assets underpinned by land value or based on contracts associated with the delivery of essential services. He observes that direct infrastructure and commercial real estate should not be viewed as a substitute for a diversified portfolio that comprises a wide range of assets and strategies. The size of the allocation to direct infrastructure and real estate should be influenced by investors long-terms goals and fit with their capacity to deal with the less liquid nature of these asset classes. In addition, he notes that the investors goals and constraints can also inform the type of assets and funds selected within these sectors. For example, portfolios built for retirees whose goal is the delivery of a stable and visible cash flow may display a preference for mature social infrastructure or real estate funds with a focus on long-term leases. PERSPECTIVES insights.ideas.results. 3

4 WHAT S THE REAL APPEAL? Direct infrastructure can be considered appealing because: > Companies tend to generate very stable cash flows each year and this allows them to pay out high and growing dividend payments to shareholders. > Infrastructure companies tend to have long-term debt structures, and debt maturities can stretch out decades into the future. > Typically, a large portion of the debt tends to be at a fixed interest rate; consequently interest payments are not sensitive to fluctuations in central bank rates. > Contracts are often negotiated on a cost-plus basis, allowing charging structures to increase in an environment of rising interest rates and inflation. > If interest rates rise due to stronger economic activity, this provides natural economic support and an associated higher demand for infrastructure assets. Commercial real estate can be considered appealing because: > A consistent income yield can generally be expected as contracted leases typically last for more than 12-months. > Commercial leases typically incorporate annual, fixed or market reviews throughout the term of the lease, meaning that the rent is, in many cases, continually rising. > The rate of increase is negotiated with the tenant when a new lease is signed and the type of review is subject to market conditions at the time. > Typically, it enjoys long cycles between downturns. Historically, the majority of the investment return has been generated from the yield rather than capital growth and is priced accordingly. Nevertheless, it s important to be aware of potential risks in the infrastructure and real estate sector around interest rate sensitivity and refinancing risk, lack of liquidity, regulatory, political and operating risk. Every asset is different and will have its own specific risks. As such, risk identification, mitigation and management are crucial. 4 PERSPECTIVES vol 02

5 WHAT COULD UPSET THE REAL ASSETS APPLE CART? Both infrastructure and commercial property are defensive classes of assets, but, like all investments, they are subject to risk. More recently, we have witnessed some overpricing in infrastructure as well as overdevelopment in real estate. Michael Kingcott, Head of Property Investment Strategy and Research, notes that the recent volatility in bond markets suggests interest rates are closer to bottoming out, which may moderate future valuation increases in real estate. However, the absence of inflationary pressures and ongoing patchy global economic momentum suggests a significant rise in bond yields in the near term is unlikely. However, the spread between the real estate yield and the 10-year Australian bond yield is close to an historic wide, which provides a substantial buffer if there is a sharper than expected rise in bond yields. Listed market volatility could actually benefit prices by taking some of the pent-up demand away and helping to keep direct property values more stable. Michael Kingcott also notes that the other risk to Australia is the momentum in the Chinese economy. At the moment, it appears to be muddling through, but there is downside risk due to local debt issues, and possibly slowing global economic momentum. This could then transfer to Australia. A slowdown in the Chinese economy would likely be negative for our export sectors, but strong population growth, a lower Australian dollar and even lower interest rates, would help offset some of this impact. Greg Maclean, Head of Research, Infrastructure, notes that a stabilisation of interest rates would moderate growth in future infrastructure valuations. However, in common with property, the risk margins in current valuations are at near record highs, suggesting a large buffer. Australian infrastructure is also less leveraged to Chinese growth than property and the impact of slowing economic growth in China would be less evident on direct infrastructure assets. PERSPECTIVES insights.ideas.results. 5

6 SPOTLIGHT ON DIRECT INFRASTRUCTURE IN AUSTRALIA ALIA In a low-return environment, high-performing and relatively low-risk investments are likely to attract a lot of interest. We have witnessed solid demand for large cap infrastructure trophy assets, particularly from sizable local and international institutional investors seeking to rapidly build exposure to direct infrastructure. This demand has driven prices higher for large cap and high-yielding g assets. On the other hand, mid-cap and growth assets have not experienced the same intensity of demand and, as a result, our view is that it offers better value. Assets in different social, energy and utility, and transport infrastructure sectors all offer diverse characteristics and opportunities. Social infrastructure Social infrastructure includes a broad range of assets including schools, hospitals, car parks and convention centres. Increasingly, state governments are using Public Private Partnerships (PPPs) for the delivery of a wide range of social infrastructure assets under concession arrangements. Social PPPs are typically availabilitybased; that is, the investor ensures that the assets are available for use while the government counterparty takes the demand risk. Risk transfer to the private sector includes financing over the term of the concession, delivery risk, ongoing provision of operating services and maintenance. For investors targeting yield, Australian social infrastructure PPPs are particularly attractive since yields are high, relative to current bond rates. This has led to a thriving secondary market in mature social infrastructure PPPs. Most social PPP s have limited growth potential, with the consequence that valuations are sensitive to long term government bond rates, primarily through their impact on discount rates used for DCF analysis. Although they tend to be highly geared, debt positions are usually hedged, so the operational impact of any increase in the cost of debt is limited. Inflation may also be passed through making these attractive real absolute return investments. Other forms of social infrastructure, including student accommodation, attracts higher levels of return relative to the availability model as they involve a greater degree of demand risk. Student accommodation, in particular, is also leveraged to -high-growth Asian economies, ensuring full occupancy for mature assets. Bed scarcity around the leading tertiary institutions supports growth in market pricing, making these assets particularly attractive. 6 PERSPECTIVES vol 02

