Diversified private real assets: real diversification with the potential for sustainable outcomes

Why now? This is a question many investors ask before they put their money to work, and the answer in this case is simple: We believe now is an opportune moment to take advantage of key tailwinds that may support private real assets. Policy-rate inflection points are the nearest-term factor to consider. Longer term, we see themes such as the growth of artificial intelligence (AI) and sustainable investment outcomes as supportive of private real asset values. In what follows, we explore these factors and outline the characteristics that make an allocation to diversified private real assets attractive.

As interest rates fall, the value of real assets may rise

In 2022, central banks began raising interest rates to combat what proved to be a fairly intractable higher-inflation environment. The U.S. Federal Reserve (Fed), for example, raised rates a total of 11 times between the first quarter of 2022 and January 2024. This created a challenging backdrop for some real asset categories, particularly real estate. Now, as developed-market central banks have begun their rate-cutting cycles, the backdrop for a range of real assets, including real estate, infrastructure, and timberland, is brightening.

In the case of real estate, higher interest rates over the last two years created severe dislocations in the market, putting substantial pressure on commercial property valuations. As the likelihood of Fed rate cuts has risen in the third quarter of 2024, the prospect of lower rates has begun to prime the market with the promise of lower borrowing costs. As financing becomes more accessible, that may help lift capital appreciation potential and increased transaction volumes. We believe this could produce a meaningful tailwind for the sector and, consequently, we think it’s a timely moment to consider deploying capital into this segment.

Unlike some areas of real estate, the infrastructure asset class broadly experienced stress but not distress in the higher-inflation environment. Utility ratepayers, for example, generally absorbed higher costs pushed through by utilities. Also, the energy transition and digitalization trends continued to drive investment in renewables and technology infrastructure, and transportation as a sector continued to grow. With the advent of lower rates, we’d expect to see potentially higher levels of capital market activity and a renewed focus on aging infrastructure, particularly in the United States. Therefore, as with real estate, we think the opportunity for enhanced valuations will be higher against the backdrop of a lower-rate environment.

For timberland, we would expect interest-rate cuts to boost construction activity, driving higher demand for timber, including sustainably harvested timber. A deep gap in U.S. housing stock, in addition to aging current supply, would underpin broad potential scope for housing market expansion. With downward pressure on construction costs as well as on mortgage rates, we’d expect a sizable amount of pent-up demand could be released among homebuilders and related areas of the housing supply chain.

In addition, we expect a lower-rate cycle to help shore up demand for products produced with renewable resources. These would include paper packaging used as a substitute for single-use plastics and new products such as mass timber panels that allow wood products to compete more directly with higher greenhouse gas-emitting concrete and steel in multistory construction.

Long-term investment themes such as digitalization and AI may affect private real assets in unique ways

As long-term trends, digitalization and AI may affect every sector and asset class because of their potentially comprehensive impact on labor and workflows. But these trends may have unique implications for different sectors and asset types, including private real estate and infrastructure, because these enduring, physical assets may effectively underwrite the persistence of these technological trends.

Data centers are a case in point. The demand for data centers is surging as AI begins to revolutionize various sectors. This demand is particularly strong from some of the mega-cap cloud companies, including Amazon, Microsoft, Google, and Alibaba, as these entities are the primary tenants of data centers and drive most of the leasing activity in the industry. As these companies continue to grow revenue through the expansion of cloud-based services, that may well signal robust expansion potential in data centers.

What’s more, a shift toward locations that can offer immediate power availability—sourced, for example, by on-site renewables to satisfy AI applications’ outsize thirst for energy—is expected to transform the data center landscape significantly. On-site power generation is becoming a key consideration in construction budgets, especially as data centers accommodate AI-driven, high-density servers that require advanced cooling systems. Consequently, data center operators are now navigating both real estate and utility roles, and those who can swiftly adapt are likely to dominate future market demands. Despite these challenges, data center landlords retain strong negotiating power. Favorable lease terms, such as fixed yield on cost for build-to-suit projects, are ensuring that tenants share the burden of increasing costs.

Diversification: circumventing traditional public market dynamics

Real assets offer a diversifying source of returns relative to traditional asset types. This is because they represent a diverse group of assets and strategies that may benefit from a range of themes and tailwinds to which stocks and bonds may not be fully leveraged.

In a multi-asset investment portfolio, traditional fixed income is typically relied on to provide stability and income, while equity allocations are used to pursue growth and capital appreciation. However, both of these asset types are publicly traded and therefore susceptible to short-term market dynamics, including changing market sentiment, fluctuating market technicals, and geopolitical forces.

