For many investors focused on income-generating opportunities, fixed income and dividend-paying equities might be the first investments that come to mind. However, when thinking more broadly about how to generate income in a portfolio, one asset class that shouldn’t be overlooked is real assets.
Real assets are defined as investments that are valued on the basis of their substance and properties. Considered to have “intrinsic value” by virtue of their tangible attributes, these investments are typically land-focused, and as a result, can include opportunities as diverse as oil and gas properties, timberland, farmland and mining developments.
For many years, investors have recognised the benefits of including real assets in an institutional portfolio, including the potential for enhanced diversification and strong returns. More recently, investors have come to appreciate the income-generating capabilities that such investments offer. Income as part of the return profile can be attributed to the productive capacity of these investments given that many strategies involve the sale of underlying commodities generated from the properties. This results in a potentially attractive annual yield component for certain investments. The income component becomes increasingly important in mitigating risks by de-emphasising a need to rely on long-dated, capital appreciation aspects while also allowing institutional investors to exert greater control over their portfolios, particularly in matching liabilities.
Investors must be mindful that not all real assets investments are the same, nor do they all have a similar return profile. Many investments have little to no current income as part of their return profile. Yet those investments that possess an identifiable cash flow profile can be attractive to the investor seeking to balance overall return with current yield. Two good examples of these income generators are oil and gas opportunities and farmland.
Oil and gas – and income
When considering opportunities in oil and gas, many investors consider the “upstream” sector, the ownership of and exploration and production on physical properties, to be the most relevant. A foundational aspect of these investments is the sale of the underlying commodity on a regular basis and the associated cash flow from these activities. As a result, investors seeking current income can benefit in this sector.
Further, the investor can capitalise on differing perceptions with respect to non-cash flowing assets. Oftentimes, for reasons unrelated to the quality of the underlying asset (e.g., fragmented ownership of properties, differences in ownership rights and interests), certain types of assets may be unappreciated in the market. Investors who can withstand little to no current income in the early years of an investment could be repaid in later years with robust cash flow once the properties are fully operational. For example, for every one oil and gas operator, there are over 500 owners of mineral rights (landowners who lease their properties to operators and receive a portion of the revenues generated from drilling and producing activities in return), the vast majority of which are individuals and families. Given the fragmented nature of the minerals segment, this translates into a glut of untapped opportunities to target undeveloped, “pre-yield” minerals acreage that is expected to be developed in the near term, at which point these assets are expected to generate a very attractive cash yield.
Harvesting income from farmland
Although quite different from oil and gas properties, farmland is another area that has similar characteristics that should be considered by investors seeking current income. Much like the fragmented nature of mineral rights ownership, there are currently a large number of small farms, and many high-producing farmers are over the age of 60. In many cases, these farmers do not have a lot of capital or willingness to re-invest and re-develop assets. Yet for those who want to do so, there is significant potential for cash flow generation, provided one is able to develop crops below replacement cost.
Keep in mind that investments in real assets are typically designed to be held for the longer term. Increased yield potential from these investments can take several years in some cases; for example, blueberry production may have three to five years of limited cash flow before its yield potential is fully realised. Investors should be prepared to stick with their investing plan by considering their liquidity needs before committing to a strategy that may need some time to properly develop and produce cash flows.
Know your liquidity needs
Opportunities to generate income needn’t be limited to traditional financial assets. However, investments in real assets must be thoroughly vetted to determine their potential for yield and overall return while taking into account their risk profile. A seasoned real assets manager can help an investor select promising opportunities that help diversify and enhance the overall portfolio.
Jim Gasperoni, Head of Real Assets
Ryan Sullivan, Senior Investment Manager, Real Assets
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