What are Real Assets?
Real assets are defined as economic resources that provide the holder with a consumption right. Also, real assets are mainly physical assets with intrinsic value due to its consumption rights rather than the financial properties.
Natural resources and land are two institutional-quality real assets, which include commodities, precious metals, real estate, etc.
All consumption ultimately originates from real assets, and as compared to its counterpart, i.e., financial assets, real assets provide a holder with a right to consume rather than serving as conduits of value.
What are the types of Real Assets?
- Natural Resources
Natural resources can be defined as a type of real assets which focus on direct ownership and have received minimal or no human alteration. Examples of natural resources include mineral and energy reserves.
Commodities are a type of natural resources; however, it differs from them for being extracted and can be defined as homogeneous goods such as metals, agricultural products.
- Real Estates
Real estates are defined as improvements on lands that are permanently affixed.
The land is a type of real assets which comes in a variety of forms including undeveloped land, timberland, and farmland. While land might appear to belong to natural resources, it is not, as the option to develop it often requires a considerable managerial decision.
Timberland includes both the land and the timber of forests tree. Likewise, farmland consists of both the land and the product cultivated.
Institutional Quality Real Assets
- Natural Resources
Examples of natural resources include oil, coal, ore, water, and any other inputs to production that largely remain in the natural state.
As natural resources are under the surface; landowners and the government conjointly hold the rights for any manipulation to the land containing natural resources. Ideally, in many jurisdictions, landowners typically have surface rights, and the government holds the underground rights.
Development of Natural Resources as Exchange Options
Considering natural resource as an option to develop commodities or any other real assets widen the analysis of natural resources.
Ideally, a developer of natural resources, mainly mining companies expend money to develop the natural resource at the land into a commodity.
The process of developing commodities from natural resources include using mineral rights with other inputs such as labour, materials, fuel, and management.
Thus, the development of natural resource into commodities is usually seen as an exchange option, i.e., an option to exchange one risky asset for another.
Generally, mining companies exchange mineral rights and other inputs for output.
Therefore, the development of a natural resource into commodities is a function of several factors as below:
- The volatility of the price of the asset (inputs).
- The volatility of the price being received.
- The correlation between the prices of inputs and the prices of output.
- The overall moneyness of the development process, i.e., the ratio of the developed value to the development cost.
Ideally, the ratio of the developed value to the development greater than one is considered as a point to execute the exchange option of the natural resource.
Any land which is raw, undeveloped and is not generating substantial food, resource, shelter, or recreation is an option just like natural resources.
Investment in undeveloped land is an option similar to natural resources exchange options with the strike price of the cost of developing the land with an unlimited expiry.
Valuation and Volatility of Real Assets
Unlike financial assets, real assets often do not have observable market values; thus, they are valued by appraisals, which leads to smoothing on its return and price volatility.
Appraisals – A Method to Value Real Assets
Appraisals are defined as professional opinions concerning the value of a real asset. The appraised value of a real asset, especially real estates, is based on two methods, i.e., Discounted Cash-flow and Comparable Sales.
Comparable sales method is ideally used for real assets having no income, and the method includes collecting data on prices of real assets with comparable properties with an economic value that has traded in the recent past.
For real assets with regular income, alternative analysts/fund managers generally use the DCF method, i.e., a method of finding the present value of the expected future cash flow at a discount rate.
However, one pitfall with appraisal valuation method is that it tends to smooth the data that can mask the true risk of an underlying real asset.
What is Smoothing?
Ideally, smoothing is defined as the reduction in the reported dispersion in a price series. A valuation by appraisal often leads to smoothing, which, in turn, can mask the risk of real assets.
For example, assume that an investor buys two risk-free instruments, say a one-year T-bill and a one-year certificate of deposit (CD). Now let us assume that both the investments offer the same risk-free cash flow in one year.
However, let’s assume that the one-year CD is non-negotiable with a large withdrawal penalty.
Does the risk of both the instruments match?
The answer is no, obviously as the investor has to pay the penalty for liquidating the CD, it has more risk as compared to the other instrument.
Thus, the method of reporting the values of both instruments may vary.
Generally, the market price of T-bills varies or fluctuate as interest rate shifts, and ideally, as both instruments are correlated to interest rate, the CD should also fluctuate as much as a T-bill over the change in the prevailing interest rate.
However, despite that many financial statements demonstrate a very stable value that accrues slowly at the CD’s coupon rate while ignoring the impact of interest rate on CDs for accounting simplification.
Over the period of time, this accounting simplification causes a smoothed reported price series relative to the economic value; thus, an investor observing this price series might wrongly perceive that CD is less risky as its volatility is masked.
Likewise, the true value of a portfolio could also be smoothed to mask its volatility. For example, an asset manager can buy out-of-the-money (OTM) puts while simultaneously writing-off OTM calls, allowing him to cap the upper and the lower range of returns, resulting into lower than the reported volatility.
What are the Advantages and Disadvantage of Real Assets?
The major advantage of real assets is the diversification benefit and their small correlation with macroeconomic factors such as inflation, currency fluctuations, as compared to the financial assets.
However, real assets tend to have lower liquidity and ideal valuation methods used to value financial assets might not give a true picture of the intrinsic value of a real asset.
Also, the price data of real assets are not easily available, and the market structure is relatively more complex as compared to the financial market.