The Bull Thesis For Real Assets

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Includes: BAM, ET, FPI, LAND, MMP, O, SPG, STAG
by: Jussi Askola
Summary

The investment world is faced with an unprecedented challenge: both stocks and bonds have become overvalued and risky.

Investors are quickly seeking refuge in real assets, such as farmland, airports, timberland, energy pipelines, and other.

Real assets have historically outperformed stocks and bonds, and we expect more of the same in the future.

While investing in real assets may have been reserved to high net worth individuals in the past, today there exist a lot of publicly traded alternatives.

Assets are the lifeblood of the economy. They enable us to store, transfer, and create wealth. Historically, investors have allocated the great majority of their capital into “financial assets” such as stocks, bonds and cash.

I never liked this approach because:

(1) Stocks are generally risky and efficiently priced.

(2) Bonds provide mediocre returns.

(3) Cash does not protect against inflation.

This is especially true today with stocks back at all-time highs with stretched valuations in a late cycle economy…

And interest rates at such ridiculously low levels that they may not even cover inflation in the long run...

This creates two major problems to investors:

  1. Stocks: With high valuations in a late cycle, risks are very high and investors could suffer significant capital losses from a return to historic valuation multiples.
  2. Bonds: Not enough income is earned to meet investor's immediate needs. This is particularly dangerous to large institutions and retirees.

What is then the solution to deal with these challenges?

We believe that it is real assets. We are not alone to think so. Over the past 10 years, institutional capital in this space has grown by $20 trillion (with a "t") and another ~$40 trillion is expected in the decade ahead.

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Allocations to real assets were only 5% in 2000. Today, it is closer to 25%. And in 10 years, this figure is expected to exceed 40%:

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Needless to say, that real assets are becoming very important for investors who remain overexposed to stocks and bonds.

But What are Real Assets Anyways?

Real assets are value-generating physical assets that a business and/or investor owns to generate a return on investment. These include:

  • Real estate
  • Energy pipelines
  • Timberland
  • Farmland
  • Airports
  • Railroads
  • Windmills
  • Solar farms
  • Goldmines
  • Ships
  • And many other…

Real assets are similar to traditional stock and bond investments in that their valuations are generally tied to their cash flow generation potential. However, the key difference is that a real asset also has intrinsic value in and of itself and does not rely on monetization and/or exchange in order to provide value for its owner.

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Why You Should Invest in Real Assets?

At High Yield Landlord, the majority of our Core Portfolio is already invested in high cash flowing real assets. My personal net worth is also allocated at over 50% into real assets. There are 4 main reasons to that:

  1. Higher income yield: The 10-year treasury may yield only 2%, but real assets will often trade at yields in the 6-10% range – and can be leveraged to generate even greater cash-on-cash returns.
  2. Greater total returns: Real assets generate high income, but they also appreciate in value and grow cash flow. A well-located office tower may yield 6% and grow in value by 3% per year. Add to that a bit of leverage and you can reasonably expect double-digit total returns.
  3. Inflation protection: One of the biggest and most underrated risks today is accelerating inflation. When you invest in low yielding bonds, you are at big risk. Real assets, on the other hand, are well-protected as their income and values tend to grow along with inflation. As such, they provide a good hedge against inflation risk.
  4. Valuable Diversification: Traditional assets (stocks and bonds) are highly volatile and adding real assets to a portfolio has proven to lower volatility. As such, investors can profit from diversification benefits while boosting returns and income.

The best approach to invest in Real Assets

There are 3 main approaches to invest in real assets:

  1. You can buy real assets directly yourself in the private market.
  2. You can invest in a private partnership.
  3. Or you can buy shares of a publicly traded real asset company.

#1 Direct Investment

I believe that buying real assets directly in the private market is a bad idea for 99% of the investors out there (excluding your own home). Buying and managing real assets demands a very specific set of skills and in most cases, it is far wiser to have a team of professionals make these decisions on your behalf. Moreover, most individuals just don't possess the resources to create a well-diversified portfolio, either by geography or by asset type. In consequence, most direct real asset investors will remain highly concentrated and take on much greater risk than is needed.

#2 Private Partnership

The second alternative is to invest in a private partnership. This solution solves some of the issues from investing directly in farmland. It enables the individual investor to profit from a professional management team and gain exposure to the returns of a diversified portfolio.

