ALT 4 Real Estate and Infrastructure

Real estate, defined broadly, is land together with the buildings on it. As an investment it covers developed land: commercial and industrial property as well as residential property. Three traits set it apart from paper assets. Every property is heterogeneous, meaning no two are alike; the assets are long lived; and each one is tied to a fixed physical location. Raw or lightly developed land used for agriculture or forestry is treated separately as a natural resource investment, not as real estate.

Infrastructure combines land, buildings, and other fixed assets that public bodies, or public and private partners together, develop for economic use. Both real estate and infrastructure are held in many portfolios for the same reason: they tend to move with traditional stocks and bonds only weakly, and they supply risk and return blends across a wide range. In return, they demand specialist skill to select, acquire, manage, and eventually sell, just as other alternative assets do.

What this reading covers

The module works through four ideas: the features that make real estate distinctive, the investment characteristics of real estate, the features of infrastructure, and the investment characteristics of infrastructure. A few anchor facts frame everything that follows.

• Real estate splits into two sectors, residential and commercial. Residential is the larger by far, at roughly 75% of the global market. Commercial covers offices, shopping centers, and warehouses.
• The asset class carries built-in frictions: heterogeneity, fragmentation, difficult price discovery, and transactions that are both costly and slow.
• Exposure can be direct or indirect, public (for example through REITs) or private, and on the equity or the debt side. Return comes from income, from appreciation, or from both; more than half of what commercial investors earn is income, and income holds up more steadily across a cycle than capital gains do.
• Infrastructure assets are capital intensive and long lived and are meant to deliver essential services for public use. They divide into economic assets (transport, utilities, energy) and social assets (such as education), and into stages of development: greenfield, secondary stage, and brownfield.
• Among the three stages, greenfield carries the highest expected return and the highest risk, while secondary stage sits at the lowest of both. Investors look first for stable long-term cash flows that track growth and inflation, and second for capital appreciation.

Governments finance, own, and run most infrastructure, but private capital is taking a growing share through public-private partnerships. Because these assets typically show low correlation with other public investments, they add diversification, some cushioning against swings in GDP growth, and some protection from inflation.

Individuals and institutions both buy real property, either residential or commercial. The residential sector, the housing market, is made up of single-family detached homes plus multi-family attached units that share at least one wall, such as condominiums, cooperatives, townhouses, and terraced housing. The commercial sector is dominated by office buildings, retail shopping centers, rental properties, and warehouses. Where the owner-occupied market houses its owners, rental property is leased to tenants.

Residential is the largest sector by both value and size. Savills World Research put it at more than 75% of global real estate value in July 2018. Any single home is worth less on average than an office building, yet the total floor space needed to house a population dwarfs the space used for offices and shops, so the sector leads on aggregate value.

Why real estate is different

Property may sit in private hands or trade on public markets via REITs. Equity ownership, direct or indirect, carries a claim on the property residual cash flow, which may be fixed or variable. Debt exposure usually starts as a mortgage from a bank, part of which can then be packaged and traded as mortgage-backed securities (MBS). Several features separate the asset class from listed stocks and bonds:

• The initial outlay is usually large.
• Each property is one of a kind, set apart by where it sits, its age, the credit blend of its tenants, its lease length, and the local demographics.
• There are many ways in, from relatively liquid stakes in stable income property to illiquid positions running the full development cycle of purchase, construction or upgrade, occupancy, and sale.
• Spreading money across every real estate type can be hard to achieve.
• Private-market indexes that track performance are not themselves directly investable.

Price discovery in private markets is also opaque. Past sale prices may no longer reflect current conditions, transaction costs run high because deals pull in agents, banks, and lawyers, and trading can dry up when local supply or demand stalls. Because location and possible uses are unique to each asset, markets tend to be fragmented, with value set by local supply and demand. All of this means that selecting, valuing, buying, managing, and selling a real estate portfolio is generally harder than running a book of listed corporate debt and equity.

