Portfolio Construction: Infrastructure vs Property vs Equities

As we navigate an evolving economic environment marked by easing monetary policy, investors are looking for assets offering stability, growth and income.

In this context, global real asset classes, such as Listed Real Estate Investment Trust (REITs) and Listed Infrastructure, are compelling additions to any diversified portfolio.

These asset classes not only provide attractive dividend yields and inflation protection but also offer unique benefits that can enhance portfolio performance during periods of monetary easing.

In this blog, we explore why Listed REITs and Listed Infrastructure are particularly well suited for the current economic climate and delve into how their distinctive characteristics make them valuable assets for any portfolio.

Whether seeking to bolster the defensive qualities or aiming to capitalise on growth opportunities, understanding the role of these global real assets can help you to make informed investment decisions within the changing financial landscape.

The 2022-2023 interest rate hike cycle has been one of the steepest in decades for various central banks. Throughout this period, the Global Listed REITs market, represented by the Dow Jones Global Select ESG REIT Index (NZD), has faced significant challenges, declining sharply by approximately 16.5% from its peak at the start of the rate hike cycle in March 2022 through to the trough in October 2023 (Figure 1).

This downturn coincided with the onset of the global rate hike cycle, which put immense pressure on property values and increased borrowing costs for real estate companies.

Although there has been some recovery since the trough, the performance of REITs has remained subdued compared to Listed Infrastructure and broader global equities, reflecting the impact of tighter monetary conditions on the sector.

In contrast, Listed Infrastructure has consistently demonstrated resilience over the same period, supported by stable cash flows and inflation-linked revenue streams, as highlighted in our research on global listed infrastructure.

As we move into the last quarter of 2024, the global economy is at a turning point. After a challenging period of high interest rates aimed at controlling inflation, several central banks have already kicked off their easing cycles. Notably, the US Federal Reserve made a significant move in their first easing by cutting its benchmark rate by 50 bps in response to slowing growth and cooling inflation.

The anticipated shift in monetary policy, with rate cuts expected to materialise in major economies, could turn the tide for both asset classes, reducing borrowing costs and enhancing their relative appeal.

The early effects of these changes are already evident. As shown in Figure 2 below, while global equities have been volatile through August and started on a weak note in September, Listed Infrastructure and Listed REITs have delivered strong returns.

Specifically, over the three months ending 31 August 2024, Listed Infrastructure - proxied by Dow Jones Brookfield Global Infrastructure Gross Total Return index (NZD)- returned 7.72%, and Listed REITs – proxied by Dow Jones Global Select ESG REIT Index (NZD) - delivered an impressive 11.66%. Both asset classes have outperformed global equities – proxied by S&P Global 100 Ex-controversial weapons TR index (NZD) by 2.2% and 6.2%, respectively. This strong performance highlights the potential benefits that current and upcoming monetary conditions may hold for these asset classes.

Looking ahead, central banks are likely to adopt more accommodative policies to support growth amid moderating inflation. Expected rate cuts could provide a tailwind for income-generating assets, making Listed Infrastructure and REITs attractive options for investors seeking diversification and income in a lower-yield environment.

Further, ongoing investments in critical infrastructure and sustainable urban development are set to drive growth in these sectors, particularly in areas such as digital infrastructure, renewable energy, and sustainable real estate.

With global equities appearing expensive on nearly every valuation metric following the AI-driven rally of the past year, there are rising concerns about downside risks and lower return expectations going forward.

By contrast, we believe that listed Infrastructure and REITs are well-positioned to benefit from the anticipated shift to a more supportive interest rate environment, making them compelling components of a well-diversified portfolio.

Here are a few key reasons as to why ensuring your clients’ portfolios have a portion allocated to infrastructure and/or property.

Over the long run, the performance of listed real assets is largely driven by the underlying real estate markets, which have economic sensitivities that are distinctive from other business sectors.

This distinct behaviour is reflected in their imperfect correlation with global equities and notably low correlation with NZ equities and fixed-income assets during the period from 31 August 2019 to 31 August 2024 (Table 1).

Interestingly, the short-term correlations of listed REITs and listed infrastructure with other asset classes further emphasise their diversification benefits, particularly during periods of market turbulence as in August.

Over the past 12 months leading up to 31 August 2024 (Table 2), listed REITs and listed infrastructure have shown notably lower correlations with global equities. This trend has been especially pronounced following the AI-driven market rally, where fears of a potential AI bubble have raised concerns about the stability of broader equity markets.

The reduced correlations of listed “real asset” classes, as shown in Figure 3 with the 12-month rolling correlation data from 31 August 2020 to 31 August 2024, highlight their potential value as portfolio diversifiers. This characteristic is especially relevant in today’s environment of heightened market volatility and shifting economic conditions.

Both infrastructure and REITs can serve as effective hedges against inflation, thanks to their unique revenue structures.

Listed REITs, which primarily generate income through rent collection, provide a natural inflation hedge as many leases are tied to inflation rates. This supports dividend growth and provides a stable income stream during inflationary periods.

