October 25, 2016

Don Stracke, Senior Consultant Tony Ferrara, CAIA, Sr. Consultant Support Analyst

Real Assets Education

City of Fresno Retirement Systems

• What are Real Assets? – Physical/tangible asset or an investment whose value is derived from a contractual

claim on an underlying physical/tangible asset – There are several strategy types within Real Assets:

• Commodities, Inflation-linked products, Private Energy/Infrastructure, Real Estate, Timber, Treasury Inflation Protected Securities (TIPS), inflation-sensitive equities, etc.

• Why invest in Real Assets?

– Offers an Inflation Hedge • Components within in Real Assets are sensitive to rising prices and thus, over the long term,

should provide a hedge against inflation • As a result, Real Assets tend to provide a “real” (after inflation) return

– Diversification • Real Assets have historically exhibited a low correlation to stocks and bonds which should serve

as a benefit to the overall portfolio

• What are the challenges associated with investing in Real Assets? – Liquidity Risk

• Similar to other illiquid investments, investors may take on liquidity risk depending on the Real Asset strategy type

• Liquidity can also impact the correlation to periods of rising inflation – Return Expectations

• Real Assets generally have lower expected returns than equities which may prove problematic in a low return environment

• Can underperform traditional markets for extended periods of time – Is now the right time for inflation protection?

Real Assets Overview

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Public Market or Liquid Strategies

Private Market or Illiquid Strategies

US TIPs

Emerging Markets Currency/Bonds

Real Estate Real Estate

Energy Energy

Commodities Commodities (Metals & Mining)

Infrastructure Infrastructure

Timber Timber

Agriculture Agriculture

What are Real Assets?

Active and Passively Managed Funds

Open-end and Closed- End PE Funds

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• Attractive real and relative returns during extended periods of high inflation

• Reasonable long-term return expectations (earn a risk premium for holding risky assets)

• Low correlation and diversification • Diversification along the liquidity spectrum

Attributes of an Effective Real Assets Program

A well-diversified Real Assets program enables better risk-adjusted returns through a full cycle

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• Real Assets are not a ‘one size fits all’ investment program

• They offer a broad range of risk/return strategies to be customized based on fund objectives

• In constructing a real assets portfolio there are several key considerations that impact the allocation, including:

– Fund inflation sensitivity – Fund investment policy – Liquidity requirements of fund – Allocation to illiquid alternatives – Existing investments with inflation hedging characteristics – Return, risk, and volatility expectations – Size of fund assets – Timing and pacing considerations

Real Assets Portfolio Structure Considerations

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• Institutional quality/commercial real estate is property intended to generate a return from rental income and/or capital appreciation

– Can be publicly traded or privately held – Strategies exist spanning the risk/return spectrum from stabilized core real estate to

development-oriented opportunistic real estate – Main property types include apartments, office buildings, shopping centers, hotels,

industrial properties, etc.

• Large real estate investable universe – Over $400 billion of privately-owned institutional quality real estate in the US – Nearly $1 trillion of total capital raised by closed-end fund managers since 2005 – US publicly-traded REITs with an aggregate market cap of over $800 billion

• Two components of real estate return:

– Current Income: Derived from tenant rents/leases that typically increase with inflation – Capital Appreciation: Increase in the value of an asset between acquisition and sale

• Leverage can amplify (both positively and negatively) returns from

current income and capital appreciation

Real Estate Overview

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Market size data as of December 31, 2014; private real estate represented by the NCREIF Property Index gross asset value, closed-end fundraising data from Prequin, REIT market cap represented by the NAREIT All Equity REITs Index

• Current income is derived from tenant rents/leases that typically increase with inflation

• Capital appreciation is the increase in the value of an asset between

acquisition and sale – Typically the result of lease-up, repositioning, renovation, development, etc. – Assets may require capital investment for the repositioning of the asset

• Both current income and capital appreciation returns are driven by

changes in net operating income (NOI), which in turn is largely driven by rent and occupancy levels

