The ascent of real assets

But their intention to accelerate their allocations and staff accordingly probably signals a more strategic role for real assets in institutional portfolios in the future.. Against a bac

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THE ASCENT OF REAL ASSETS

GAUGING GROWTH AND GOALS IN INSTITUTIONAL PORTFOLIOS

FOREWORD “What are our peers doing?”

For institutional investors the question is both timeless and timely Investors have always sought to learn from organizations facing challenges similar to theirs Lately, our conversations with clients indicate that the desire to do so is stronger than ever—not surprising during a pivotal period of rethinking and reassessment for many of them

The topic of real assets is a particular focus The growing appeal of real estate and infrastructure investments was one of the major trends highlighted by the institutional portfolio rebalancing survey we conducted late last year and released in January, and the interest has only grown since then That was a broad survey, however, and didn’t explore the goals and practices of investors as they put real assets to work—matters that we know are of great interest to our clients

This report, the fruit of a collaboration between BlackRock and The Economist Intelligence Unit, is a deep dive into those issues We think the research has yielded some significant findings, and we thank the 201 organizations around the world participating in our survey, and the eight senior investors who agreed to

be interviewed, for helping us uncover them

Among other things, the survey sheds new light on the interplay between interest rates and flows into real assets Readers will want to consider the results for themselves, but our view is that there is more going on than a short-term tactical shift Years of near-zero rates have led investors to look to real assets for return and income But their intention to accelerate their allocations (and staff accordingly) probably signals a more strategic role for real assets in institutional portfolios in the future

Not that the road to this future is necessarily a straight one High valuations, though far from universal, are one concern Lack of supply in infrastructure is another Real assets pose real challenges as well as real opportunities, and our report also features commentary from three BlackRock experts on how to think about the complete picture

We hope this report will be helpful to you as you get on with the task of making real asset investments that move you closer to your objectives As many of you know, we are strong believers

in the power of collective intelligence—and in the partnerships that contribute to it

Mark McCombeGlobal Head of BlackRock’s Institutional Client Business and Chairman of BlackRock Alternative Investors

About the research ����������������������������������������������������������������������������������������������������������������4

Executive summary ���������������������������������������������������������������������������������������������������������������5

Introduction ��������������������������������������������������������������������������������������������������������������������������7

Section 1: Real assets on the rise ������������������������������������������������������������������������������������������8

Section 2: Real estate rules ������������������������������������������������������������������������������������������������� 14

Section 3: Building up infrastructure ����������������������������������������������������������������������������������� 20

Section 4: Considering commodities ����������������������������������������������������������������������������������� 24

Conclusion �������������������������������������������������������������������������������������������������������������������������� 26

BlackRock commentators ��������������������������������������������������������������������������������������������������� 27

THE ASCENT OF REAL ASSETS

Gauging Growth and Goals in Institutional Portfolios

In September 2014, The Economist Intelligence Unit, on behalf

of BlackRock, conducted a global survey of 201 executives from institutional investment organizations in 30 countries to ascertain their level of interest in and strategies related to real-asset investment.

In terms of geographic distribution, 80 respondents were located in North America,

80 in Europe, the Middle East and Africa and 41 in Asia-Pacific Approximately one-third of the organizations represented in the survey have assets under management (AUM) of more than $75bn, with a similar proportion reporting between $1bn and $5bn

As a qualifier, all of the respondents indicated that they have significant responsibility for investment decisions and that their organization currently invests in real assets Moreover, the survey findings were complemented by in-depth interviews with eight senior financial executives at institutional investors across the globe

Our thanks to the following individuals for their time and insight (listed alphabetically):

Real assets—primarily real estate, infrastructure and

commodities—are an increasing focus of the world’s

institutional investors, according to a global survey of 201

organizations conducted by The EIU The trend is part of a

broader move into alternative investments by institutions that

are seeking to lessen their reliance on traditional stocks and

bonds amid the challenging conditions of the post-crisis years

Against a backdrop of ultra-low interest rates, sluggish growth and ongoing

uncertainty, nearly half of these investors have increased their allocations to at least

one real asset category in the last three years, the survey results show More than half

expect to increase in one or more categories within the next 18 months They cite two

main drivers for their greater investment: a desire to increase returns and their view

of the macroeconomic environment Many are also motivated by a need for income

Other objectives commonly associated with real assets—notably, diversification and

protection against possible inflation—are cited as well, but rank lower

Investors are using a variety of vehicles and strategies to get exposure to real

assets, a diverse category that also includes timber and farmland (See box at right

for definitions.) Nearly all respondents (96%) invest in real estate, which has long

played a role in institutional portfolios Infrastructure, the newest and

fastest-growing segment, is owned by 66% of the respondents Just under one-third of the

respondents (29%) invest in commodities

The median allocation to real assets was 11% of the total portfolio, a percentage

that will rise further if the respondents maintain their current course Overall, the

survey results signal the continued evolution of real assets as building blocks

in institutional portfolios, with many organizations adding staff to support such

effort However, there is an important caveat resulting from the same unusual

financial conditions that have been a tailwind for this asset class A majority of

respondents say that a significant rise in interest rates would cause them to

rethink some of their allocations to real assets

The key findings from the research are as follows:

