Real appeal 2 - Spotlight on direct infrastructure in Australia
This is the second in a three-part article series that explores the benefits of direct assets in an investment portfolio
In a world of sluggish economic growth and low interest rates, investors have to look widely to generate investment returns. Direct infrastructure is a compelling asset class in this environment.
In a low-return environment, high-performing and relatively low-risk investments are likely to attract interest. Assets in different social, energy and utility, and transport infrastructure sectors all offer diverse characteristics and opportunities.
Social infrastructure includes a broad range of assets including schools, hospitals, car parks and convention centres. Increasingly, state governments are using public private partnerships (PPPs) for the delivery of a wide range of social infrastructure assets under concession arrangements. Social PPPs are typically availability-based; that is, the investor ensures that the assets are ‘available for use’ while the government counterparty takes the demand risk. Risk transfer to the private sector includes financing over the term of the concession, delivery risk, ongoing provision of operating services and maintenance.
For investors targeting yield, Australian social infrastructure PPPs are particularly attractive since yields are high, relative to current bond rates. This has led to a thriving secondary market in mature social infrastructure PPPs.
Most social PPPs have limited growth potential, so valuations are sensitive to long-term government bond rates, primarily through their impact on discount rates used for discount cash flow (DCF) analysis. Although they tend to be highly geared, debt positions are usually hedged, so the operational impact of any increase in the cost of debt is limited.
Inflation may also be passed through making these attractive real absolute return investments.
Other forms of social infrastructure, including student accommodation, attract higher levels of return relative to the availability model as they involve a greater degree of demand risk. Student accommodation, in particular, is also leveraged to high-growth Asian economies, ensuring full occupancy for mature assets. Bed scarcity around the leading tertiary institutions supports growth in market pricing, making these assets particularly attractive.
Ports and airports
Airports represent growth assets that are geared towards the strong growth potential that’s coming from Asian markets. This is evident in international air passenger growth in the Asia-Pacific region, which has sustained double-digit compound average growth rates (CAGRs) for many years. However, a comparison with growth in developed countries still reveals a huge latent demand that will be unlocked in future years as per capita wealth grows. This suggests sustained, high future demand growth will persist for attractive destinations.
The picture is less clear for seaports as very high multiples have been paid recently for specialist and general cargo ports, the most recent being a reported 25 times EBITDA multiple for the 50 year lease on the Port of Melbourne1. Such assets are leveraged primarily to Australian rather than Asian growth and long-term growth is unlikely to match airports.
Valuations of these assets are sensitive to long-term interest rates, but are more resilient than PPPs, as the factors that could see an increase in bond rates, for example, increased demand in the economy, are also likely to see an acceleration of growth.
Some legacy road assets were developed under PPPs with the concessionaire taking demand risk. Such roads broadly provide investors with direct exposure to Australian economic growth and, in some cases, significant growth opportunities. Typically, new private sector toll roads are provided under the availability model, with governments taking demand risk.
Currently, the government is developing an estimated $16.8 billion, 33-kilometre toll road network in Sydney through the WestConnex tollway project2. Funding via a PPP structure is a likely next step post-construction, and allows the state to 'recycle' the capital. Such assets provide investors with high-yielding opportunities. However, the large size of a future sale of the WestConnex project is likely to attract ferocious international competition and may not offer the value of mid cap growth assets.
Most Australian freight rolling stock is now owned by the private sector. Road congestion in major cities and improved rail services has seen strong growth in rail commuter volumes (for example, 8% CAGR in Sydney) as well as network expansions. Favourable policies coupled with the obsolescence of much of the legacy rolling stock suggests that new passenger rolling stock could also be privatised along similar lines to the UK industry.
Commuter network capacity is still limited by nineteenth century system architecture and there may be further private sector opportunities in this area. Governments are also open to private sector proposals for greenfield track developments.
Compared with the other sectors, rail is somewhat immature as an investment class but could prove very attractive to the private sector if the private sector were invited to participate, similar to the UK model.
Australia’s electricity industry was reformed in the 1990s by eliminating vertically integrated state monopolies in favour of separate generation, transmission and distribution operators and retail suppliers. Consequently, in the eastern states, generation and retailing are now largely privately-owned while transmission and distribution assets have a mix of public and private ownership and operation.
At a geographical level, assets in Queensland and Western Australian represent some of the largest potential future privatisation prospects in Australia; New South Wales is in the midst of leasing and contracting operations of the majority of its distribution assets.
The sector is also sensitive to technological change in solar photo voltaic generation, real time grid management and economic on-site energy storage, when coupled with the need to de-carbonise energy production, which suggests that the century old utility business model is under threat.
The final part of this three-part article series looks at opportunities in commercial real estate.
1 As reported in the AFR September 19, 2016
2 O'Sullivan, M., 2016, WestConnex: Extra tunnel, road widening makes $16.8b motorway even bigger, Sydney Morning Herald, published 19 July 2016