7 Ports and airports Airports represent growth assets that are geared towards the strong growth potential that s coming from Asian markets. This is evident in international air passenger growth in the Asia-Pacific region, which has sustained double-digit compound average growth rates (CAGRs) for many years. However, a comparison with growth in developed countries still reveals a huge latent demand that will be unlocked in future years as per capita wealth grows. Michael Cummings, Head of Australia and NZ Funds, Infrastructure Equity, notes that this suggests sustained, high future demand growth will persist for attractive destinations. The picture is less clear for seaports as very high multiples have been paid recently for specialist and general cargo ports, the most recent being a reported 25 times EBITDA multiple for the 50 year lease on the Port of Melbourne 1. Such assets are leveraged primarily to Australian rather than Asian growth and long term growth is unlikely to match airports. Valuations of these assets are sensitive to long term interest rates, but are more resilient than PPPs, as the factors that could see an increase in bond rates, for example, increased demand in the economy, are also likely to see an acceleration of growth. Roads Some legacy road assets were developed under PPPs with the concessionazire taking demand risk. Such roads broadly provide investors with direct exposure to Australian economic growth and, in some cases, significant growth opportunities. Typically, new private sector toll roads are provided under the availability model, with governments taking demand risk. Currently, the government is developing an estimated A$16.8 billion, 33-kilometre toll road network in Sydney through the WestConnex tollway project. 2 Funding via a PPP structure is a likely next step post-construction, and allows the state to 'recycle' the capital. Such assets provide investors with high-yielding opportunities. However, the large size of a future sale of the WestConnex project is likely to attract ferocious international competition and may not offer the value of mid cap growth assets. Rail Most Australian freight rolling stock is now owned by the private sector. Road congestion in major cities and improved rail services has seen strong growth in rail commuter volumes (for example, 8% CAGR in Sydney) as well as network expansions. Favourable policies coupled with the obsolescence of much of the legacy rolling stock suggests that new passenger rolling stock could also be privatised along similar lines to the UK industry. Commuter network capacity is still limited by nineteenth century system architecture and there may be further private sector opportunities in this area. Governments are also open to private sector proposals for greenfield track developments. Compared with the other sectors, rail is somewhat immature as an investment class but could prove very attractive to the private sector if the private sector was invited to participate, similar to the UK model. Electricity utilities Australia s electricity industry was reformed in the 1990s by eliminating vertically integrated state monopolies in favour of separate generation, transmission and distribution operators and retail suppliers. Consequently, in the eastern states, generation and retailing are now largely privately-owned while transmission and distribution assets have mix of public and private ownership and operation. At a geographical level, assets in Queensland and Western Australian represent some of the largest potential future privatisation prospects in Australia; New South Wales is in the midst of leasing and contracting operations of the majority of its distribution assets. The major Australian utilities are very much large cap assets and tend to sell at relatively high prices. However, the regulatory position is unclear with the Australian Energy Regulator s more consumer friendly last regulatory decision overturned on appeal. This uncertainty has the potential to dampen enthusiasm to pay high EBITDA multiples for future transactions. The sector is also sensitive to technological change in solar photo voltaic generation, real time grid management and economic on-site energy storage. When coupled with the need to de-carbonise energy production, this suggests that the century-old utility business model is under threat. PERSPECTIVES insights.ideas.results. 7

