Partners Group has raised serious questions over investors' flight to quality. Claude Angéloz talks to Richard Lowe about investing outside the core markets

Recoveries in the global real estate markets have taken place almost exclusively in the prime space, while secondary markets have continued to stagnate, producing an ever-widening gulf. A growing number of fund managers are talking up the case for moving outside of core real estate, but demand for the best quality assets in the top locations remains among risk-averse investors.

Partners Group has been arguing the case for looking outside the core space for some time, and the firm's latest market view holds some strong counter-cyclical convictions. "We highly doubt that many of the recent flows into core assets will turn out to be promising investments," it reads. "In our view, now is the time to invest outside the core space where assets are still attractively valued."

The Swiss-based firm has even suggested that those investors looking to invest in mezzanine debt opportunities now exist mainly beyond the core markets of London, Paris, Munich and New York. It seems investors are following a similar flight to quality in the junior debt space as they are in the direct property space - and it's having the same effect.

Claude Angéloz, co-head of real estate at Partners Group, agrees with the suggestion that the junior debt markets - a space becoming increasingly popular among institutional investors - is beginning to mirror the pure real estate markets. "In a way, yes," he says. "We see a phenomenon where investors are acting in parallel." For this reason, Partners Group, which has been an active player in the real estate debt markets, favours second and third-tier cities in large real estate markets where significant capital flows are yet to appear, despite the existence of solid fundamentals. Within these secondary locations, the focus is on high quality assets in good locations.

"The money is going into the most obvious markets: the city of London, into Paris, into Manhattan, Chicago and Boston. But as soon as you go to Pittsburgh, or Philadelphia, to Arizona or in Europe to places like Birmingham, the flow of capital is pretty insignificant in comparison," Angéloz says.

"There certainly is more interest in real estate debt strategies," he says. "Debt strategies have become pretty common knowledge and investors know the market fairly well, so there is an increasing amount of money that is looking to be deployed in these strategies."

Returning to the topic of direct real estate, Angéloz says the potential pitfall for investors focusing on the very prime end of the market could be that it transpires to not provide an effective hedge against rising inflation. "We remain only modestly optimistic, to put it nicely, with respect to the economic development in some of the markets here in Western Europe and the US," he says. "The challenge you face with a core real estate investment is, as per the definition, they are operating at their maximum capacity - they generate the highest possible rental income you can possibly get from these properties. Our concern remains that the debt issue and the provision of liquidity by global central banks could eventually lead to inflation."

When interest rates go back up, properties bought on low yields are likely to suffer. Core real estate in tier one cities has been acquired as substitutes for fixed income investments, but once bond yields rise there could be a reduced allocation to real estate from these yield-chasing investors. In this environment, core real estate acquired at low yields may provide an inflation hedge over the very long-term - that is, 20-25 years - but for most institutional investors it is likely to cause discomfort.

"Some sovereign wealth funds or family offices can have such time horizons, where people can think in generations," Angéloz says. "However, the majority of investors that we speak to in the institutional world operate in a different framework."

An obvious recent example is the Norges Bank Investment Management's acquisition of a 50% stake in a €1.4bn Paris office portfolio for the Norwegian Government Pension Fund Global. But such activity also has an impact on the spread between core real estate assets and government bonds. "If we have a scenario where inflation kicks in, we prefer to be invested in assets that we have bought at higher cap rates," Angéloz says. "Just by acquiring B-class assets in first-tier cities or buying grade-A assets in second and third-tier cities you can enjoy a spread pick-up versus trophy assets, which can easily be two to three points in terms of cap rates. If cap rates start to go up you have a much higher spread versus government bonds that gives you a much needed cushion. However, this strategy requires experienced teams on the ground and tax and legal specialists for a timely execution." Assets that allow for "valuation increases through active management", such as those with 20-30% vacancy rates or repositioning and redevelopment potential, could provide an additional hedge, he adds. "All these measures provide you with additional flexibility and more control over your destiny so you can create more value in an environment where valuations might go against you."

Partners Group also continues to be bullish on opportunities in the real estate funds secondary market, or ‘secondaries'. Over the past 18-24 months, the investment manager has completed close to $1bn in secondaries trades. Since the start of the year, Angéloz says his team has seen a record-breaking volume of deal flow on the supply side - that is, investors looking to sell out of existing real estate funds and direct investment portfolios - close to $13bn.

"It is the highest deal flow we have ever seen at this time of the year in our entire secondary investment history," he says. "Furthermore, we have been able to execute a record-breaking volume of transactions in the first six months - they have by far been the largest types of investments that we have made over that period."

He adds: "A lot of people are asking: can you still trade at significant discounts to NAV?" However, there is a general rule of thumb that has emerged from Partners Group's experience in the secondary markets in both real estate and private equity sectors: more often than not, buying a quality portfolio at close to NAV is likely to be more effective than acquiring poor portfolios at a steep discount. "It can often make sense to buy quality portfolios at NAV or just a small discount of maybe 5-15% or 20%, and you can still earn very good returns. We do not trade quality for discounts," he says.

Angéloz is also seeing a growing number of opportunities to buy interests in real estate portfolios on the secondary market. However, he is wary of making exact predictions about how the market for secondaries will develop over the next 12 months, but he feels the current market uncertainty will help sustain it for the long run. "With what's going on right now, with the nervousness that is around right now, we believe it will help trigger additional deal flow on the secondaries side," he says. "We actually do like volatility in the markets, because it creates irrational behaviour."