Michael Underhill: ‘Lack of Political Will’ to Fund Infrastructure Has Left it in Disrepair

By Henry Bonner

Photo: Washington State Department of Transportation

Highways, roads, and phone lines require huge up-front capital commitments to build.

In the US, Federal and local governments often undertake building these infrastructure projects. But in many cases, financial stress on Treasuries results in under-funding of care and maintenance needed to prevent that infrastructure from decaying.

Michael Underhill is the sub-advisor to Sprott Asset Management’s infrastructure, agriculture, real asset, and timber fund. He recently spoke with me about investing in our national infrastructure.

Can you comment on the overall state of infrastructure in the US? Is it truly in disrepair?

Yes, but it’s improving.

Once every four years, America’s civil engineers provide a comprehensive assessment of the nation’s major infrastructure. They rate each category in the ASCE’s Report Card for America’s Infrastructure. Using a simple A to F grade format, the Report Card provides a comprehensive assessment of current infrastructure conditions and needs. The ASCE also makes recommendations for how to raise these grades.

ASCE members assign the grades according to the following eight criteria: capacity, condition, funding, future need, operation and maintenance, public safety, resilience, and innovation. Since 1998, the grades have been near failing due to delayed maintenance and underinvestment across most categories.

The 2013 Report Card grades are now in. America’s cumulative GPA for infrastructure rose slightly from a D to a D+. The best performer was solid waste at a B-. The worst were inland waterways and levees with a D-. Solid waste, drinking water, wastewater, roads, and bridges all saw incremental improvements, and rail jumped from a C- to a C+.

Assuming the grades are a reliable indication of the state of national infrastructure, what is the cause of these poor results? Negligence by authorities? Lack of market mechanisms for funding?

In my view, it’s a lack of political will to raise taxes or implement any significant large-scale ‘user pay’ model, such as tolls roads, water usage fees, or airport usage fees,

The Great Depression was attributed in part to over-investment in infrastructure such as railroads. Do you think that the pendulum has swung in the other direction?

Yes. Analyzing current investment trends for each infrastructure sector, the economic impacts in terms of change in GDP, household income, employment, and exports in the years 2020 and 2040 are staggering. In short, investing in infrastructure is an engine for long-term economic growth, increasing GDP, employment, household income, and exports. The reverse is also true – without investing, infrastructure can become a drag on the economy.

The ASCE’s economic report on surface transportation, released in July 2011, found that our deteriorating infrastructure will cost the American economy more than 876,000 jobs and suppress the growth of our GDP by $897 billion by the year 2020. We are facing a funding gap of about $94 billion a year with our current spending levels.

The good news is that with only modest investment, roughly equivalent to 60 percent of what Americans spend on fast food per year, we can protect jobs, save travel time, and keep about $1,060 a year in the bank account of American households each year.

Do you see a return to privately-run infrastructure projects?

Yes. It will take private investment management as well as publicly-traded infrastructure securities (equity and debt) to finance these large projects adequately.

Can you give an example of a specific infrastructure investment?

One company we made a big investment in was Kinder Morgan Partners, which owns and operates approximately 80,000 miles of pipelines and 180 terminals.

What infrastructure assets are receiving attention now?

Water dams are about to receive hefty new investment from the Federal government. While the average person might think it’s just about farms, the Farm Bill funding for dams was perhaps one of the most unsung wins for infrastructure in 2014.

The 2014 Farm Bill that Congress passed in the summer provided the United Stated Department of Agriculture with $262 million to distribute to states for rehabilitating dams. The funding provided rehabilitation assistance for 150 dams in 26 states. This increased the typical annual investment in rehabilitation 20 times over! Dam infrastructure’s role in flood management, water supply, and agricultural productivity is critical to the economy.

Arizona was the largest recipient of Watershed Rehabilitation assistance, receiving $98 million in Federal assistance. Other States that received large amounts for dam rehabilitation were Texas with $33 million, Oklahoma with $26 million, West Virginia with $14 million, Utah with $12.6 million, and Pennsylvania with $11.4 million.

Massachusetts, Nebraska, Virginia and Mississippi all received between $10 million and $5 million.

Colorado, New York, Tennessee, Kansas, Oregon, and Kentucky all received between $5 million and $1 million.

Smaller recipients included Ohio, New Mexico, Wyoming, Connecticut, Arkansas, North Dakota, Nevada, Idaho, Georgia, and New Hampshire.

What should investors consider regarding an investment in infrastructure or hard assets?

There are two types of investments you can make in infrastructure. You can invest in publicly-traded securities – stocks or bonds – that are backed by infrastructure. Some investors can also invest through private equity deals, where you own a security that is not publicly-traded.

Publicly-traded options that any investor can buy or sell include stocks in infrastructure companies, REITs which are dividend-paying securities backed by real-estate, and MLPs which are derived from an income-producing infrastructure asset like an oil pipeline.

The advantage of a publicly-traded security is that investors can easily access infrastructure investments with greater liquidity. Investors can exit their investments by selling them on the market. Publicly-traded securities are typically more accessible to retail investors since the minimum allocation can be smaller.

On the other hand, the assets that back publicly-traded securities are usually illiquid. If a large number of investors are buying or selling, the fund may need to acquire or sell illiquid assets quickly and at unattractive prices. As result, these funds often cannot make long-term commitments with their capital and can be very volatile.

Private ventures are an option for some investors – for instance a limited partnership that acquires ownership of a toll road or an airport. The advantage is that investors can recruit a management team that is highly adept at maximizing revenues from assets without the need to accommodate buying and selling by average investors. The investors also have more direct control over management of the assets and can access certain assets that would not be available to the general public.

Of course, private investments come with disadvantages too. They might come with higher fees, may be more illiquid, and can involve complex financial structures.

What do you think is the biggest area of opportunity now?

‘Data centers,’ large groups of networked computers that serve to process and store data efficiently, are extremely well-positioned in 2015.

Internet growth is powering forward at a double-digit rate. Global digital advertising spending in 2014 could reach $138 billion, up 15% year-over-year. Worldwide e-commerce spending could increase 20% this year to $1.5 trillion. More content and faster speeds are fueling Internet expansion. As Internet traffic has increased, data storage demand has blossomed over the last few years and could continue to grow strongly for many years.

The demand for outsourcing and leasing data storage is accelerating. As existing customers demand more storage space, facilities will invest in scaling up their size, allowing for greater price efficiency and rendering them even more attractive.

Today, only 20% of data storage is in data centers. I believe that their superior reliability, speed and pricing will make them more broadly used. The global data center market, including for ‘cloud’ storage, could total approximately $58 billion dollars in 2014 and is forecasted to increase at a double-digit annual growth rate.

The decline in the price of oil, while hurtful to energy companies, might actually benefit data centers. They require vast amounts of energy to power hard drives and for cooling, and energy companies may seek operating efficiencies by outsourcing their data storage needs.

I’m looking at investing in data centers using a ‘real-estate investment trust’ (REIT) structure, which shields investors from most corporate income tax. Dividends yielding 4% to 5% annually will likely grow with free cash generation. CoreSite Realty Corporation and DuPont Fabros Technology, Inc., two companies that own and lease data centers, recently increased their dividends by 20%.

As data centers show strong growth and demonstrate their ability to operate at a net profit and pay dividends, I expect that these assets will prove rewarding to their shareholders.