8 HIGH-GROWTH INFRASTRUCTURE ASSET CASE STUDY MELBOURNE AIRPORT Melbourne Airport is a good example of an asset that is exposed to the high growth potential in the Asia-Pacific region. Situated in Australia s second largest city, Melbourne Airport was privatised by the Australian Government in 1997 and is now operated by the Australia Pacific Airports Corporation (APAC). APAC continues to work closely with Melbourne s civic leaders to establish Melbourne as a major tourist destination in its own right. These efforts have been rewarded with consistent growth in Melbourne s number of international passengers. Figure 2: Melbourne Airport s number of passengers is growing Passenger numbers (m) Melbourne Airport - Domestic Source: Australia Pacific Airports Corporation, as at 31 December 2015 Since privatisation, Melbourne Airport s total number of domestic passengers has grown at a compounded rate of 5% per annum. On average, Melbourne Airport s number of international passengers is growing at an annualised rate of 7% since 1997 or 9% since The strong demand reflects the fact that China travel volumes have increased 21.9% on the last 2014/15 financial year.* To support growth, APAC has expanded the range of ancillary services available at the airport. This development extended to an air transport-related business park, hotel accommodation, car parking and additional retail offerings such as duty-free shopping and food and beverage outlets. Consequently, air transport fees now amount to less than 50% of revenues and EBITDA growth has consistently outpaced passenger growth.** *Melbourne Airport, Victoria celebrates 9.5% growth in international travellers for FY16 Media release, published 20 July 2016, < melbourne-airports passenger-traffic-results-2030.html>, accessed 23 August 2016 ** Melbourne Airport, APAC2014/15 Financial report, < accessed 23 August Melbourne Airport - International 8 PERSPECTIVES vol 02

9 RISKS AND OPPORTUNITIES IN EMERGING TECHNOLOGIES Australians are typically early adopters of new technology. The uptake of new technical developments is supported by strong consumer protection mechanisms and relatively open regulatory frameworks. To illustrate this point, Australia s plentiful sunshine has seen household solar photovoltaic penetration reach 1.57 million installations (with a combined capacity of over 5.4 gigawatts) in the 2016 financial year. This means the development of any new utility scale base load power plants is unlikely in the foreseeable future. 3 Greg Maclean, Head of Research, Infrastructure argues that the emergence of a range of mutually complementary disruptive technologies will seriously challenge some established infrastructure business models while providing investors with a wide range of alternative opportunities. Some disruptive technologies that are likely to impact on infrastructure development include: > Cost-effective small scale distributed photovoltaic electricity generation; > Cost-effective small scale energy storage devices; > Electric and autonomous vehicles; and > Peer energy trading platforms. Most at risk is the established 100-year old electricity utility model. On current costings it is now viable for larger domestic users to substitute high-cost and high embodied carbon peak and shoulder electricity with stored local green PV-generated energy. While still reliant on existing networks for the supply of off-peak energy, by flattening peak loads, this small scale distributed generation has the potential to significantly increase the capacity of existing networks, greatly reducing the need for future network investment. Electric cars will also have a major impact on road infrastructure, requiring large-scale charging facilities. Longer term, autonomous vehicles may blur the line between public and private transport and lead to a substantial increase in the utilisation of vehicles and a corresponding reduction of road congestion. PERSPECTIVES insights.ideas.results. 9

10 SPOTLIGHT ON COMMERCIAL REAL ESTATE IN AUSTRALIA The fall in inflation and interest rate expectations over 2016, and continued below average growth in the global and Australian economy has helped to underpin the lower for longer trajectory for interest rates. This has been beneficial for Australian commercial real estate, effectively extending the cycle another year. As long as a recession is avoided, it is our view that more yield compression is possible. From a total return perspective, Australian commercial real estate is expected to remain strong over the next three years, although the rate of growth is likely to decelerate from double digits, as captured in figure 2. The strongest return potential is expected from South east central buiness district office markets across Sydney and Melbourne and high-growth shopping centres that expand to capture market share. Solid returns are also likely in core plus markets such as secondary CBD offices in Sydney and Melbourne, and some suburban office markets that are lagging in the capitalisation rate compression cycle. Figure 2: Robust outlook for total commercial real estate returns Australian Annual Prime Total Return (%) f Source: AMPCI/IPD/ AMP Capital, forecasts, as at 30 September 2016 Over the medium-term, high-growth shopping centres (those in strong population growth areas that have been repositioned and expanded) are expected to be the star performers as they capture increased market share of retail spending, which flows through to growth in rents and strong occupancy rates. The robust Sydney and Melbourne markets are expected to see increased construction later in the decade, which will take some of the rental momentum away as vacancy rates rise, but cities such as Brisbane will be improving, supporting returns in the sector. Figure 3 shows that over a 10-year horizon, there is very little difference in returns across all three sectors of office, retail and industrial. Figure 3: Returns across office, retail and industrial are similar over a 10-year time horizon Return (%) year 5-year 10-year Office High Growth Retail Medium Growth Retail Industrial Source: AMP Capital, forecasts, averages from and including 2017, as at 30 September PERSPECTIVES vol 02