Real assets have a significant and growing presence in institutional portfolios�

Close to half (46%) of the institutions surveyed have increased allocations in at

least one category in the last three years In the next 18 months, 60% will increase

in at least one category Looking within categories, 49% of infrastructure investors,

48% of real estate investors and 46% of commodities investors expect to increase

in the next year and a half

The need to increase returns is a—if not the—major motivation for adding to

real-asset allocations� In real estate, 63% of investors planning to grow allocations

rank ‘increasing returns’ among the three most important factors in their decision

The same percentage cite macro-environment considerations, while 38% say

Executive summary

REAL ASSETS DEFINED

This survey defines real-asset investments

as follows:

`

` Real Estate: real estate debt; private real estate equity; public real estate securities (REITS)

`

` Infrastructure: debt and equity

in hard assets (e.g power plants and toll roads) that generate cash flows by providing essential services

`

` Commodities: exposure to energy, metals or

agricultural products via physical commodities, natural resource equities or private commingled funds

`

` Timber and farmland: also considered to be real assets, but with relatively few investors owning them, allocation trends are not explored in depth here

increase allocations indicate a desire for returns, with 55% citing the macro environment and 43% referencing a need for income For those that plan on increasing allocations in commodities, 70% give returns as a reason

Low interest rates are a tailwind for investment in real assets; a spike in rates could be a headwind� Nearly half (47%) of survey respondents say low interest rates influence their investments in real assets Almost two-thirds (62%) say they would rethink some of their allocations to real assets if a ‘significant’ rise in interest rates were to occur In some sub-sectors, concerns about lofty valuations are influencing investment choices

Many institutions have real-asset teams, and they expect to add staff to them� Nearly one-third (32%) of respondents have a real-assets team, sometimes working within a larger alternatives team A similar number (30%) plan to increase the number of employees dedicated to real assets in the next 18 months Of those without a dedicated real-assets team, 14% indicate that they will put one in place in the next 18 months Nearly all respondents (96%) have staff dedicated to specific real-asset strategies

In real estate, core equity strategies draw the most interest, but value-added equity and opportunistic equity also have appeal� More than half (59%) of investors increasing allocations to real estate are either somewhat or very interested in core strategies, which are the most conservative and income-oriented Nearly half of those increasing allocations (47%) express interest

in value-added equity, with 34% expressing interest in opportunistic equity strategies—the highest-risk/highest-return investments

Most real estate investors have some non-domestic exposure; a significant minority show strong geographic diversification� Close to half (44%) of real estate investors currently have between 1% and 10% of their portfolios invested outside their domestic markets, compared with 22% that have more than one-quarter of their portfolio invested outside their home countries

In infrastructure, equity investments and brownfield projects are preferred� Among infrastructure investors expecting to increase allocations, 75% expect

to increase equity exposures and 38% expect to increase debt Existing (brownfield) projects are preferred: In developed markets, 51% of those expecting to increase allocations are at least somewhat interested in brownfield projects vs 23% that are interested in new (greenfield) projects

Infrastructure investors express noteworthy interest in emerging-market opportunities� Investors planning to increase infrastructure allocations find emerging markets almost as attractive as developed ones Nearly half (45%) are

at least somewhat interested in emerging-market brownfield investments, and 23% are interested in emerging-market greenfield opportunities—the same percentage interested in new developed-market projects

The highly unusual economic and financial conditions of recent

years have spurred a variety of changes to institutional investors’

portfolio management A climate of sluggish growth,

near-zero interest rates and general uncertainty has led investors

to rethink their approaches in traditional asset classes and to

increase allocations outside traditional categories—to so-called

alternative investments.