Private real assets, by contrast, include investments in the built economy as well as natural capital—things such as data centers, airports, apartments, dams, farms, and forests. These assets and their potential income streams tend not to be publicly traded, which offers the potential for an illiquidity premium and a more stable, less cyclical return profile relative to stocks and bonds.

Inflation hedging: real assets are a good hedge for inflation risk

Inflation erodes the real return and purchasing power of investments and savings, but real assets have an intrinsic value that’s rooted in what’s concrete, enduring, and essential. Unlike more cyclical financial assets, real assets can be less vulnerable to unexpected changes in inflation—and can provide more income and higher asset values as inflationary pressures increase.

Many of the components of inflation in national inflation indexes are directly or indirectly related to real assets. Infrastructure, for example, is tied to transportation; farmland assets are tied to food; and both timberland and real estate are tied to housing. Real assets that are exposed to the global supply chain, such as shipping and warehousing, also factor into components of consumer price indexes. Therefore, long exposure to these underlying components of inflation is an effective way to hedge inflation risk over the long term.

Over the past 20 years, real assets such as real estate and infrastructure have outperformed equities and fixed income while providing a hedge against inflation—specifically in rising inflation regimes. This, coupled with their enhanced return potential and diversification benefits, has made real asset allocations a must for pension schemes. Investing across real estate, infrastructure, timberland, and farmland are all examples of ways to enhance the average defined benefit plan.

Policy changes in some geographies have made the inflation-hedging case for real assets even stronger. This is evident in the case of the disappearance of real return bonds in Canada. Long a reliable way to hedge against inflation, a recent decision by policymakers to cease all new issuances of these instruments means Canadian plan sponsors need to explore other avenues for hedging their plans against inflationary pressures.

Sustainable outcomes: pursuing resilient returns along with sustainability objectives

Real assets like infrastructure and real estate are part of what we call the built economy. Real assets such as timberland and farmland represent what we call natural capital. When managed sustainably, natural capital investments carry similar inflation hedging diversification potential as built-economy assets but also offer natural climate solutions that can contribute to climate change mitigation—as with carbon sequestration—as well as the reversal of nature loss. In this way, natural capital investments can help investors pursue strong risk-adjusted returns over time as well as sustainability objectives tied to key nature-related risks.

Sustainable investing opportunities can be found across the real assets spectrum. Renewable energy, for example, is central to sustainable opportunities within the infrastructure asset class. Real estate assets and construction practices are also vital to decarbonizing the built economy, and we expect investors will increasingly be drawn to building efficiency improvements and renewable technology that can support carbon reduction goals.

Natural capital, including timberland and farmland, represents 37% of the opportunity to deliver the emission reductions needed to limit global warming to 2˚C or below. Moreover, with biodiversity loss and ecosystem collapse regarded as one of the top 10 risks facing the planet in the next decade, sustainably managed natural capital assets may carry high impact potential.

A number of factors continue to amplify interest in sustainable strategies, including the need to meet net zero goals, commitments to greater corporate transparency, and pressure to demonstrate accountability to a broad range of stakeholders. Pension plans and asset managers now routinely account for the effects of climate change, biodiversity loss, and socioeconomic inequality as fundamental components of effective risk management and a matter of fiduciary duty.

Real assets are enduring assets

Allocating to a diversified portfolio of private real assets offers a compelling mix of diversification, inflation protection, and sustainable investment opportunities. In addition, real assets exert the enduring appeal of the real, which is to say the essential economy: They include our sources of food, fiber, fuel, and shelter; the physical arteries and nerve centers of the global economy, from shipping and ports to outdoor storage and data centers; and the natural capital assets that sequester carbon and have the potential to help rebuild our world’s struggling biodiversity. Investors can see what they’re investing in when they invest in real assets, and this can be a powerful driver of demand in a world of relentless change, technological disruption, and deep uncertainty about the future that goes hand in hand with key systemic risks.  

At the moment, the stage is set for a broadening interest-rate-cutting cycle in developed markets and a downward drift in global yields. Coming into the year, our base case had been that central banks would in fact begin easing around mid-2024, and our view has been validated. While inflationary pressures aren’t entirely gone, they’ve clearly moved closer to the Fed’s target. Outside the United States, muted economic growth may also be an incentive to continue normalizing interest rates. Against this backdrop, the prospect of lower financing costs, the potential for enhanced asset values, and the three pillars of real assets’ ongoing benefits for investors, we believe an allocation to this segment of the private markets would be a valuable addition to any investment portfolio.