– Appreciation return is also affected by changing market cap rates and (to a lesser extent) debt financing available to potential buyers

• Drivers of rent – Occupancy (to an extent) – Job growth – GDP growth – Inflation

Real Estate Economic Return Drivers

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• Drivers of Occupancy

– New supply – Job growth – Economic factors (including GDP growth,

homeownership rates, etc.; vary by property type)

NEPC believes that real estate plays an important role as part of an overall investment plan:

1. Low historical correlation to stocks and bonds 2. Provides diversification benefits to the overall portfolio 3. Provides both current income and the potential for capital appreciation (each of which can

be enhanced with leverage) 4. Over the long term, provides a partial hedge against inflation as certain components of real

estate are sensitive to inflation 5. Offers a spectrum of investment strategies (with different return and risk expectations) that

can be customized to meet plan objectives

However, there are considerations of investing in real estate: 1. Investments are generally illiquid, particularly during falling markets (excluding public REIT

investments) 2. Limited and imperfect benchmarks exist to gauge investment performance 3. Valuations are based on underlying transaction markets which have limited transparency

and property appraisals can lag real-time market valuations 4. Investments outside of the base currency are affected by currency movements 5. The use of leverage amplifies negative performance

Real Estate as Part of an Investment Plan

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Spectrum of Real Estate Investment Strategies

Real Estate Investment Style / Overview

Investment Strategy

Portfolio Role Considerations

Core • Return driver: income • Primary vehicle: open-end funds • Historical avg. returns: 7-8% • Leverage: 15-30% • Hold period: long-term

Stabilized income producing assets

• Current income • Broad exposure to

commercial real estate (asset class beta)

• Inflation protection

• Vehicles are semi-liquid (entrance/exit queues)

• Limited alpha producing opportunities

REITs • Return driver: income • Primary vehicle: REIT funds • Historical avg. returns: 7-9% • Leverage: 30-50% • Hold period: long-term

Stabilized income producing assets

• Current income (dividends) • Long-term exposure to

commercial real estate (beta)

• Long-term inflation protection

• Volatility • Equity correlation

Value-Add • Return driver:

income/appreciation • Primary vehicle: varies • Historical avg returns: 8-10% • Leverage: 40-70% • Hold period: 3-5 years

Properties requiring lease-up,

repositioning, renovation or rehabilitation

• Provides part current income and capital appreciation

• Some inflation protection

• Vehicles are semi-liquid or illiquid

• Vintage year is important • Higher leverage vs core • Poor benchmarks

Opportunistic • Return driver: appreciation • Primary vehicle: closed-end funds • Historical avg. returns: 10-12% • Leverage: 60%+ • Hold period: varies

Distressed investments,

recapitalizations, development, etc.

• Real estate alpha through capital appreciation with minimal current income

• Vehicles are illiquid • Vintage year is important • High leverage • Poor benchmarks

Real Estate Debt • Return driver: varies • Primary vehicle: closed-end funds • Historical avg. returns: 8-10% • Leverage: varies • Hold period: varies

Varying risk/return profiles (senior loans

to higher risk structures)

• Mixed strategies: • Current income

w/downside protection • Higher risk

opportunistic/mezz. debt strategies

• Limited return upside (asymmetric risk profile)

• Minimal inflation protection • Vintage year is important • Poor benchmarks

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Cor

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Str

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• Real estate investment strategies vary in geographic scope

• Global or non-US (e.g. Europe-only) strategies may allow for managers to pursue more attractive markets

– Global managers tend to be large platforms with investment professionals around the world while non-US managers may be more localized in a particular region or country

• A global real estate investment strategy may benefit from diversification

as various regions are at different points in an economic cycle

• Considerations of investing in real estate outside the US: – Currency risk – Geopolitical risk – Market liquidity risk – Limited inflation hedge