A major trend in alternatives has been the growth of allocations to real assets, an

investment arena that spans real estate, infrastructure, commodities and

less-common holdings such as timber and farmland (See box on page 5

for definitions.) These assets all share an underlying physicality, and many

(but by no means all) of the instruments used to access them are less liquid

than traditional investments Historically, diversification and inflation protection

have ranked high among the reasons for owning them But investors have other

objectives, too—notably, returns and income—and the goals can vary considerably

by investment type

Real-asset classes differ in other ways as well Real estate, for example,

has long played a role in institutional portfolios, and investors use a range of

instruments and strategies to invest in it, from highly liquid REITS to direct ownership

of specific properties Commodities are less widely owned but equally familiar—

modes of access include exchange-traded futures and stock in natural resource

companies Infrastructure, rooted in project finance, is relatively new, highly diverse

and still evolving The sector is attempting to connect the growing institutional

appetite for infrastructure exposure with the vast global need for infrastructure

capital (See, for example, “Institutional investors and infrastructure financing,”

published in 2013 by the Organization for Economic Cooperation and Development.)

Given these differences, should these alternative investment types be considered

one asset class? Are institutional investors thinking of real assets in those terms?

What are their objectives, strategy preferences and allocation plans in the three

major sectors? How do investment patterns differ around the globe? How deep—

and how durable—is the recent expansion of interest in real assets?

This report explores the answers to these questions Like the survey on which it is

based, the report has four main parts: an overview that maps trends across the

real-assets spectrum, followed by sections that delve into how institutions are using each

of the three major segments The survey results are supplemented by qualitative

interviews with eight senior executives at institutional investors across the globe

Institutional investment in real assets has grown in the last three years and is likely

to accelerate, our survey suggests It also shows that the level of ownership of the different investment types varies, with real estate owned by 96%, infrastructure by 66% and commodities by 29% (See Chart 1.)

CHART 1: CURRENT OWNERSHIP OF REAL ASSETS

% of all respondents invested in each sector

Commodities Infrastructure Real estate

% 0 10 20 30 40 50 60 70 80 90 100 (n=201)

Source: The Economist Intelligence Unit, 31 October 2014.

But, as shown in Chart 2, recent and expected increases for each segment are similar About one-third of the investors in each category have increased their allocations since 2011; about half in each category expect to increase allocations further over the next 18 months

CHART 2: INCREASES IN REAL ASSET ALLOCATIONS

% of respondents increasing in past three years/next 18 months

Real estate (n=192)

Infrastructure (n=132)

Commodities (n=59)

is the third most common motivation in all three segments

CHART 3: REASONS FOR INCREASE IN REAL ASSET ALLOCATIONS

% of respondents citing factors below among top three motivations

Macro environment considerations

Increase return

Replace or enhance current income

Address long-duration liabilities

Diversify overall portfolio

Real estate (n=92) Infrastructure (n=65) Commodities (n=27) Source: The Economist Intelligence Unit, 31 October 2014.

This may say more about the urgency of current needs than the fading of traditional

ones The desire for inflation protection, for example, hasn’t disappeared; 29% of

those increasing investment in infrastructure cite it as a motivation, even at a time

when deflation is probably the greater threat In a climate of extremely low returns,

however, investors seem especially focused on finding adequately rewarded risks, and

the illiquidity risk associated with many real assets has proved a popular candidate

“In the current low-interest-rate environment, real assets look more attractive

because of the potential illiquidity premium they can provide,” says Susan Martin,

chief executive officer at the $7.7bn (£4.8bn) London Pensions Fund Authority (LPFA)

Ben Mahon, alternatives investment officer at the $89bn Oregon State Treasury,

provides some context on the quest for returns “The general objective of the

fund as a whole is to pay benefits to participants and their beneficiaries, and any

investment needs to produce a return that is prudent and reasonable given the

level of liquidity and risk associated with it,” he explains “Expected returns are

necessary but not sufficient by themselves to warrant an allocation.”

Clearly, low rates have been a tailwind for real-asset investments: Nearly half (47%)

of respondents say that low interest rates influence their investments A spike

in rates, moreover, could be a headwind Almost two-thirds (62%) say they would rethink their allocations to real assets if there were a significant rise in interest rates As shown in Chart 4, perceived sensitivity to interest rates varies by segment, with real estate seen as most sensitive By region, respondents in Asia-Pacific felt most exposed to rising interest rates, with nearly three-quarters (73%) agreeing that their real asset allocations were particularly sensitive

CHART 4: “OUR STRATEGY IS PARTICULARLY SENSITIVE TO RISING INTEREST RATES”

Source: The Economist Intelligence Unit, 31 October 2014.

What might it signal that half the group expects to increase allocations, while nearly two-thirds say they would rethink allocations if rates rise significantly? Respondents weren’t asked for interest rate predictions, but the mainstream view

is that rates will rise gradually

Raphael Arndt, chief investment officer of the $93bn (AUS$104bn) Future Fund

of Australia, looks ahead: “The acid test [for real assets] will be when bond yields rise in a few years We are seeing the start of that cycle now and how real assets perform for us in the coming years, and through the rest of the cycle, will prove to be the most important thing for us.”