11 Rental growth has lagged the rise in values, but this will start to redress Australian commercial real estate values have risen sharply since 2012, but net income growth has lagged due to patchy economic growth, higher vacancies, and some structural adjustments, for example, in the retail sector. Looking forward, many of those structural and cyclical adjustments are considered to be now bottoming, so the fundamentals for rental growth are likely to improve. Sectoral performance and portfolio construction opportunities reflect variations in the underlying drivers and are highlighted below. Retail The retail sector has undergone a structural transformation associated with growing online competition. Occupancy cost ratios have adjusted in shopping centres and landlords are repositioning malls to combat the online threat. Portfolios could benefit from a focus on dominant assets and convenience assets, preferably in population growth areas, expand to capture market share and incorporate all the retail of the future insights to manage structural headwinds. Office The Sydney and Melbourne office markets are next strongest in terms of rental growth outlook, both benefiting from a rise in tenant demand as economic fundamentals improve at a time of slowing construction. The Sydney CBD is on track for undersupply in 2017/18. This market is going to record the strongest rental growth in the country over the next 5 years. Non CBD markets are also expected to see above average rental growth in this window also. Melbourne, too, is heading in the same direction, but it is not as cyclical, which complements Sydney s volatility in portfolio construction models. Brisbane is also starting to stabilise with a slow recovery in rents expected over the latter few years of the decade now that construction is slowing in that city. AMP Capital optimisation models suggest a Sydney/Melbourne bias in the short term, supplemented by secure high yield (any market). Our models are suggesting a wider geographic allocation in the medium to long term as Sydney and Melbourne rise on the real estate cycle. Industrial Industrial assets in central metropolitan areas that are experiencing gentrification pressure and demand growth from e-commerce related business are also expected to be resilient, outperforming greenfield industrial areas in terms of both rental and land values. At the other end of the spectrum, there is still downside risk in Perth with weak economic fundamentals expected to persist into Weak conditions are expected in parts of the industrial market in Melbourne and Adelaide over the next 12 to 24 months as the effects of the car plant closures ripple through the supply and support chain. The lower for longer environment is allowing developers to be more competitive with pre-lease rents, holding back potential growth in market rents in the land rich greenfield suburbs in the industrial market. Portfolios could benefit from investing in good core assets in prime locations close to intermodal hubs and transport interchanges, or more established areas facing gentrification pressures and growth in demand from e-commerce due to their central location. PERSPECTIVES insights.ideas.results. 11

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13 Shifting thematics call for greater commercial flexibility Digital disruption, demographic changes and globalisation are significant themes that represent risks to existing real estate models. Amongst these is the risk that assets could become less relevant to tenants, which undermines the ability for rents to be raised. Shopping centres were the first mainstream commercial real estate sector to face the threat of digital disruption. AMP Capital has been proactive on repositioning and expanding major shopping centres to position them for the new world of retail, and exit assets that the thematic research suggests will struggle in this new world, such as second tier sub-regional malls in low population growth areas. The same pressures are evident in the office sector. For the past five years, we have seen a slowly widening gap between population growth and base office demand. Demographic change, globalisation, and new technology are influencing demand patterns, which will ultimately impact rents. The challenge (and opportunity) is that technology is enabling a more portable and less localised workforce, with power to shift business processes offshore or to automate them and to give staff more flexibility. This is being supported by demographic change as younger cohorts look to integrate work, rest, and play rather than segregate them as their parents and previous generations have done. Consequently, buildings and space utilisation arrangements will need to become as flexible as possible to evolve with tenants who are managing an ever-changing workforce and workplace. PERSPECTIVES insights.ideas.results. 13

14 IN SUMMARY > In a world of low returns and lower interest rates, direct infrastructure and commercial real estate have emerged as compelling asset classes for investors seeking relatively low volatility returns uncorrelated with equities; and opportunities to access growth assets with consistent income streams. > The search for yield is a positive tailwind for commercial real estate, helping to lift prices. Rental growth has lagged price growth but is likely to improve from here. > The lower for longer environment has extended the real estate cycle, and commercial real estate yields will remain relatively high versus most other asset classes. We are mindful that as bond yields appear to be bottoming out, this may moderate future valuation increases in real estate. > We continue to anticipate significant growth prospects for Australian infrastructure. On balance, overall returns for infrastructure could be relatively higher than for commercial real estate. 1 As reported in the AFR September 19, O'Sullivan, M., 2016, WestConnex: Extra tunnel, road widening makes $16.8b motorway even bigger, Sydney Morning Herald, published 19 July Australian PV Institute Solar Map, funded by the Australian Renewable Energy Agency, June 2016 INSIGHTS.IDEAS.RESULTS. Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN , AFSL ) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. Certain information in this document identified by footnotes has been obtained from sources that we consider to be reliable and is based on present circumstances, market conditions and beliefs. We have not independently verified this information and cannot assure you that it is accurate or complete. This document has been prepared for the purpose of providing general information, without taking account of any particular investor s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor s objectives, financial situation and needs. Copyright 2016 AMP Capital Investors Limited. All rights reserved.