Direct investment

Buying a property and arranging its debt for your own account is direct private investing. Ownership can be free and clear, where the title passes to the owner with no financing liens such as an outstanding mortgage attached. Up-front costs may include legal fees, surveys, engineering or environmental studies, and appraisal. The advantages of holding property directly are control (only the owner decides when to trade, how much to spend on capital projects, which tenants to accept, and what lease terms to offer), tax benefits (taxable income can be reduced through non-cash depreciation and deductible interest), and diversification (real estate has historically shown low correlation with other asset classes). The drawbacks are complexity, the need for specialized local knowledge, large capital requirements, concentration risk for smaller investors, and poor liquidity paired with high transaction costs. Institutional owners often hire advisers and can use a separate-account structure that keeps control of the timing and pricing of purchases and sales in the investor hands.

Indirect investment and REITs

Indirect investing pools money from many investors to buy one or several properties through vehicles that may be public or private: limited partnerships, mutual funds, listed equities, REITs, and exchange-traded funds. Investors sometimes form joint ventures, which are common when one partner brings something distinctive such as land, capital, development know-how, or due-diligence skill.

A real estate investment trust is a tax-advantaged trust that owns, operates, and sometimes develops income-producing property. There are three forms: equity REITs, which own buildings directly or via partnerships and joint ventures; mortgage REITs, which extend real estate loans or hold MBS; and hybrid REITs, which combine the two. The structure appeal is that it removes double corporate taxation: a REIT can escape corporate income tax by paying out dividends equal to 90% to 100% of taxable net rental income. The equity REIT playbook is straightforward, namely push occupancy and rents up while holding operating and maintenance costs down, so that cash income and dividends are maximized. Equity REITs report earnings per share under GAAP or IFRS, and many also publish funds from operations (FFO), which adds back depreciation and adjusts for distributions and preferred dividends to give a cleaner read on future dividends.

Listed REITs solve several problems of private ownership: they offer more transparency, they let an investor trade shares rather than whole buildings, they are not forced to dump property to meet redemptions the way an open-end fund can be, and they bring professional management. The trade-off is a higher correlation with public equity markets than private real estate shows.

Real estate offers competitive long-term total returns, blending income with the chance of price appreciation. Many commercial leases run for several years at fixed rents, so lease income is usually predictable and stable. Because rents are adjusted at intervals, the asset class also tends to hedge inflation, and it has historically shown low correlation with other asset classes, which lets it add diversification at a relatively modest level of risk. A range of global indexes exists to measure total and component returns for both listed and non-listed real estate.

Where the return comes from

Return arises from income, from asset appreciation, or from a mix. Income-producing property earns mainly from rent and lease payments, including renewals, net of direct and indirect costs such as maintenance and improvement. This is mostly low-risk direct investment whose success hinges on lease payments arriving on schedule. Investors who rely on appreciation instead are betting that a longer development project succeeds and that the exit price clears the total invested plus any interim cash flow.

The risk and return spectrum

Real estate strategies span debt and equity, and can be arranged from bond-like to equity-like. At the low-risk end sits senior debt, whose returns behave like bonds because the underlying instruments are bonds. Moving up, the source of return shifts away from contractual cash flow toward speculative price appreciation, and leverage magnifies both gains and losses at every step.

In a sale-leaseback the owner sells a property to an investor and leases it back for continued use, which keeps default risk low and the return steady. Opportunistic strategies, such as development and distressed situations, carry special risks: zoning, occupancy, and environmental approvals, construction delays, and cost overruns. Because these projects run long, economic conditions can shift midway, lengthening construction, delaying leasing, raising costs, and lowering rents against the original plan. The result can be an internal rate of return below expectation, leaving the investor undercompensated for the extra risk and illiquidity.

Measuring and monitoring leverage

Because most strategies mix debt and equity, lenders watch the loan-to-value ratio closely and often require it to stay under a stated ceiling.

Diversification benefits

Real estate investors, whether direct or indirect, whether public or private, and whether on debt or on equity, look for high, stable, steady returns. Leases produce bond-like cash flows, and their variability shrinks with longer terms, stronger tenant credit, and the option to raise rents. On top of that income comes the prospect of capital appreciation. More than half of what commercial investors earn is income, with the balance from long-term price gains, and across a cycle income is the more consistent contributor. In that sense real estate resembles a convertible bond: steady cash flow, upside from appreciation, and low correlation between property price gains and equity price gains, since stock returns lean heavily on long-run appreciation.