• Within particular markets, managers may target specific sub-markets

– Investing in good markets is important, but a manager’s ability to identify attractive sub-market locations is critical as well

– For example, visibility from major roadways may boost retail center performance, access to key highways or ports are key for industrial properties

Geographic Considerations

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Relative Expected Risk Return Profile of Real Estate Sectors and Geographic / Market Focus

Illustrative Risk / Return Profile

Expected Risk Low High

Low

H

igh

Current Income Return Driver

Notes: - Debt-related strategies can span the illustrative risk / return spectrum depending on the specific strategy - Manager-specific risk, operations and leverage can skew expected risk / return profile

Capital Appreciation

Viewed as more risky with higher

return expectations

Viewed as less risky with lower return

expectations

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• Commodities are real assets – Corn, wheat, lean hogs, live cattle, gold, silver, crude oil, natural gas…

• Commodity trading

– The Chicago Board of Trade is the oldest exchange, and the first commodity contract was traded there in 1851

• Commodity exposure is achieved through “indirect investment”

– Indirect investment is achieved through commodity futures, options and swap contracts

• Direct investment in hard assets is impractical

– Delivery and storage are specialized businesses – Commodities generate wealth as they are consumed – Holding commodities in physical form precludes adding value

• Futures markets offer benefits to financial investors

– Compensation for assuming risk from commodity producers – Reward for providing liquidity to commodity consumers – Access to commodity returns without dealing in physical commodities – Futures contracts are a way to standardize deals

What are Commodities?

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• Investments in physical assets or companies that operate assets that provides essential services to society and typically exhibit one or more of the following: − Monopolistic or quasi-monopolistic

− High barriers to entry

− Long term assets

− Regulatory or permitting constraints

• Sector types include: − Transportation

− Energy and Utilities

− Communications

− Social Infrastructure

• Time Horizon to Liquidity is usually 6-12 years • IRR’s range from 6-10%, primarily driven by current income and capital

appreciation • Favorable conditions for investing:

− Improving economy

− High levels of deal flow that provide an opportunity to choose from a broad range of investment opportunities

− Assets with significant upside potential

What is Infrastructure?

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• What are sustainable real assets? – Strategies that are focused on investments that address issues related to natural

resources or physical/tangible assets – Incorporate environmental, social and governance (“ESG”) issues into investment

philosophy – Positive impact is measurable and is reported

• Why are sustainable real assets important? – ESG factors becoming increasingly important to investors and fund managers as

sustainability is seen as an important aspect of an investment philosophy – Superior business models with appealing long-term principals attractive to customers

and investors with potential long-term performance advantages – Provides enhanced return potential by optimizing asset values

Sustainable Real Assets

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• Sustainable strategies include: – Green real estate

• Developing or renovating properties to be energy efficient and environmental sustainable based off industry certifications and programs

– Renewable energy • A naturally generated source of energy that is not derived from fossil or nuclear fuel • Examples include: Solar, wind, hydro, biomass

– Timber • Harvest practices that take into consideration the regeneration and the long-term well

being of the forest – Agriculture

• Production of agricultural products using farming techniques that protect the natural environment and the surrounding social and economic conditions

– Land and water resources • Restore natural resources and generate environmental credits and other ancillary revenues • Examples include: mitigation banking and water assets

Sustainable Real Assets

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• Sustainable forestry management – Certified as Sustainably Managed

• Criteria and indicators developed by various organizations to implement and evaluate sustainable management

• Forests that are certified can realize price premiums and market interest • Forestry Stewardship Council, Sustainable Forestry Initiative, American Tree Farm Systems

– Balance between economic interests and preservation of forest health, productivity and future growth

• Non-Timber Forest Revenues

– Working forestland conservation easements – Carbon sequestration, wind power leases, water resource protection credits, biomass

and alternative energy supply agreements – Restoration or conservation activities

• State and Federal Legislation helps support conservation

– New Markets Tax Credit program provides low-cost debt that can be used for timberland investments

