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The Power of Real Assets

Investments with Tangible Worth and Intangible Value

"Specialty assets have the potential to balance out the impact of market- based investments over the long term and benefit from evolving demographics worldwide."

Chris Hyzy Chief Investment Officer

Real assets undoubtedly are an essential element in a well- managed investment portfolio. This asset class—which includes agriculture, timberland, commercial real estate and energy—can provide the opportunity for long-term total returns, inflation protection, and the ability to offset the volatility of equity and fixed-income investments. 

For those investors wishing to leave a significant legacy, specialty assets can provide the ability to pass on something real, tangible and valuable to future generations. And, for those interested in creating positive social change, these assets offer the opportunity to invest in sustainable and environmentally sensitive resources. In summary, specialty assets can be a solid investment that can help investors “do well while doing good.”

2019 Outlook

Looking ahead, the long-run picture for specialty assets remains positive. Despite slightly weaker economic growth and fears of a global trade war, various global themes point to increased demand for agricultural products, timber, commercial real estate and energy in the coming years.

Economic outlook and trade risks

After a strong year for the U.S. economy in 2018, we expect economic growth to continue this year at a solid pace, though somewhat less robust amid tighter financial conditions and elevated global trade tensions. Current strong consumer spending and a healthy labor market should be positive for the economy and specialty assets going into 2019, while headwinds related to trade negotiations and slower growth abroad remain key risks to watch. Upside risks to the growth outlook include a pause in Federal Reserve interest rate hikes, a weaker U.S. dollar, and stimulus from China.

Trade tensions are among investors’ top risks for 2019, but we believe the base case is that the U.S. and China will avoid a full- blown trade war. Another trade deal to track is the U.S.-Mexico- Canada Agreement (USMCA), which currently awaits ratification by Congress. Positive developments on trade could help alleviate some uncertainty for owners of specialty assets, particularly farmland investors who are largely exposed to U.S. exports.

Long-term themes

Looking beyond these short-term risks, many global trends point to increasing demand for specialty assets over the long run. First, with the world population estimated to grow by 2 billion people to nearly 10 billion by mid-century, the global demand for food, energy and other commodities should also rise accordingly.

Meanwhile, emerging markets are currently seeing an important shift towards greater per capita incomes and a growing middle class. As of 2018, according to the Brookings Institution, half of the world is considered middle class or wealthier, with five people entering the middle class each second. Wealthier consumers in emerging markets are likely to stimulate demand for more diverse foods, housing and other higher-value goods, and U.S. exports— from agriculture to oil—should benefit.

Another major global force underpinning demand for specialty assets is the migration to cities, or urbanization. The percentage of people living in urban areas globally is expected to increase to 68% by 2050, up from 55% today, with close to 90% of this increase taking place in Asia and Africa, according to the United Nations Department of Economic and Social Affairs. This should drive greater demand for agricultural goods, consumer products, housing and energy—as per-capita consumption tends to be higher in cities than in rural areas, and a more urban population demands a more diverse product selection.

Other factors contributing to increased global consumption of specialty asset-based products include a growing global labor force, higher levels of educational attainment, and, in various emerging markets, the increasing role of women in the formal economy. Additionally, pent-up housing demand from U.S. millennials is expected to drive construction in the coming years, supporting demand for timber and wood-based products. Meanwhile, we believe constraints on the supply side should push up farmland and timberland values over the long term as world arable land per capita continues to decline due to industrialization and climate change.

Key takeaways for 2019 and beyond

Ultimately, these long-term global supply and demand dynamics should help mitigate the short-term damage from trade protectionism resulting in our view of a positive outlook for specialty assets in the coming years. During times of market uncertainty, investors can look to specialty assets as a way to help keep portfolios appropriately diversified. Other potential benefits of specialty assets include attractive risk-adjusted returns, inflation protection, relatively low volatility, a source of cash flow, and, in some cases, tax advantages for high-net-worth investors. As the world continues to change and new challenges emerge, specialty assets offer a way to make a commitment to sustainability and provide investors something real and meaningful to hold on to, and pass down to the next generation.

Trends Driving Demand for Specialty Assets

  • Rise in global population and demand for food, energy and other commodities 
  • Growing labor force and middle class creating greater purchasing power
  • Urbanization bringing higher per-capita consumption of consumer goods
  • Increasing housing needs of millennials

FARM AND RANCHLAND - Retaining value amid trade and pricing challenges

The underlying case for farmland remains resilient for 2019. Overwhelming global macro trends should continue to drive demand for U.S. agricultural commodities despite the low commodity price environment. And farmers are finding ways to manage the disparity between expenses and revenue.

Overall, global demand for key commodities is anticipated to strengthen as the need for food sources continues to grow.

Trade tensions

Agriculture came into the crosshairs of several political clashes in 2018 and trade tensions have lingered. While many trade challenges were resolved with limited impacts to the farm economy, the United States-Mexico-Canada Agreement (USMCA) is one deal that is expected to have a beneficial effect on U.S. farmers and domestic commodity prices. The new agreement would ultimately allow for continued free and fair trade between the three key agricultural trading partners in North America. Meanwhile, trade disputes between the U.S. and China could derail optimism that would likely support higher commodity prices in the United States.

Programs bring stability and relief

The 2018 Farm Bill brings much needed stability for U.S. agricultural producers while also providing greater support for the struggling dairy industry. Meanwhile, the 2018 Market Facilitation Program will provide much needed relief to producers impacted by the trade disputes in 2018, but it is unlikely that the program payments will offset the full impact of the lower commodity prices.

Chart of prices received for corn and soybeans by month

Influences  on  crop prices

In 2018, prices for most major commodities declined due to larger supply expectations and trade uncertainty. In 2019, however, a potential trade resolution with China may create optimism and impact soybean prices. The near-term benefit may be limited as an anticipated large South American soybean crop could provide strong competition. Acreage shifts away from soybeans could prevent soybean prices from retreating.

Chart of U.S crop farms: prices received and prices paid by farmers

The outlook for corn and wheat appears more favorable than soybeans due to available export opportunities and supply and demand fundamentals. In addition, the USMCA is helping to support and stabilize corn prices domestically. Overall, global demand for key commodities is anticipated to strengthen as the need for food sources continues to grow.

Managing  the  disparity between expenses and  revenue

Expenses have been steadily increasing for various reasons (mainly cost of seed, and to a lesser extent fertilizer) while crop prices have clearly declined. Fortunately, most farmers have been able to maintain profitability due to increases in production and farming efficiency that have helped buoy revenues despite the lower price received per bushel.

Farmland inventories remain thin; values  steady

Demand for farmland continues to be strong despite the low prices for commodities. Additionally, the low turnover rate and thin supply of farmland continues to help support land values, which we expect to remain steady or dip slightly lower in 2019.

Key Takeaways

  • Macro-trends in global population, labor, urbanization and income continue to drive demand for farm products. 
  • Constraints due to global industrialization and climate change restrict supply.
  • Farmland value remains steady with long-term upside as the availability of arable land shrinks.
  • Farmland brings investment diversity and the opportunity to walk the land for those with a long investment horizon.
  • Advancements in crop production technology are helping boost output and ultimately higher revenues on a per acre basis.

TIMBERLAND - Positive market fundamentals persist   

Heading into 2019, positive market fundamentals persist, with an anticipated favorable impact on timberland investments expected in the mid and long term. However, other factors and unknowns such as general late-market cycle behaviors, political friction, global trade stress and tariffs are contributing to a potentially higher level of uncertainty this year. Ultimately, the introduction of innovative forest products and modern timberland management strategies is helping mitigate these challenges and offering a long-term path forward for this asset class.

The demand for renewable and sustainable forest products is inspiring new, innovative solutions.

Supply  and  demand optimism

The supply of British Columbia (BC) salvage timber from forests killed by beetles continues to shrink. An overhang of supply in many southeast U.S. markets has heightened in part due to the maturing of stands planted +/-30 years ago. Additionally, strengthening timber prices in the southeast suggests the supply situation may be reaching an inflection point. We believe this is likely to have a positive impact on prices for timberland in that region.

Current timber demand also suggests favorable conditions in 2019, especially in the southeast U.S. There, existing sawmills are investing in increased lumber manufacturing capacity and closed facilities have reopened, leading to rising timber demand in those areas. Canadian firms are opening sawmills in this region as well, to replace diminished operations in BC due to the lack of timber there. The southeast U.S. region’s highly developed transportation  infrastructure and export capabilities are adding to the favorability of timber operations in that area. In addition, increasing demand for larger trees to manufacture building supplies, combined with the adjusting supply of timber, also support mid- and long-term optimism for this asset class.

Trends drive need for paper products

An aging population and the expansion of the global middle class suggest an increasing demand for absorbent products and packaging for consumer goods. Additionally, the shift from brick-and-mortar to online shopping is generating considerable need for corrugated shipping boxes and liner board. The timber industry should benefit from these trends as the pulp and paper industry gears to keep production aligned with market demand. While increased demand is typically met by thinning harvests, the process advances biological growth and leads to final harvests of more mature and larger trees—which can help meet future needs.

Building with cross-laminated timber (CLT)

Innovative forest products translate into benefits

The demand for renewable and sustainable forest products is inspiring new, innovative solutions. The development of wood pellets as a carbon neutral fuel for power generation continues to make slow and incremental gains in market share. Another evolving forest product making its way to the U.S. is Cross Laminated Timber (CLT), which offers a renewable and sustainable building material with certain construction advantages over traditional steel and concrete. While CLT has been used in Europe for many years, U.S. building codes have not uniformly adopted use of this product. Recently, however, changes to Oregon building codes allow CLT in the construction of high-rise buildings. Should other states follow Oregon’s lead, this product could have significant potential long-term benefits for timberland investors.

Chart of return VS volatility 2007-2018

Strategies to adapt to challenges

Fortunately, many of the market and trade uncertainties that might create headwinds for timberland can be mitigated through implementation of modern timberland management strategies and adoption of reasonable return expectations. Some of the approaches to strategic timberland management include: aligning harvest scheduling with fluctuating cycles in timber markets (keeping in mind this could change cash flow projections); modifying harvests in response to demand for certain types of products; and using strong genetic stock when replanting to increase biologic growth rates and lower mortality risk. Active management and disciplined acquisition strategies mitigate much of the uncertainty expected during the year, but investors should focus on patience and a long-term outlook.

Key Takeaways

  • Mid- and long-term fundamentals for timberland appear positive, but market uncertainties may influence short-term outlooks.
  • Timberland remains a strong risk diversification asset class for investors with a long-term outlook and reasonable return expectations.
  • The low-risk attributes of timberland make it a viable investment option during times of heightened volatility in the equities markets. 

ENERGY - Economy, new methodologies fuel activity in oil and gas

A look at significant events and trends in oil and gas helps shape the outlook for 2019. In addition, an update on other sources of energy provides insights regarding the direction these specialty assets might take in the year ahead.

Development in the Permian Basin continues at a very high rate, with operators spending large sums of money to acquire leases from mineral owners.

Oil prices tumble

Despite the historical non-correlation of oil prices to the equity markets, oil prices tumbled in step with the markets in the fourth quarter of 2018, with West Texas Intermediate (WTI), the benchmark domestic crude oil price, falling from approximately $70 per barrel to $51 per barrel. In an effort to moderate oil prices, OPEC implemented additional cuts in production, which, in the past, has proven successful in reducing global oil inventories and raising global oil prices.

Scrambling for hydrocarbon resources

Development in the Permian Basin continues at a very high rate with operators spending large sums of money to acquire leases from mineral owners. In the most active areas, lease bonuses per acre have reached unprecedented highs. This activity is expected to continue in 2019. Likewise, purchase offers for minerals are also at historical highs, with operators and investors taking advantage of the vast hydrocarbon reserves attributed to the Permian Basin. 

Longer-lateral wells help boost yields and returns

Technological advancements in horizontal drilling and well completions have spurred a trend toward creating long-lateral wells. While the cost of drilling these longer laterals is higher, the expense appears to be justified by the increased initial production rates and improved returns we’ve seen by operators who have recently leveraged these techniques.

Chart for U.S. energy production projected to change significantly under current laws and regulations

Energy trends at-a-glance

Oil

  • The U.S. Energy Information Administration (EIA) expects U.S. crude oil production to rise from
  •  10.9 million barrels per day in 2018 to 12.1 million barrels per day in 2019.
  • West Texas Intermediate (WTI) crude oil prices are expected to average $54 per barrel in 2019, as compared to $65 per barrel in 2018, according to the EIA.

Natural Gas

  • The EIA expects U.S. dry natural gas production to increase in 2019 to 90 billion cubic feet per day versus 83.3 billion cubic feet per day in 2018.
  • Due to record production rates, Henry Hub natural gas prices are expected to average $3.11 per million BTUs in 2019, down $.06 from the 2018 average, according to the EIA. 

Electricity/Coal

  • Natural gas-fired electricity generation is expected to account for 35% of total electricity in 2019 and will continue to displace coal-fired generation, which accounts for 26%, according to the EIA..

Renewables/Other

  • Wind, solar, and other non-hydropower renewables are expected to provide 11% of the nation’s total energy needs in 2019, while nuclear and hydropower are expected to provide 19% and 7%, respectively, according to the EIA.  

Key Takeaways

  • The U.S. Energy Information Administration (EIA) expects domestic production of both crude oil and natural gas to reach new records in 2019.
  • The EIA forecasts West Texas Intermediate (WTI) crude oil prices will average $54 per barrel in 2019. This compares to an average price of $65 per barrel in 2018.
  • Henry Hub natural gas prices are expected to average $3.11 per million BTUs, which is $.06 lower than the 2018 average price, according to EIA’s forecast. 

COMMERCIAL REAL ESTATE - Steady income and favorable conditions to help bridge market  cycles

General economic conditions were supportive of commercial real estate (CRE) investments through 2018 with expectations for more of the same going into 2019. Factors having a strong influence on U.S. real estate over the long term include: urbanization, favorable demographic trends, low unemployment, rising incomes and a strong demand for space.

The growth of real estate value from cap rate compression has run its course in the current cycle. Investors should look largely to current income returns driven by increases in rents and cash flow over time. In addition, well-located properties in regions that exhibit strong demand for space should provide a bridge for investors to transition into the next cycle.

2019 real estate market

U.S. real estate markets broadly remain in good shape, with low vacancy rates for most property sectors. CRE fundamentals will generally be in balance given the level of aggregate demand for space in the property markets. The demand side of the equation is expected to be positive, largely based on a currently strong U.S. macro backdrop of economic growth, a healthy job market, and increasing consumer spending. In addition, rising but relatively low interest rates, along with a persistent demand for U.S. real estate in seeking a global “safe haven,” continue to support this view.

Chart for Vacancy rates by property type

Low vacancy market rates typically stimulate increased supply to catch-up with demand. The leveling of demand from continuing lender discipline, rising land and construction costs and increasing short-term interest rates should help keep supply on par with demand. However, low vacancy rates combined with growing rents in many markets could potentially compromise the CRE environment. If leverage and lending build momentum such that it becomes excessive, it could potentially create imbalances in the supply-demand relationship in the property markets.

Chart for Vacancy rates by property type

Income vs. appreciation

Consistent with the overall U.S. economy, CRE is in a mature phase of the cycle, which may continue for a while given the right conditions. Since emerging from the financial crisis, CRE has generated several years of above-trend returns, driven mostly by cap rate compression which has now run its course. This is expected to be followed by lower returns coming mostly from income versus appreciation. This trend is evident in the chart (right) as indicated by the declining appreciation leading up to a CRE slowdown or recession.

Key Takeaways

  • As a non-correlated, low volatility asset class and a potential hedge against the corrosive effects of inflation, CRE can help investors bridge into the next cycle.
  • CRE has generally balanced market fundamentals in a mature phase of market cycle.
  • Aggregate demand for rentable space is considered relatively durable, largely based on the continuing view of a U.S. macro backdrop of economic growth, a healthy job market along with growth in business and consumer spending.
  • Continuing mega trends in demographics, urbanization and e-commerce should continue to drive the future of CRE well through 2019.
  • On the supply side, beyond situational pockets of softness in some markets and sectors, current low vacancy rates coupled with increasing construction costs and continuing lender discipline can be expected to help balance supply and demand.

Bank of America Private Bank Specialty Asset Management Team

The Specialty Asset Management Team at Bank of America Private Bank can offer the strategic insight and specialized expertise required to manage and maximize the potential of these investments. Today, the team manages over 94,000 client assets with a total asset value of $13.6 billion. Our more than 200 employees across 38 cities nationwide give us a broad geographic scope and the experienced “boots on the ground” approach to help meet our clients’ needs.*

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