Views on REITs vary: some treat them as a separate alternative asset class, some as a slice of the broader real estate market, some as a fixed-income and equity hybrid, and and some as a fixed-income holding that yields a little more than investment-grade corporate bonds. Whether listed property acts more like equities or like private real estate remains an open question. Listed REITs are priced continuously, while private property is appraised perhaps once a year, and that timing mismatch pushes measured correlations artificially low. Public equity investors discount future cash flows, whereas private appraisers lean on current conditions and recent trends.

Source: annualized quarterly returns of the Private Capital Quarterly Index rebased to 31 December 2007, Preqin.

During stress, equity REIT correlations with market benchmarks rise, especially in steep downturns such as the 2007 to 2008 financial crisis, and they stayed elevated through the recovery that lifted most asset classes; a similar pattern showed up in the COVID-19 recovery. Even so, the broad consensus is that real estate diversifies portfolios, because property markets are often idiosyncratic and weakly correlated with traditional assets. An Oxford Economics study for EPRA concluded that a substantial allocation to listed real estate enhances the risk and return profile of a multi-asset portfolio and recommended larger allocations for European investors.

Infrastructure serves a social purpose and supports broad economic, technological, and social development. It usually pairs land and buildings with other durable fixed assets, and it underpins transport, airports, utilities like water, gas, and power, and, more recently, information networks such as telecommunications, cable, and wireless. Early projects were financed privately for profit; governments then took the lead role by the second half of the twentieth century; and a later wave of privatizations opened up assets that states had long owned and run. The market for privately funded infrastructure is now sizeable.

What infrastructure investment involves

These are real, capital-intensive, long-lived assets built for public use and essential services, for instance airports, hospitals, and plants that treat sewage. Investors put in equity, with its usual claim on residual cash flow, and debt to finance and maintain the assets. As with real estate, buying existing infrastructure means acquiring unique, illiquid assets with a specific location and use, while building new infrastructure aims to earn either income or capital appreciation. Deals often run through a consortium that pairs strategic partners holding operational or technical skill with financial investors. Instead of tenant rents, cash flow usually comes from contractual payments:

• Availability payments, received in exchange for keeping the facility available.
• Usage-based payments, for example tolls or fees charged to use it.
• Take-or-pay arrangements, which oblige buyers to pay a minimum price for a pre-agreed volume.

Allocations rise both because demand for infrastructure is growing and because governments seek alternative funding from investors experienced in building and running these assets. Most infrastructure is still financed, owned, and operated by governments, with much of it publicly funded in the developing world, but private capital increasingly enters through public-private partnerships (PPPs). A PPP is a long-term contract in which a private party delivers a project or service the public sector has traditionally supplied. The private partner may lease assets back to the government, sell newly built assets to it, or hold and operate them to maturity or beyond. Some deals also involve development finance institutions, specialized intermediaries that supply risk capital for development projects on a non-commercial basis, such as the European Bank for Reconstruction and Development.

Economic and social categories

The broadest split is between economic and social infrastructure.

Transportation income is usually tied to demand from traffic, port charges, tolls, and fares, so it carries market risk. Utility and energy income can also swing with demand for power and resources, though take-or-pay contracts can lock buyers into minimum purchases, with recourse if the utility underperforms or delivers late or inferior supply. Social infrastructure focuses on providing, operating, and maintaining the asset itself; the services delivered through those facilities are usually run separately by the public authority or a contracted provider, and income typically comes from a lease-type payment linked to availability and to maintaining the asset to set standards.

Stages of development

Infrastructure can also be sorted by the stage of the underlying asset.

• Greenfield investments build new assets and are opportunistic. The aim may be to lease or sell the asset to the state once built, or to keep and run it, either for the long term or until operational maturity, followed by a sale that captures appreciation as reward for taking on construction and commissioning risk. Greenfield investors usually partner with strategic developers.
• Brownfield investments enlarge facilities that already exist, sometimes by privatizing state-owned assets or through a sale-leaseback of finished greenfield builds. They have a shorter horizon, immediate cash flow, and an operating history, so they draw in strategic operators and, above all in privatizations, financial investors after steady long-run returns.
• Secondary-stage investments hold fully operational assets that need no further development over the horizon, generating immediate cash flow. Certain assets never arrive at this stage, since they keep demanding fresh capital.