– Public support for conservation is strong

Timberland

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• Sustainable investments across the value chain – Growers, processers, and distributors of produce with a focus on sustainable farm

practices and organic produce – These practices can be best practices and can maximize returns

• Reduce costs, improve yields, increase quality of product

• Sustainable Farming Strategies

– Micro and drip irrigation and micro application fertilizer – Environmentally friendly pest control – Improve worker health and productivity

• Organic Produce

– Market for organic and sustainable products is increasing • From 2004 to 2011 organic food sales grew from $11B to $25B

– Certifications include: USDA Organic, Sustainable Farm Certification International, Rainforest Alliance, Fair Trade, UTZ Certified

– Price premium for organic products as consumers become more conscious of food sources

Agriculture

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• Mitigation Banking – Acquire, restore, manage and ultimately divest large rural properties that generate

revenues through the sale of environmental credits – Support the “No Net Loss” of natural resources requirements of federal, state and local

environmental laws – Capitalize on the Land-Based Environmental Offset markets established to mitigate

unavoidable, permitted impacts to wetlands, streams and other important natural resources

– Other revenue sources from ancillary land-based activities including conservation finance, sustainable timber management and agricultural and recreational leasing

• Water

– Target water assets that can provide freshwater for consumptive and environmental uses

– Water rights and entitlements that allow for storage/conveyance/delivery of water – Acquire water rights/entitlements directly or indirectly through a bundled transaction

inclusive of other assets such as land, interests in mutual water companies or interests in ditch companies

• Measurable Impact

– Acres under conservation easement – Jobs maintained and supported – Number of ecosystem services provided

Land & Water Resources

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• Metals and mining managers’ commitment to responsible investing – Supporters of UN Global Compact, Universal Declaration of Human Rights,

International Labor Organization, International Council for Mining and Metals and the UN Principles for Responsible Investing,

– Identify and manage project risks responsibly • Social, political, environmental, ethical and corruption risks

• Even these investments can have a positive impact – Many metals and mining investments are in under-developed communities – Sustainable development at the community level, such as education and healthcare

programs – Contribute to poverty reduction and job creation – Improved infrastructure systems – Consideration for long-term impact on community post investment

• ESG in due diligence process

– Pledge to invest in companies and projects which undertake ESG practices • Risk mitigation strategy

– Many managers produce an annual ESG Report • Details and quantifies aspects of their positive impact on the local community • Documents projects rejected due to socio-political risks, legislation issues, community

safety, health and safety risks for workers

Other Real Assets Strategies Incorporating ESG: Metals and Mining

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• Past performance is no guarantee of future results.

• The opinions presented herein represent the good faith views of NEPC as of the date of this report and are subject to change at any time.

• Data used to prepare this report was obtained directly from the investment manager(s). While NEPC has exercised reasonable professional care in preparing this report, we cannot guarantee the accuracy of all source information contained within.

• This report may contain confidential or proprietary information and is intended only for the designated recipient(s). If you are not a designated recipient, you may not copy or distribute this document.

Disclaimer

It is important that investors understand the following characteristics of non-traditional investment strategies including hedge funds and private equity: 1. Performance can be volatile and investors could lose all or a substantial

portion of their investment 2. Leverage and other speculative practices may increase the risk of loss 3. Past performance may be revised due to the revaluation of investments 4. These investments can be illiquid, and investors may be subject to lock-ups

or lengthy redemption terms 5. A secondary market may not be available for all funds, and any sales that

occur may take place at a discount to value 6. These funds are not subject to the same regulatory requirements as

registered investment vehicles 7. Managers may not be required to provide periodic pricing or valuation

information to investors 8. These funds may have complex tax structures and delays in distributing

important tax information 9. These funds often charge high fees 10.Investment agreements often give the manager authority to trade in

securities, markets or currencies that are not within the manager’s realm of expertise or contemplated investment strategy

Alternative Investment Disclosures