Friday Letter From real estate to real assets

The so-called ‘real asset’ class is attracting increasing attention from LPs for its inflation-hedging capabilities. That has prompted one real estate fund of funds manager to also enter the space. 

In the midst of the credit crisis, investors were fearful the global economy could be gripped by deflation. Eighteen months after the world’s financial markets pulled back from the brink of collapse thanks to massive infusions of government funding, inflation has become the primary concern.

Inflationary concerns are not just are the remit of central bankers, though. It’s a real concern that is making itself felt among the institutional investment community as well, as they evaluate whether their current portfolio will cover their future liabilities.

Real estate, like gold, has traditionally benefitted from the perception it is a good hedge against inflation, typically holding its value and purchasing power during inflationary periods when compared with many other asset classes. However, that belief is being challenged by the fact that in most developed countries high inflation could – this time round – be coupled with low growth. With vacancy rates for many real estate sectors set to increase over the 12 to 24 months, just how easily will landlords be able to pass on rising prices to their tenants?

In response, many institutional investors are also eyeing other options to help hedge their portfolios, particularly real assets – the umbrella group that includes infrastructure, energy, timber and agriculture. Commitments to infrastructure funds, including energy, in the first quarter of 2010, for example, totalled $5.9 billion, according to placement agent Probitas Partners – more than half the 2009 total and more than three times the total for the first quarter 2009.

It is such investor interest that has prompted New York-based fund of funds manager Franklin Templeton Real Estate Advisors to launch a real assets multi-manager business. Focused on infrastructure, energy, water, agriculture and timber sectors globally, the new team – to be led by ex-Brookfield Asset Management executive Joyce Shapiro – expects the industry to grow dramatically in the near future.

Franklin Templeton Real Estate Advisors is not alone in that expectation. Probitas said fundraising in the first half of 2010 should eclipse the entire amount raised in 2009, while Michael Nobrega, chief executive officer of Ontario Municipal Employees’ Retirement System, last October said infrastructure assets’ inflation-adjusted revenue streams were an “ideal match” for pension funds that pay inflation-indexed benefits.

The question is will there be enough growth to support a fund of funds model in an asset class that many assume will generate lower returns than real estate? Real assets may have a higher correlation as an inflation hedge than real estate, but will that be enough to offset the fact investors will be charged twice for their investments?

For Franklin, the obvious answer to that is yes. However, fund of funds entering the infrastructure space may need to be creative when it comes to fees as a pure private equity-style model might not be the most suitable method of investment for the asset class. Whether that be through lower fees, or by tying performance fees directly to cash flows is uncertain.

What is certain, however, is that private equity and private equity real estate’s interest in infrastructure will only continue to grow as institutional investors continue to see the asset class as “almost perfect”, as Nobrega said, for its inflation-hedging needs.