Click here to read the full paper including graphs: LGC article – Infrastructure & Affordable Housing
Against a backdrop of uncertain global markets, the Local Government Pension Scheme (LGPS) continues to face the challenge of increasing maturity of membership. As funds become cash flow negative, when benefits paid out are compared to contributions received, the need for sources of investment income to top up shortfalls has never been more pressing.
In this setting, real asset income solutions have entered the spotlight for their income orientation. Certain types of infrastructure and real estate investments, in particular, can provide attractive levels of stable income payments, often enjoying built-in protection from inflation due to index-linked contractual growth. These assets have also demonstrated low correlation with traditional assets such as equities.
There is a compelling case to increase exposure to UK affordable housing and global infrastructure, which are particularly attractive in the current environment due to their low sensitivity to GDP and resilience to economic shocks.
When it comes to weathering the storms of economic disruption, the type of infrastructure investment is critical. With the emergence of Covid-19, for instance, specific asset types sit in different places along a risk spectrum, as depicted in the diagram below. While some infrastructure assets have shown remarkable resilience during the recent global lockdown, data centres and utilities for example, others have been much more sensitive, such as airports and toll roads. This demonstrates the importance of understanding the drivers of cash flow and return for individual infrastructure assets. Those with lower sensitivity to the volume of demand can offer substantial diversification from assets that are more susceptible to impacts of GDP shocks.
Similarly, strong fundamentals of high demand and regulatory oversight underpin the affordable housing sector, making it less vulnerable to economic shocks. There is a long-standing undersupply of affordable housing in the UK, and during periods of downturn, data suggests house building slows, exacerbating the shortage. Meanwhile, the number of eligible households and those in need of affordable housing tend to rise in periods of weakness.
Both affordable housing and global infrastructure enjoy an unusually high level of income certainty over the long term. The UK affordable housing sector operates within a well-defined regulatory system. It provides a strong governance structure where private investors work with registered providers (usually local authorities or housing associations) letting assets on long leases, often 15 years plus. The assets maintain consistently high occupancy rates, with tenants waiting many years for a property. Turnover remains low as tenants must re-qualify for the waiting list if they vacate. Consequently, as the graph shows, rental growth for social and affordable housing has typically been superior to that experienced by both private residential and commercial real estate.
Similarly, many infrastructure assets are regulated or benefit from long-term contracted income. Even if demand for their services drops, these assets may still receive ‘availability’ payments from counterparties simply for the continued provision of essential services.
The two sectors also offer unusually steady income with inflation protection built in. In the case of infrastructure, payments are often explicitly linked to CPI through contracted increases during the period of the lease. In the affordable housing sector, rental growth is determined by government policy, typically set on a five-yearly basis with uplifts tracking an inflationary index. This provides a very attractive degree of income certainty compared with other asset classes.
Typically, with high barriers to entry and characteristics of natural monopolies, infrastructure assets are capital intensive and have very long operational lives. When held privately, their value is driven by the income they generate over their lifetime rather than by market sentiment. And as there is high visibility of income over the long term, they are less sensitive to market volatility than other assets.
Meanwhile, capital values in the affordable housing sector are insulated from the market forces that impact the private housing or commercial markets, as valuations increase steadily in line with the rental stream of an asset.
Both sectors offer attractive income streams that can secure funding for pension liabilities in the future. And in doing so, they also actively contribute to society. The provision of infrastructure and affordable housing makes an important contribution to the social fabric of communities and brings significant environmental and social benefits such as the development of renewable energy and social infrastructure assets. With attractive risk-adjusted returns expected for both sectors, these assets combine positive impacts on society with compelling investment cases, aligning with the long-term investment priorities for LGPS funds.