Similarly, listed infrastructure assets often benefit from inflation-linked revenues, although the degree of protection varies across different types of infrastructure. A well-diversified listed infrastructure index typically includes significant exposure to sectors with inflation-indexed revenues.

For example, our licensed index, the Dow Jones Brookfield Global Infrastructure Index allocates over 60% to Utilities (such as electricity, water, or gas utilities) and Transportation (including toll roads, airports, freight rails, and marine ports). These sectors often pass inflation through to consumers via tariff adjustments or operate under concession agreements allowing CPI-linked rates.

When thinking of defensive assets, cash and fixed income often come to mind. However, as central banks begin to ease monetary policy to stimulate economic growth, global listed infrastructure presents a compelling defensive alternative.

Historically these assets have delivered higher returns over the long-term, on average, than fixed income assets, while carrying relatively lower risk compared to global equities (Figure 4 below).

Further, the assets owned and operated by listed infrastructure companies are broadly categorized into two main types:

1. Regulated assets such as electricity, water, and gas utilities, which have steady demand and are regulated, ensuring stable earnings over time, and;

2. User-pays assets such as airports and data centers, which generate revenue from demand driven pricing, often secured by long term contracts.

These assets have proven resilient, even amid disruptions like the Covid-19 pandemic.

With their solid and stable income sources, listed infrastructure assets are often regarded as ‘defensive’ equities, providing reduced downside risk relative to other equity sectors. This characteristic is particularly advantageous in the current environment of increased market volatility following last year's AI-driven equity rally.

REITs and Infrastructure are known for their attractive dividend income, often surpassing those of traditional stocks (Figure 5).

As cash flow-focused businesses, REITs are typically required by law to distribute most of their taxable income to shareholders, distinguishing them from other sectors. For example, REITs in the US, UK, Japan, and Germany must pay out 90% of their income, while in Italy and France, the requirement is 85%. This legal structure allows REITs to avoid standard corporate taxes and efficiently pass income directly to shareholders.

Similarly, infrastructure companies benefit from stable earnings derived from essential assets, enabling them to offer predictable and high-yield income distributions. This stability further enhances their appeal as income-generating investments making them attractive for investors seeking reliable dividend income.

Furthermore, Global listed REITs and listed infrastructure both offer significant growth potential by addressing critical sectors of the economy with distinct but complementary characteristics.

Listed REITs have strong growth potential due to several key factors.

• E-commerce Growth: The rise in e-commerce has increased demand for industrial and logistics spaces

• Changing Work and Living Patterns: Shifts in work habits and lifestyles impact office and residential property needs.

• Sustainability Focus: REITs that focus on sustainability and eco-friendly building practices can attract more tenants and boost property values.

• Property Management Innovations: Advances in property management and services also help REITs stay competitive and meet evolving market demands.

In parallel, the listed infrastructure presents significant growth potential across three key sectors.

• Transportation infrastructure: Airports and railways, benefit from increasing mobility demands and technological innovations like autonomous vehicles.

• Commodity infrastructure: Essential services such as water and energy, enjoy stable cash flows and opportunities for modernisation and efficiency improvements.

• Data infrastructure: Telecommunications towers and data centers, are driven by surging data demand and technological advancements like 5G and IoT.

Collectively, these sectors offer attractive investment opportunities due to their essential roles, adaptability to technological changes, and capacity to meet growing global needs.

As we approach the end of 2024, the economic landscape is evolving, marked by a pivot in monetary policy as central banks adopt easing measures to support growth amid cooling inflation. With rate cuts on the horizon, the focus is turning to “real asset” classes such as Listed Infrastructure and Listed REITs, which stand to benefit from lower borrowing costs.

Recent performance highlights this potential, as Listed Infrastructure and Listed REITs have significantly outpaced global equities, posting returns of 7.72% and 11.66%, respectively, over the three months ending August 31, 2024. These gains reflect their growing appeal in a market shaped by more accommodative monetary policies.

In this context, we believe the Kernel Global Infrastructure Fund, which tracks both the Dow Jones Brookfield Global Infrastructure Index in its hedged and unhedged versions, along with the Kernel Global Green Property Fund, which tracks the Dow Jones Global Select ESG RESI Index (NZD hedged), can provide investors with a cost-effective and well-diversified exposure to real assets.

These funds are well-suited for inclusion in a long-term investment portfolio. For these reasons, both funds are featured in Kernel’s High Growth and Balanced Funds within the KiwiSaver diversified funds category.

Incorporating global listed infrastructure and REITs into a long-term investment strategy offers several advantages, including enhanced diversification, inflation protection, and attractive dividend yields.

Their potential for growth is particularly promising given the shift toward a low-carbon world and the increasing focus on digital infrastructure, renewable energy, and sustainable transportation. Additionally, listed infrastructure with its solid and stable earnings sources can help mitigate downside risk compared to traditional equity markets.

Given their unique investment attributes and the favorable interest rate environment on the horizon, we believe there is certainly room for including listed infrastructure and listed REITs in a well-diversified asset portfolio.