The greenfield life cycle common in PPPs is the build-operate-transfer (BOT) model. The build phase brings a long approval and construction period with negative cash flow; the operate phase runs under a concession agreement that lets the private investor earn income on pre-agreed terms; and the transfer phase hands the asset to a government entity on set terms, sells it to a third party, or decommissions it.

Forms of infrastructure investment

Much like real estate, infrastructure can be held directly or indirectly, and the route chosen shapes liquidity, cash flow, and income. Most investors favor equity, with some appetite for straight debt (infrastructure bonds) and convertible debt.

Buying the underlying asset directly gives control and the chance to capture full value, but it requires a large commitment and brings both concentration and liquidity risk while the asset is run. Given that risk and the long horizon, direct investment usually runs through a consortium of strategic investors who divide the financial risk or take on a set role in building or operating the asset. Large pension funds and sovereign wealth funds are frequent direct investors, since they are better positioned to handle particular risks and frequently give priority to domestic infrastructure.

Indirect routes include infrastructure funds (structured like private equity funds, closed end or open end), infrastructure ETFs, shares in listed infrastructure providers, and master limited partnerships (MLPs). Publicly traded securities bring liquidity, reasonable fees, transparent governance and pricing, and diversification across underlying assets, but they are only a small slice of the market: S&P Dow Jones Indices put the total global market capitalization at USD 2.23 trillion as of 31 December 2021, clustered in a few categories. MLPs trade on exchanges and are pass-through entities like REITs, minimizing double taxation; they appear most often in energy transportation, processing, and storage, generate stable fee-based cash flow, and distribute large parts of free cash flow. Debt financing can be private or public, with flexible terms that can absorb stretches of zero cash flow and long horizons, as with the perpetual bonds of the Airport Authority of Hong Kong and the US dollar bonds of the Indonesian Infrastructure Fund.

The expected risk and return of an infrastructure investment depend on the type of asset, its stage of development, its geography, and how the deal is structured. Across the three stages, secondary-stage assets, which already have a track record of steady, bond-like cash flows, carry the lowest risk and the lowest return; brownfield is incrementally riskier; and greenfield is the riskiest. The asset type matters too: basic social services and existing regulated industries usually mean lower risk and return, while demand-based projects, which rest on projections of future growth and usage, are riskier.

Source: annualized quarterly returns of the Private Capital Quarterly Index rebased to 31 December 2007, Preqin.

In developing economies, where infrastructure underpins growth and shares in the wealth it helps create, risks are considerable but so are the long-horizon returns; greenfield projects there can offer exceptional opportunities over very long periods. Target returns vary sharply by risk profile.

Target equity returns are net of fees. Source: Cambridge Associates (April 2017).

Most funds cluster in the medium- and low-risk profiles, earning an average long-term annual return near 10%. As with other alternatives, less liquid direct equity offers the highest expected return and risk, publicly traded debt the lowest, and assets backed by stable long-term concessions the steadiest returns.

Diversification benefits

Investors look to infrastructure first for stable long-term cash flows that keep pace with economic growth and inflation, and second for some capital appreciation, which varies with the type and timing of the investment. Because these assets typically serve inelastic demand or enjoy high barriers to entry, produce steady cash returns, and have long life cycles, equity in infrastructure correlates less with public equities and the wider economy. So the asset class supplies an income stream, adds diversification through low correlation with other public investments, cushions changes in GDP growth, and offers some inflation protection.

Source: annualized quarterly returns of the Private Capital Quarterly Index rebased to 31 December 2007, Preqin.

Notably, public and private infrastructure returns show low correlation with each other, and private infrastructure correlates weakly with broad market returns. Most institutions use infrastructure to balance public equity because it has proven relatively resilient to equity swings. Given stable cash flows, infrastructure debt usually shows fewer defaults and stronger recoveries than comparable fixed income, and it swings less over the cycle. The asset class also matches the long-dated liabilities of pension funds, superannuation schemes, and life insurers, and it suits the long horizon of sovereign wealth funds, which commit the largest shares, at roughly 5% to 6% of AUM. Much of the inflation link runs through regulation, concession agreements, or fee contracts whose rates climb to or beyond the inflation rate.