Real asset: Meaning, Criticisms & Real-World Uses

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What Is Real Asset?

A real asset is a tangible, physical asset that derives its value from its inherent substance and properties. These assets belong to the broader financial category of alternative investments and are typically valued for their utility, scarcity, and potential to generate income or appreciate over time. Unlike financial assets, which represent claims to future cash flows or ownership interests, real assets are physical entities such as real estate, commodities, infrastructure, and natural resources. Investors often include real assets in their investment portfolio for portfolio diversification and as a potential hedge against inflation.

History and Origin

The concept of investing in tangible assets dates back centuries, with land ownership historically being a primary form of wealth and power. However, the formal recognition and structured investment in diverse real assets as a distinct asset class, particularly for institutional investors, gained significant traction in recent decades. The rise of modern financial markets led to a greater focus on publicly traded securities, but the unique characteristics of real assets continued to attract investors seeking stability and inflation protection.

For example, the modern form of real estate investment trusts (REITs) was established by the U.S. Congress in 1960, aiming to provide all investors, including small investors, with access to income-producing real estate. This legislation, signed by President Dwight D. Eisenhower, combined attributes of real estate and stock-based investment, democratizing access to commercial properties previously available primarily to large financial intermediaries and wealthy individuals.²²

Key Takeaways

Real assets are tangible, physical items with intrinsic value, such as real estate, commodities, and infrastructure.
They often serve as a hedge against inflation and can offer diversification benefits within an investment portfolio.
Unlike financial assets, real assets generally have limited liquidity.
Their valuation is often influenced by supply and demand dynamics specific to their physical nature.

Formula and Calculation

There is no single universal formula for "real assets" as a collective class, given their diverse nature. However, the value of individual real assets can be determined using various valuation methods applicable to their specific type. For instance, real estate is often valued using income capitalization approaches, comparable sales, or replacement cost methods.

For income-producing real estate, a common formula for basic valuation is:

\text{Value} = \frac{\text{Net Operating Income (NOI)}}{\text{Capitalization Rate (Cap Rate)}}

Where:

Net Operating Income (NOI): The annual income generated by the property after deducting operating expenses, but before debt service and taxes. This relates to the concept of return on investment.
Capitalization Rate (Cap Rate): The rate of return on a real estate investment property based on the income that the property is expected to generate. It is used to estimate the investor's potential return on their investment.

Interpreting the Real Asset

Interpreting real assets involves understanding their underlying characteristics, market dynamics, and how they contribute to an overall asset allocation strategy. For example, a high demand for a specific commodity, such as oil, can indicate economic growth or geopolitical tensions, affecting its value. Similarly, strong rental growth in a particular real estate market might suggest a healthy local economy.

Investors interpret real assets not just for their current value, but also for their potential for future appreciation, income generation, and their role in mitigating risks. Real assets are often considered for their low correlation with traditional financial assets like stocks and bonds, which can enhance a portfolio's resilience during periods of market volatility or rising interest rates.

Hypothetical Example

Consider an investor, Sarah, who owns a diversified portfolio of stocks and bonds. Concerned about rising inflation, she decides to allocate a portion of her portfolio to real assets.

Sarah invests $100,000 in a piece of undeveloped land. After five years, due to increased development in the surrounding area, the land's value appreciates. She sells the land for $130,000.

In this scenario:

Initial Investment: $100,000
Sale Price: $130,000
Capital Gains: $30,000

This example illustrates how a real asset like land can appreciate in value over time, providing a tangible gain to the investor, separate from the performance of financial markets.

Practical Applications

Real assets are integrated into various aspects of finance and investing. They are frequently used by institutional investors, such as pension funds and endowments, to achieve long-term investment objectives, manage risk management, and provide inflation protection.

