Market Watch

The AMP Capital Wholesale Australian Property Fund recently bought Stage 1 of the Connect Corporate Centre in Mascot, Sydney, a sleek, brand-new building close to the Sydney CBD valued at $43.6 million. 

What made the building so attractive? For a start, it has a list of blue-chip tenants that will deliver reliable income, but also excellent growth prospects in a transforming area.

It’s characteristics like that that underpin successful commercial property investments. But while there is growing excitement around commercial property’s potential to generate reliable income, particularly for those moving into retirement, few investors understand the real drivers of good commercial property investment. 
There are five features that help investors distinguish good commercial property investment or funds from the bad.

High-quality tenants

Quality tenants are the major building block of commercial property. You want access to high-quality tenants with deep pockets and fixed leases – whether government departments, Australian businesses or international companies.

The Connect Corporate Centre in Mascot has a list of high-quality tenants, including the Commonwealth Government, Kone Elevators, global real estate services firm Jones Lang Lasalle, former Qantas credit union Qudos, and international medical device maker, Boston Scientific.

The Fund’s portfolio more broadly consists of household names such as Coles, Woolworths, Leo Burnett, ConocoPhillips and Dulux.

High occupancy rates and a long rent roll

In addition to quality tenants, investors should look for properties and funds that have a high number of tenants. But, importantly, you should look for a high occupancy rate that has been demonstrated right through the cycle. A high occupancy rate allows the property or fund to maintain consistent cash flow streams.

Past performance is not a reliable indicator of future performance.

We have a good track record of renewing tenants and our occupancy rate has been more than 95 per cent for more than 10 years.

Maintaining high occupancy requires excellent management: making sure tenants are well taken care of and that we’re doing all we can to service them.

The right level of debt

Debt often plays a big part in real estate. Debt juices up capital returns – it multiplies both gains and losses. But debt can make income less secure. The right level of debt depends on your investment objectives. 

If you are looking for a defensive, income-generating investment, then you’re likely to prefer an investment with lower levels of debt underpinning more predictable returns.

Because we focus on a solid income profile with a little bit of capital growth, our fund’s policy is to use debt very conservatively. Our gearing levels are typically 0 to 15 per cent. 

Location, location

Just as with residential property, location matters. History shows that assets in major cities tend to benefit from a larger pool of tenants and industries, creating higher rental demand, strong underlying land values and more stable rental returns. 

The property should also be in an area with potential. We believe the Connect Corporate Centre’s location in Mascot provides significant upside to rents. The South Sydney market has been transformed over the past decade and Mascot is establishing itself as an attractive new commercial precinct.

Rents in Mascot at $360sqm to $400sqm are cheap relative to the CBD, which have risen from $600sqm to $1000sqm, but also relative to the likes of Chatswood, Parramatta and Macquarie Park. However, Mascot rents probably won’t stay cheap forever. As the area continues to change and densify, our view is that the market will catch up over time, providing solid capital growth.

Another recent acquisition, the Brickworks Centre, a 15,183 square metre single -level lifestyle centre at Southport on the Gold Coast, has 50 tenants across fresh food markets, eateries, furniture, homewares and boutique retailing.

The Brickworks Centre is located in Southport, a hotspot for population growth on the Gold Coast. Southport has been classified as a priority development area which has led to a surge in development applications including several mooted large-scale apartment projects. The Centre also benefits from the recently constructed light rail, built for the Commonwealth Games.

Scale and diversification

The final factor is diversification. Diversification is crucial to producing quality, stable returns from commercial property. Ideally, you don’t want to be exposed to one property with one tenant. If the tenant leaves and you have difficulty re-leasing, your income could dry up.

Few commercial properties are priced under $1 million, and it can be difficult to get the scale required to achieve a diversified exposure unless you invest in a fund. A fund provides diversification across national property markets, property sectors, buildings and tenants.

The Wholesale Australian Property Fund, as an example, has exposure to NSW, Queensland, Victoria, South Australia and the ACT. We are also diversified across retail, office and industrial sectors, which bring different benefits to a portfolio. Industrial, for example, typically generates more yield. (Broadly, we aim for one-third in retail, a third in office, and another third in industrials.)

We have a mix of 300 tenants in our 22 properties across many sectors such as retail, government, financial and business services and manufacturing and transport. 

Ideally, you don’t want to be overly exposed to one tenant. Our largest tenant, generates less than 5 per cent of the portfolio’s revenue and if we acquire further properties in the fund that percentage will fall. 

Locking in solid returns

There is no doubt that commercial property can deliver solid, stable income streams. But to deliver that stable income stream, investors need to focus on the right properties and right funds.

Our team is extremely selective and for every property we buy, we typically consider and reject another 20. 

If investors can focus on properties and funds that have good quality assets and tenants, then they will lay the platform for solid returns over the medium to long term. 

For more information on the Wholesale Australian Property, listen to our recent webinar.

It’s important to be aware that there are risks associated with investing in the Wholesale Australian Property Fund. Before investing, please read the Product Disclosure State which can be found by visiting our website.

Source: AMP Capital 12 October 2017

Author: Christopher Davitt, Portfolio Manager

Important note: Investors should consider the Product Disclosure Statement (“PDS”) available from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (“AMP Capital”) for the Wholesale Australian Property Fund (“Fund”) before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. National Mutual Funds Management Ltd (ABN 32 006 787 720, AFSL 234652) (“NMFM”) is the responsible entity of the Fund and the issuer of units in the Fund. Neither AMP Capital, NMFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance.

While every care has been taken in the preparation of this document, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. 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. Investors and their advisers 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.

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

Conditions in the global economy have improved. Labour markets have tightened and above-trend growth is expected in a number of advanced economies, although uncertainties remain. Growth in the Chinese economy is being supported by increased spending on infrastructure and property construction, with the high level of debt continuing to present a medium-term risk. Australia’s terms of trade are expected to decline in the period ahead but remain at relatively high levels.

Wage growth remains low in most countries, as does core inflation. Headline inflation rates are generally lower than at the start of the year, largely reflecting the earlier decline in oil prices. In the United States, the Federal Reserve has indicated that it will begin the process of balance sheet normalisation in October and that it expects to increase interest rates further. In the other major economies, there is no longer an expectation of additional monetary easing. Financial markets have been functioning effectively and volatility remains low.

The Australian economy expanded by 0.8 per cent in the June quarter. This outcome and other recent data are consistent with the Bank’s expectation that growth in the Australian economy will gradually pick up over the coming year.

Over recent months there have been more consistent signs that non-mining business investment is picking up. A consolidation of this trend would be a welcome development. Business conditions as reported in surveys are at a high level and capacity utilisation has risen. A large pipeline of infrastructure investment is also supporting the outlook. Against this, slow growth in real wages and high levels of household debt are likely to constrain growth in household spending.

Employment has continued to grow strongly over recent months. Employment has increased in all states and has been accompanied by a rise in labour force participation. The various forward-looking indicators point to solid growth in employment over the period ahead, although the unemployment rate is expected to decline only gradually over the next couple of years.

Wage growth remains low. This is likely to continue for a while yet, although the stronger conditions in the labour market should see some lift in wage growth over time. Inflation also remains low and is expected to pick up gradually as the economy strengthens.

The Australian dollar has appreciated since mid year, partly reflecting a lower US dollar. The higher exchange rate is expected to contribute to continued subdued price pressures in the economy. It is also weighing on the outlook for output and employment. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.

Growth in housing debt has been outpacing the slow growth in household incomes for some time. To address the medium-term risks associated with high and rising household indebtedness, APRA has introduced a number of supervisory measures. Following some tightening in credit conditions, growth in borrowing by investors has slowed a little recently. In the housing market, conditions continue to vary considerably around the country. Housing prices have been rising briskly in some markets, while in others they have been declining. In Sydney, where prices have increased significantly, there have been further signs that conditions are easing. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. Rent increases remain low in most cities.

The low level of interest rates is continuing to support the Australian economy. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Source: Reserve Bank of Australia, October 3rd, 2017

Enquiries

Media and Communications
Secretary’s Department
Reserve Bank of Australia
SYDNEY

Phone: +61 2 9551 9720
Fax: +61 2 9551 8033

If you look around the world we face unprecedented risks. The Trump Presidency, North Korea’s nuclear ambitions, rising interest rates, and fully valued markets are all spot fires that could engulf portfolios.

These risks can seriously dent investor’s and client’s life savings, and damage their ability to reach important financial goals. The stakes are high.

Savvy investors and advisers are now actively looking to insure against those portfolio risks by using natural hedges like diversification and defensive assets.

Unfortunately, as you can see in the chart below, two big market events in recent memory – the 2000 tech wreck and the 2008 global financial crisis (GFC) – highlighted the limitations of diversification. Bonds were meant to provide a ballast against falling equities. But just when we needed protection the most, both fell at the same time (positive correlation).

click to enlarge

Source: Bloomberg, AMP Capital 2017

It was as if we’d bought insurance for our house and the insurer didn’t pay up.

In this risky market environment, investors and advisers need to look to other forms of portfolio insurance and protection, particularly options. 

Some investors and advisers think options are risky; but options reduce portfolio risk, like insurance on your house. The key is to use them in a dynamic, cost-effective way that minimises performance drag, like only buying insurance only when a fire or storm starts to threaten your house and when insurance premiums are cheap.

A simple contract

Options may seem complex, but basically they are a contract that is sold by an option ‘writer’ to an option ‘holder’. That contract gives the holder the right (but not obligation) to buy or sell a security, such as shares, at an agreed price on or before a specified date.

A ‘call’ option gives the holder the right to buy the underlying security; a ‘put’ option gives the holder the right to sell the underlying security. 

You can limit your trading to options themselves; you don’t have to trade the underlying security themselves. If the underlying shares fall, for example, your put options become more valuable. 

Of course, like any insurance, options cost. The holder must pay the option seller a ‘premium’.

Protection from puts

Put options are a great way to provide protection against market falls.

Buying protective put options are like buying classic insurance – you pay a premium upfront and it pays a positive return when the market declines. 

Source: Bloomberg, AMP Capital 2017

The put contract illustrated in the chart above has a strike 5 per cent below the market level. If the market falls 10 per cent, you will get a 6 per cent return. The premium is 1.5 per cent. If the market goes up or falls less than 5 per cent, the option will expire worthless and you lose the premium.

The cost of options

We buy insurance on our house all the time. Can’t you just hold protective puts all the time to protect portfolios?

Unfortunately, because options cost money (the premium you pay to the option seller) they drag on performance. 

Source: Bloomberg, AMP Capital 2017

In the chart above, you can see the impact on a notional $10,000 of rolling put options at 5 per cent below the money on the S&P500 in the US. There were positive payoffs to the left towards the GFC. But, generally, they are a drag on performance.

Most investors and clients are in accumulation phase. They can take short-term volatility, but they can’t take this drag on performance.

Prudent protection

The good news is that by using options selectively and dynamically, you can get portfolio protection without major performance drag. 

There are three ways to use options cost-effectively.

1. When it’s time

The first method is to only use options when your process or methodology says to reduce risk. For example, AMP Capital uses a Sentiment Score for its dynamic asset allocation (DAA) process, which informs our use of options.

2. When they’re cheap

Another is to buy options when they are cheap. Premiums you pay for options change depending on what the market expects volatility will be. If the market expects higher volatility in the future, people buy more options which pushes their price up. The VIX index measures the implied level of volatility. If the VIX is low, options are cheap.

3. Other markets

Another way to keep costs low is to buy options in countries outside the US. Put options are expensive in the US. Regulations give insurance companies a big incentive to buy put options on market exposures, mostly the S&P500. That pushes up the price of put options. So you should look at other markets, such as Europe and China, to buy protective puts.

Successful protection against Presidential uncertainty

At AMP Capital we successfully use options to protect against worrying market events. 

In September 2016, we were particularly concerned about the US Presidential election triggering a market correction. Our DAA process also showed added risks from record low yields and high valuations in the S&P500.

So for relevant portfolios we entered into a more complex options strategy, called a ‘reverse collar’ to protect against a possible correction.*

Click to enlarge

Source: Bloomberg, AMP Capital 2017

As shown in the chart above, we entered the position in early September, a good time. The market continued to be volatile along with the polling of the candidates. The market fell almost 5 per cent (close to the maximum payoff) and we exited the position when the majority of the potential gain from the strategy had been captured. 

This example also highlights one of our key rules: each option must have pre-defined exit triggers so we crystallise the benefit (or loss) in a disciplined manner.

Incorporating options into strategies and decisions

Portfolios that hold different types of assets, such as multi-asset funds, obviously have an inherent level of risk protection because they have a diversified range of assets. 

But as we’ve seen, diversification doesn’t always deliver portfolio protection, particularly during extreme market events. Sometimes we need to turn to other forms of insurance and protection, such as options.

With the world facing significant geopolitical, economic and market risks, advisers and investors should be considering incorporating options as an insurance strategy. 

Advisers and investors should also be seeking out investment managers who have the skills to use options in a cost-effective and disciplined manner so they can maximise protection and minimise performance drag.

*A reverse collar is selling (short/writing) a put option and buying (long) the call option on the same index. At the same time, to cover any negative market movement and therefore the short put, we sell the same face value of the contracts short, with futures contracts in the S&P500 market.

A reverse collar takes advantage of skew in the US options market. Because of the previously mentioned insurance regulations, puts are more expensive than calls. The skew means we get protection (positive payoff) for the first 5 per cent of the market decline. And we only give up around 2.3 per cent of the upside if the market rallies.

Source: AMP Capital 14 September 2017

Author: Heath Palos, Assistant Portfolio Manager, Multi-Asset Group

Residential property has become the new religion in Australia. The buoyant market, particularly in Sydney and Melbourne where house prices have jumped 75% and 50% respectively in recent years, means residential is constantly talked about and analysed. 

But as more and more baby boomers move into retirement, there is a growing need to seek investments that provide reliable income streams and protect against the unique risks they face such as inflation.

So long as Australians associate ‘property’ with ‘residential’, there is a danger they will ignore commercial property — an asset class that has historically delivered the very stable income, defensive attributes and potential for solid long-term gains that retirees require today. 

More Australians, particularly retirees, therefore, need to start looking beyond residential and understand the 5 key advantages of commercial property.

1. BULK OF RETURNS FROM INCOME

The first advantage of commercial property – retail, industrial and office – is that income underpins commercial property as a great investment. Over the past 30 years, commercial property has delivered total returns of 9 per cent a year. In general, some 2 per cent of the total return has been capital growth. The remainder 7 per cent is income – that’s more than double the standard term deposit rates, albeit with more risk.

By contrast, capital growth dominates residential returns. If we use a three-bedroom home in Sydney or Melbourne as proxy, residential property delivered a greater total return over the past thirty years. However, some 7 per cent of the total residential return was capital growth. That left income at just 3 per cent.

2. A STABLE INCOME SOURCE

Importantly, the income investors earn from commercial property is stable. Tenants, such as businesses and government, lease buildings generally for between 3 to 10 years, sometimes longer. Those long-term leases provide income security.

For example, our Wholesale Australian Property Fund acquired the Codan Building, a campus-style facility in Adelaide suburb of Mawson Lakes for $32.1 million in March this year. The building is fully leased to Codan, an ASX-listed company with a strong track record. The tenant signed a new 15-year lease that started in December 2015 with a 10-year option, and the property provides an initial income return of over 7.5 per cent.

Residential tenants, however, typically sign up for just 6 to 12 months, and in most states they can break that lease with 8 weeks’ notice. 

Within commercial property’s longer leases are fixed escalations in rent – each year rents are increased at an agreed rate of around 3 to 4.5 per cent.

There is also much less chance of a commercial property being damaged by a rogue tenant.

3. PORTFOLIO DIVERSIFICATION

Commercial property also has a low correlation to equities, which makes it relatively stable when markets are volatile.

Firstly, the market prices commercial property funds based on valuations which mean a lot of the day-to-day volatility is smoothed out, both relative to the equities market and even relative to listed property options.

Secondly, in a downturn total property returns can fall hard and dramatically, but the income from commercial property is less impacted in the short term because of legally binding leases. Because they have signed up to long-term rental agreements, the tenant must keep paying their rent each year, regardless of whether their profits rise or fall.

That low correlation to equities, and relative stability, means commercial property provides excellent portfolio diversification and some protection from downside risk.

4. INFLATION HEDGE

Additionally, commercial property is an excellent hedge against inflation, one of the biggest risks for retirees. When inflation accelerates, price rises flow through to higher profits, and in turn that flows through to higher rents and rising land values for commercial property. Historically, commercial property values have tended to rise at rates similar to inflation. That relationship has held for a very long time.

Commercial property therefore provides protection against an unexpected inflation spike. These spikes can have a double-whammy effect on retirees: not only does the price of day-to-day items such as food go up, but core defensive assets such as government bonds suffer.

Commercial property preserves the ‘real’ (after inflation) value of a retiree’s portfolio, allowing the income returns they generate to grow at a similar rate to the cost of living.

5. STRONG RETURN OUTLOOK

And finally, commercial property also offers a solid return outlook. 

We have seen commercial property prices rise in recent years. Investors have been attracted to the sector’s yields in a low interest rate environment. Given our view that interest rates are set to remain low over the medium-term (the next three years or so), we believe that trend has further to run.

Overall we expect commercial property to deliver a 7-8% total return over the medium term, with about 5-6% in income and the remainder in capital growth. That outlook is based on deals we are seeing and executing, where commercial property is being valued and sold on the expectation of a 7 to 8% return.

Looking beyond residential

When we look around at other sources of income and asset classes, the outlook for returns from commercial property is excellent.

Cash and term deposits are no longer adequate sources of income, and The Reserve Bank is unlikely to raise rates aggressively any time soon. Traditional asset classes such as stocks and bonds face the large-scale challenges posed by both slowing global economic growth and historically low interest rates.

Geopolitical tensions, such as North Korea’s missile program and China’s territorial dispute with neighbouring countries over the South China Sea, is instilling further uncertainty in financial markets.

While residential property has been strong, and a crash is unlikely, its growth is now moderating.  Combined, the solid returns, stable income, and low correlation to equities that commercial property offers makes it an extremely attractive investment for Australians, particularly retirees seeking reliable income streams and protection against sequencing and inflation risk.

It’s time for Australian investors, particularly retirees, to look beyond residential and consider investing in commercial property.

Upcoming webinar

Join Christopher Davitt, Fund Manager for the AMP Capital Wholesale Australian Property Fund as he provides an update on the Fund and discusses recent properties that have been purchased. Tuesday 19 September 2017, 2pm-3pm. Register now.

It’s important to be aware that there are risks associated with investing in the Wholesale Australian Property Fund. Before investing, please read the Product Disclosure State which can be found by visiting our website.

Source: AMP Capital 14 September 2017

Author: Christopher Davitt is Fund Manager for the AMP Capital Wholesale Australian Property Fund and Australian Property Fund.

Important note: Investors should consider the Product Disclosure Statement (“PDS”) available from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) (“AMP Capital”) for the Wholesale Australian Property Fund (“Fund”) before making any decision regarding the Fund. The PDS contains important information about investing in the Fund and it is important investors read the PDS before making a decision about whether to acquire, continue to hold or dispose of units in the Fund. National Mutual Funds Management Ltd (ABN 32 006 787 720, AFSL 234652) (“NMFM”) is the responsible entity of the Fund and the issuer of units in the Fund. Neither AMP Capital, NMFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance.

While every care has been taken in the preparation of this document, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. 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. Investors and their advisers 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.

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

Conditions in the global economy are continuing to improve. Labour markets have tightened further and above-trend growth is expected in a number of advanced economies, although uncertainties remain. Growth in the Chinese economy is being supported by increased spending on infrastructure and property construction, with the high level of debt continuing to present a medium-term risk. Commodity prices have risen recently, although Australia’s terms of trade are still expected to decline over coming years.

Wage growth remains low in most countries, as does core inflation. Headline inflation rates have declined recently, largely reflecting the earlier decline in oil prices. In the United States, the Federal Reserve expects to increase interest rates further and there is no longer an expectation of additional monetary easing in other major economies. Financial markets have been functioning effectively and volatility remains low.

The recent data have been consistent with the Bank’s expectation that growth in the Australian economy will gradually pick up over the coming year. The decline in mining investment will soon run its course. The outlook for non-mining investment has improved recently and reported business conditions are at a high level. Residential construction activity remains at a high level, but little further growth is expected. Retail sales have picked up recently, although slow growth in real wages and high levels of household debt are likely to constrain future growth in spending.

Employment growth has been stronger over recent months and has increased in all states. The various forward-looking indicators point to solid growth in employment over the period ahead. The unemployment rate is expected to decline a little over the next couple of years.

Wage growth remains low. This is likely to continue for a while yet, although stronger conditions in the labour market should see some lift in wages growth over time. Inflation also remains low and is expected to pick up gradually as the economy strengthens.

The Australian dollar has appreciated over recent months, partly reflecting a lower US dollar. The higher exchange rate is expected to contribute to the subdued price pressures in the economy. It is also weighing on the outlook for output and employment. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.

Conditions in the housing market continue to vary considerably around the country. Housing prices have been rising briskly in some markets, although there are signs that conditions are easing, especially in Sydney. In some other markets, prices are declining. In the eastern capital cities, a considerable additional supply of apartments is scheduled to come on stream over the next couple of years. Rent increases remain low in most cities. Investors in residential property are facing higher interest rates. There has also been some tightening of credit conditions following supervisory measures to address the risks associated with high and rising levels of household indebtedness. Growth in housing debt has been outpacing the slow growth in household incomes.

The low level of interest rates is continuing to support the Australian economy. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.

Source: Reserve Bank of Australia, September 5th, 2017

Enquiries

Media and Communications
Secretary’s Department
Reserve Bank of Australia
SYDNEY

Phone: +61 2 9551 9720
Fax: +61 2 9551 8033

We argued, however, that global listed infrastructure would weather interest rate rises over time because of its underlying assets and strong cash flows.

Despite investors’ concerns, global listed infrastructure has had a strong start to 2017 with the US 10-year bond yield actually drifting lower due to lowered expectations on the Trump administration’s ability to deliver on their policy objectives.

But will that strong performance from global listed infrastructure continue? Do infrastructure fundamentals remain strong enough so that investors and advisers can continue to rely on strong returns and cash flows from the asset class?

Utilities to underpin performance

Utilities – electricity, gas and water – play a significant role as they represent some 30 to 40 per cent of global benchmarks. North America is clearly the most important utilities market. It’s home to a large proportion of benchmark weightings, particularly electricity and gas, and has total market capitalisation reaching an impressive $US1 trillion.

North American utilities exhibit strong monopolistic characteristics, own the assets and have transparent and stable regulation that provides for reasonably attractive levels of returns.

Like infrastructure generally, utilities, particularly in North America, have made a strong start to the year.

 As infrastructure specialists, we undergo in depth on the ground research by regularly travelling to visit company headquarters and their assets. As such, we spent ten days in the US meeting with 35 utility companies, as well as many other industry experts and participants, to develop a better understanding of the key issues for the sector and its outlook. What we found was a positive overall outlook for utilities’ fundamentals, as well as signs of risk mitigation, in the following key areas:

1. Value creation from efficiencies

Utilities have been increasingly focused on improving the efficiency of their cost base, and significantly more potential remains. We expect this to be an important driver of cash flow growth going forward. 

 Most companies are now pointing to a flat evolution of their cost base, or at least below the level of inflation. Some even suggest that it will be possible to reduce costs year-on-year over 3 to 5-year periods, providing the opportunity for companies to create significant value.  

2. Investment drivers

All three of the utility subsectors – electricity, gas and water – have seen a rapid growth in investments in recent years. One of the main drivers is infrastructure replacement, which will continue to be a driver going forward.

 Each subsector has different drivers, but we expect rate base (the value of a utility’s assets on which it can earn a return) growth over the next three to five years of 4 to 6 per cent for electric utilities, 6 to 8 per cent for gas utilities and 5 to 7 per cent for water utilities. 

3. Regulation

Regulators set an ‘allowed return on equity (RoE)’ for utilities according to their view of the prevailing rates in the market. In recent decades, allowed RoEs have fallen as the US 10-year bond rate has declined, though not to the same extent. A large spread between US 10-year bonds and allowed RoEs has emerged.

In recent quarters, however, the reductions in allowed RoEs has slowed to the point that, on average, they have even started to reverse, perhaps reflecting the view that the reference rates such as the 10-year rate may be bottoming. 

 Management teams we met with are confident that allowed RoE should remain at least flat or hopefully increase should rates rise. 

4. Tackling tax reform

Tax reform has been a key issue for markets since Trump won the US Presidency. While a reduction in the corporate tax rate, when it comes to utilities, is likely to be passed straight through to customers by regulators, a more sensitive issue for utilities is the removal of the deductibility of interest expense. Removing this benefit to the cost of debt would make utilities’ cost of capital meaningfully higher, which would also be passed on to consumers. 

 Industry associations representing utilities, however, have been lobbying politicians for this measure to be removed from planned reforms, and at industry events we attended it is understood that politicians are becoming increasingly responsive.

5. M&A activity

M&A activity has also become common in the utility industry over the years and particularly of late. Much of the M&A has been based on sound industrial logic and delivered meaningful synergies. The industry has been historically fragmented. The very low cost of debt has made acquisitions more appealing and many utilities have been able to take advantage of that to expand their service territory. 

But increasingly transactions have taken place across subsectors, particularly electric utilities looking to buy gas utilities, often to supplement what might be slowing growth at the electric utility. 

While M&A activity and speculation have persisted of late, many companies did flag that current valuation levels at which the industry trades do make accretive transactions much more challenging.

A matter of value

Considering the trends above – among others – we’re maintaining our view that North American utilities remain one of the higher-quality sectors that global listed infrastructure investors can get exposure to. On our quality scores, all these companies equate to an ‘A’ or ‘B’ on our scale of A to D. 

The main challenge is that these companies, generally, are not cheap. There are some relative opportunities, but most companies have a 3 or 4 valuation score on our scale of 1 to 4. 

 We obviously prefer those companies with stable regulation and attractive RoEs, strong investment drivers, efficient operation and/or scope for material improvement, a disciplined approach to M&A, and simple structures unlikely to be affected by tax reform. 

A strong outlook

Overall, our trip highlights the benefits of investing in an active asset manager with a research team that can conduct detailed on-the-ground research into fundamental factors in complex sectors.

But it also highlights our thesis that global listed infrastructure is well positioned to weather future challenges and continue to provide advisers and investors with strong returns. North American utilities is an important sector to this asset class. Hence, we continue to monitor the key issues mentioned above and intend to stay in touch with the main industry players to take advantage of their evolution.

Joseph Titmus
Portfolio Manager/Analyst, Global Listed Infrastructure  

Source : AMP Capital 10 August 2017

This article provides general information and hasn’t taken your circumstances into account. It’s important to consider your particular circumstances before deciding what’s right for you. Although the information is from sources considered reliable, we do not guarantee that it is accurate or complete. You should not rely upon it and should seek qualified advice before making any investment decision. Except where liability under any statute cannot be excluded, we do not accept any liability (whether under contract, tort or otherwise) for any resulting loss or damage of the reader or any other person.