The problem with private partnerships is that they are externally managed by a general partner and suffer from significant conflicts of interest. They also charge very high fees. It is not uncommon for private partnerships to charge annually up to 2% of the assets in the form of a management fee and a 20% incentive fee on the returns.

The result of this "2&20" fee structure is that in a case where a 10% return is achieved, 4% goes to the general partner in the form of fees. Almost half of the return is gone in fees alone – not an attractive proposition in our opinion. On top of all that, you have no liquidity, no control, and other complications in taxation and management oversight.

#3 Publicly Traded Real Asset Companies

The last option is to invest in shares of publicly listed real asset companies such as REITs, MLPs, Infrastructure companies and other. At High Yield Landlord, we specialize in helping the individual retirement investor enjoy the best of both worlds by investing in publicly traded real asset companies:

Financial assets:

  • Liquidity
  • Low Transaction Cost
  • Easy Diversification
  • Professional Management

Real assets:

  • Higher Total Returns
  • Greater Income
  • Defensiveness
  • Inflation Protection

Moreover, because the public market has the tendency to fluctuate wildly with daily news that are often entirely disconnected from the underlying performance of the real assets, it's not uncommon for these investments – despite all of their advantages – to trade at large discounts to the value of their underlying holdings. This provides savvy investors with the opportunity to achieve profits that exceed the already superior total return outlook for real assets.

Finally, because high-quality real asset backed financial assets will only pay out excess cash flows as dividends, retirees and other income investors do not have to worry about reinvesting their dividends if they don't want to, knowing that these investments retain all of the cash flow they need to sustain and even grow their business. As a result, investors can spend 100% of their dividend income and still very likely see their income and portfolio value appreciate over time. In contrast, real asset investors typically have to practice much more savvy math in forecasting for themselves how much they will need to set aside for future repairs and/or to keep their properties competitive in their local market.

This is why we have a strong preference for relying on these real asset-backed financial assets rather than traditional physical real asset investments.

Building a Diversified "Real Asset" Portfolio

Our Real Asset Portfolio allows us to generate over $5,000 in annual passive income from a small $70,000 Portfolio.

Source: High Yield Landlord Real Money Portfolio

Compared to traditional equities, our real asset portfolio also enjoys much more reasonable valuation metrics trading at:

  • 9.5x cash flow on average
  • 18% discount to estimated NAV
  • 7.2% dividend yield (with safe 68% payout ratio)

Most importantly, we hold sizable stakes in more defensive investments such as

  • Rentals: everybody needs a roof, even in a recession. We take advantage of discounted small cap REITs to become landlords, without actually having to do any of the unpleasant work that comes with it. There exists over 200 REITs today with each investing in different property sectors. A few popular examples include Realty Income (O), Simon Property Group (SPG) and STAG Industrial (STAG).
  • Farmland: everybody needs to eat, even in a recession. Again here, there are publicly traded companies that own valuable farmland and pay attractive dividends. You can invest in farmalnd with listed partnerships and REITs such as Farmland Partners (FPI) and Gladstone Land (LAND) among many others.
  • Pipelines: we also all need energy, even in a recession. Pipeline MLPs are protected from commodity price volatility and only take care of the logistics against a fixed fee. Popular examples include Energy Transfer (ET) and Magellan Midstream Partners (MMP). And much more… Timberland, Airports, Windmills, …

We expect this approach to strongly outperform traditional stocks and bonds which are priced for perfection right now. A Real Asset approach is in many regards safer and more opportunistic. The cash flow is more resilient and more of it ends up in your pocket.

Brookfield (BAM) is the pioneer in real asset investing and here is its track record:

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Similarly, our Core Portfolio's after-tax returns over the past year have also materially outperformed following a similar approach to real asset investing:

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By positioning ourselves ahead of the expected rush to real assets, we believe that we can enjoy superior appreciation along with high income - the best of both worlds.

The best time to invest is today. The second best is tomorrow. We do not know how real assets will perform in any given month, quarter or even year; but over the long run, we are convinced that returns will very satisfying.

We are not the only one to think so. Consider that by 2025, the capital chasing real assets is expected to increase by nearly $40 trillion. The time to act is now:

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Disclosure: I am/we are long BAM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.