Portfolio Diversification: Adding real assets like real estate or commodities can help diversify an investment portfolio by providing returns that may not be directly correlated with traditional financial assets.²⁰, ²¹
Inflation Hedging: Historically, real assets have demonstrated properties as a potential hedge against inflation, as their values and incomes often tend to rise with the general price level.¹⁶, ¹⁷, ¹⁸, ¹⁹ This is particularly relevant for commodities, whose prices often contribute directly to inflation indices.¹⁵
Monetary Policy Impact: Central bank monetary policy decisions, such as changes in interest rates, can influence real asset prices, particularly real estate values.¹⁰, ¹¹, ¹², ¹³, ¹⁴
Disclosure and Regulation: Publicly traded entities with significant real asset holdings, like REITs, are subject to specific disclosure requirements by regulatory bodies such as the U.S. Securities and Exchange Commission (SEC) to ensure transparency for investors.⁶, ⁷, ⁸, ⁹ For instance, the SEC adopted amendments to disclosure requirements for acquisitions and dispositions of real estate operations, streamlining financial statements for registrants.⁵

Limitations and Criticisms

Despite their benefits, real assets have certain limitations and face criticisms. One primary concern is their relatively low liquidity compared to publicly traded stocks and bonds. Selling real estate or a large commodity position can take significant time, potentially hindering an investor's ability to access capital quickly.⁴

Another criticism revolves around the specialized knowledge and higher transaction costs often associated with real asset investments. Acquiring and managing properties or natural resources can involve considerable due diligence, legal fees, and ongoing maintenance expenses. Furthermore, while real assets are often touted as inflation hedges, their effectiveness can vary depending on the specific asset, market conditions, and investment horizon. Research suggests that while private real assets, such as private real estate, may outperform public counterparts during inflationary periods, the effectiveness of publicly traded real assets as inflation hedges can be more complex due to their exposure to real interest rates.³

For example, the subprime mortgage crisis highlighted the risks associated with certain real estate-backed securities, demonstrating how rapid declines in property values can have widespread financial implications.² This historical event underscores the importance of thorough due diligence and risk management when investing in real assets.

Real Asset vs. Financial Asset

The primary distinction between a real asset and a financial asset lies in their nature and value derivation.

Feature	Real Asset	Financial Asset
Nature	Tangible, physical objects	Intangible claims to value or income
Value Derived From	Inherent utility, scarcity, physical form	Contractual claims, ownership interests, cash flows
Examples	Real estate, commodities, infrastructure	Stocks, bonds, mutual funds, bank deposits
Liquidity	Generally lower	Generally higher
Inflation Hedge	Often considered a potential hedge	Can be negatively impacted by inflation

While real assets are physical properties, financial assets are essentially paper claims. For instance, owning a physical gold bar is a real asset, whereas owning shares in a gold mining company is a financial asset. The value of a real asset is tied to its physical existence and practical use, while a financial asset's value is derived from its legal claim on something else.

FAQs

What are common examples of real assets?

Common examples of real assets include residential and commercial real estate, precious metals like gold and silver, energy commodities (e.g., oil, natural gas), agricultural products, timberland, and infrastructure such as roads, bridges, and utilities.

Why do investors include real assets in their portfolios?

Investors typically include real assets for portfolio diversification and as a potential hedge against inflation. They can provide a store of value, generate income, and may appreciate during periods when traditional financial assets underperform.

Are real assets more volatile than financial assets?

The volatility of real assets can vary widely depending on the specific asset and market conditions. Some real assets, like commodities, can be highly volatile, while others, like income-producing real estate, may offer more stable returns. In general, real assets tend to exhibit lower correlation with financial assets, which can help reduce overall portfolio volatility through effective risk management.

Can small investors access real assets?

Yes, small investors can access real assets through various vehicles, even if direct ownership of large-scale assets is impractical. This includes investing in Real Estate Investment Trusts (REITs), commodity exchange-traded funds (ETFs), or mutual funds that specialize in real assets. Recent developments in "tokenized" real assets, which represent fractional ownership on a blockchain, could also offer new avenues for retail investors to gain exposure to illiquid assets.¹