As investors consider what the effects of higher rates might be, they are already mindful of the manner in which strong investment flows spurred by low rates have elevated valuations in various real-asset sub-sectors Income-generating investments in real assets may be affected if rising rates make bonds more attractive As we explore in subsequent sections, these concerns are shaping investor decisions about strategies and target geographies

In addition to increased allocations, the survey indicates that some investors may

envision a longer-term role for real assets in their portfolios Nearly one-third (32%)

of respondents have a real-assets team, either dedicated or working within a larger

alternatives team As Chart 5 shows, a similar number (30%) plan to increase the

number of employees dedicated to real assets in the next 18 months Of those

without a dedicated real-assets team, 14% will put one in place over the course of

the next year and a half And almost all respondents (96%) have staff dedicated to

specific real-asset strategies

CHART 5: LIKELY CHANGES IN STAFFING FOR REAL ASSETS –

NEXT 18 MONTHS

% of respondents

% 0 10 20 30 40 50 60 70 80

Increase the number of employees

dedicated to real assets

Decrease the number of employees

dedicated to real assets

No change

EMEA Americas APAC

(n=201)

Source: The Economist Intelligence Unit, 31 October 2014.

Craig Lewis, director of private markets at The duPont Trust, says the $5bn trust is “a

very lean organization by design,” but has nevertheless added two members of staff

to provide support for real assets on due diligence and relationship management

Christopher Ailman, chief investment officer at the $186bn California State

Teachers Retirement System (CalSTRS), says CalSTRS has expanded its real estate

team to manage the complexity of the portfolio and added another member of staff

to the infrastructure team to cope with its growing allocation

BlackRock view

A beneficial rebalancing into real assets

We think most investors are significantly overweight financial assets and underweight real assets There are reasons for that—it’s much harder to invest in real assets than it is to buy stocks and bonds It’s probably a fair reading of the survey results to say that, with ultra-low interest rates driving a shift

in relative value between things with CUSIPS and things that are real, investors have begun a strategic rebalancing If so, we believe that’s a good thing for them

The trend toward adding real assets staff is also a positive one There are both liquid and illiquid ways of getting exposure to real assets, and there’s a place for both in most portfolios But the purer exposures tend to come via the less liquid vehicles, which pose their own unique challenges For example, illiquidity premia are highly unstable They can be quite large when an asset type is out of favor, then erode sharply

or even go negative when those assets come into demand We’re seeing this effect now with trophy properties in major real estate markets and stabilized, core infrastructure in developed countries.

We take a very price-aware view of real asset investments In the current climate, we find that more

complicated situations or assets that involve development or repositioning may often deliver better relative value To be sure, there are a lot of variables to consider—not just which sectors look attractive, but the different ways available to express a view, and the costs and benefits of each Most fundamentally, we advocate portfolios that are broadly constructed and aligned with an investor’s actual liabilities.

One survey finding that was a bit of a surprise was the relatively low rank of inflation protection

as a motivation Perhaps it was less cited because inflation currently seems like such a

distant possibility Unexpected inflation is, however, exactly what one wants to

guard against, since expected inflation tends to be priced into nominal return

expectations Investors in real assets today are generally benefitting from

competitive current returns with significant inflation protection, whether they

fully value that today or not.

Income, return, diversification, inflation protection: A well constructed

real assets portfolio can enhance a broader portfolio by contributing in

all four dimensions

Matthew Botein

Global Co-Head and CIO, BlackRock Alternative Investors

Real estate dominates the real-asset allocations, with nearly all survey respondents (96%) saying they have some allocation to the sector That nearly one-third (31%) increased their allocations over the last three years is consistent with the strong commercial and residential property markets in many parts of the world In the US, for example, strong inflows from institutional investors have pushed valuations

in some cities (as measured by cap rates) close to 2008 levels, as data from the National Council of Real Estate Investment Fiduciaries show

The survey signals that the flows are likely to accelerate Over the next 18 months, 48% of respondents expect to make either moderate (38%) or substantial (10%) allocations (See Chart 6.) Indications are that institutions will be selective about where they invest, however Real estate is seen as more sensitive to rising interest rates than infrastructure or commodities, with 59% of respondents agreeing that their strategies are ‘particularly sensitive’

By region, Asia-Pacific has the largest proportion of investors who plan to substantially increase real estate allocations—20%, compared with 13% for Europe, the Middle East and Africa (EMEA) and just 1% in North America Slightly more than one-third (35%) of investors in EMEA are planning a moderate increase, compared with two-fifths in North America and Asia-Pacific

CHART 6: CHANGES IN REAL ESTATE ALLOCATIONS OVER PAST THREE YEARS/NEXT 18 MONTHS

% of real estate investors reporting: