The correction in European secondary hides sector and market exceptions to the ‘flight to quality'. Shayla Walmsley reports

It was bound to happen. This time last year, secondary assets were still mopping up an excess of investor capital with nowhere to go in saturated prime markets. Now, with the days of plenty gone, the trend is upwards. "In 2007 investors were paying ridiculous amounts for secondary properties," says Nasim Eghlima, aresearch analyst at Jones Lang Lasalle (JLL). "Now they're waking up because those prices didn't reflect the risk and value. We're seeing an adjustment in pricing: yields went up more quickly in secondary than in prime." According to JLL figures, the 12 months to July 2008 saw all property income yields move out by nearly 150 basis points to 6.06% in the UK - the outrider of this trend. Secondary assets' capital values fell 21.5%, compared with a 18.6% drop in prime.
The result has been a much-observed flight to quality. PricewaterhouseCooper's (PwC) recent Emerging Trends in Real Estate Europe 2008 points to the "gravitational attraction" of "top-of-the-range" real estate. The larger risk premium for secondary characteristics - notably the absence of prospects for future returns - is the key reason for secondary repricing. "It rose in value too quickly by too much," says Alessandro Bronda, head of investment strategy at Aberdeen Property Investors. "Now it's a different market, and there's more uncertainty. There's been a move towards quality assets. If you have to invest, you'll invest in prime. That's true globally, though there are differences between markets and some still need to be repriced." What hasn't changed in secondary markets is the fact that there's more to it than a short-term lease and a less-than-optimal location. The (lack of) appeal to investors is as much about the specific characteristics of the market or the asset class as it is about the geography of the conurbation. It's about value for money, bang for buck.The truth is that secondary assets were always second choices. Where there was absorptive capacity left in prime, investors invested in it. "There's a lot less investment going on, and investors will buy the best assets they can," says Noel Manns, principal at Europa Capital. "Prime assets - those with long leases in good locations - will attract unleveraged buyers and sovereign wealth funds. On a 15-year view, they're undervalued. But leverage is missing in non-prime markets."

The suggestion is that investors who can focus exclusively on prime assets will do so. Yet this apparent consensus over what counts as secondary and prime belies a multiplicity both of characteristics and exceptions. Nor does it help ease of definition that it's possible to have secondary assets in prime markets, and vice versa.
Partly for this reason, JLL prefers the designations ‘growth' and ‘value' to ‘prime' and ‘secondary'. Growth suggests a higher expectation of rental growth; value presupposes dependence on the asset's current income, with no prospect of future rental growth. Like secondary, value is characterised by poorer quality locations, covenants and buildings, and by short-term leases. These assets compete less well for tenants.
The difference between secondary and value characteristics is arguably semantic. But it does point to some blurring between prime, secondary, and marginal versions of both. LaSalle European securities head Ernst-Jan de Leeuw sees even those willing to invest in the secondary market distinguishing on the basis of quality. "You're seeing a pricing differential between secondary and good-quality secondary, and even more so between secondary and prime. Yield movements are faster in prime and you can get rental growth from good quality assets. With secondary, you don't get rental growth," he says.
Recently another characteristic has emerged that broadens the secondary scope somewhat: proximity. You have investors committing capital to warehousing in areas of Spain, France and the UK that are secondary but located near prime . Take Swedish fund manager SEB's July acquisition of logistics in Doncaster, UK; or the trend noted by Savills earlier this year for Spanish logistics to spread outwards from Madrid into Guadalajara and Toledo. This ‘halo effect' is a potentially significant trend in other sectors, too, with investors performing due diligence on secondary cities, including Odessa, Constanta, Brasov, Timisoara, Gdansk and Krakow. PwC also points to Russian cities such as St Petersburg, Novosibirsk and Yekaterinburg, with populations above one million.The continuing traction of shopping centres in secondary cities suggests an opportunistic exception to the trend for retrenchment in prime. East Capital this year launched a €200m opportunistic fund to invest in provincial Russian shopping centres. Unlike the upmarket Moscow variety, according to chairman Peter Elam Håkansson, provincial retail had Cold War stamped on it, with low-rise concrete monstrosities that made consumers pay in ambient misery for their consumerist venality.
Is this part of a trend cited by ING Real Estate Development CEO Menno Maas back in April for increased retail investment in secondary and tertiary cities across Europe - driven by retailers, paid for by investors? Unlikely: the exceptions to an otherwise cautious prognosis on secondary retail are specific. In Central and Eastern Europe, developers are tackling secondary cities with large populations and new formats. Yet some Central European markets, notably Romania and Bulgaria, are over-supplied and a correction waiting to happen. Although it doesn't specify these two markets, the PwC report warns obliquely of poor-concept centres located in obscure, inaccessible locations. Even now, where there's capital, there's capital to waste.

So is proximity the new prime? In logistics, a report from JLL suggested that land availability, rather than the distinction between prime and secondary, was driving pricing in European markets. Where land is available, suggests Alexandra Tornow, a JLL analyst, investors can forget rental increases. In contrast, infrastructure-driven primary hubs, with strong demand and limited supply, can look to rental increases.
"Even where you have prime - for instance, property located on motorways - rents are much lower," she says. Rental increases have been notable in specific infrastructure locations, such as seaports and airports.In fact, one of the upsides of the current correction is the drying up of supply as developers struggle to finance projects. "The credit crunch is a good thing," says Bronda. "It needed a correction, an adjustment. One positive benefit is that developers will be less active - they won't be able to build as much. There'll be less new supply. Perhaps not this year but for other projects it will slow."If there's a market exception to the general investor flight from secondary cities, it's Germany - perhaps because it's less clear in this market which cities are prime and which secondary. (Arguably, Germany is a market of prime cities - or secondary ones.) Here, more rather than fewer cities are proving attractive to international investors.
Of the top 10 European cities identified by PwC in its Emerging Trends in Real Estate Europe 2008 report earlier this year, four - Hamburg, Munich, Berlin and Frankfurt - were German. The appeal of German secondary owes something to the quirks of the market itself. Unlike a capital city-dominated market (such as Finland), Germany has multiple major cities. Sascha Hettrich, managing partner of King Sturge's German office, points out that the original triumvirate of internationally investible markets 10 years ago - Hamburg, Berlin and Frankfurt - has since expanded to include ‘secondary' cities Cologne and Stuttgart. He claims that Leipzig, another secondary city that straddles the former East and West Germany, could be next. German secondaries have solid economies and stability. In contrast to, say, Dresden or Kiel, they attract international business. "Secondary cities are largely driven by office markets," says Hettrich. "These are all office towns, with retail destinations. They're also hotel markets with logistics in surrounding areas."

Yet even here, in secondary markets, investors are seeking out quality - prime - assets, including office, retail and mixed-use. The point about retail, he says, is that it offers stability in an unstable economic environment. "Even in a recession, people buy bread."
Many analysts see in the current secondary correction a return to the fundamentals of investing- a focus on the asset, not just on whether the asset (or, for that matter, the location) is prime or secondary. (Even in prime markets, notably the City of London, the risk of over-supply and reduced demand because of the downturn in the financial services sector have had the same effect.) The PwC report cited earlier points out that, during the boom, the "spread between the good, the bad and the ugly was eroded". Now, with a clearer view of risk, investors are going back to basics. The accusation often targeted at me-too investors in boomtime is that they didn't look closely enough at the assets they acquired - that there was far less awareness of risk in appraisal and pricing. Now, with leveraged investors more likely to be squeezed out of the market, those left are looking at assets up for acquisition, notably at widening yields between prime and secondary assets. In short, it's a return to reason. "There's greater risk in all economic sectors, including the property market," says Jeremy Handley, a director in valuation advisory at Jones Lang Lasalle. "It's right that the risk premium returns. It's a return to the situation we've seen historically."For opportunistic investors, and perhaps only for them, secondary is now territory for predation. Manns claims the potential to add value is not exclusive to prime markets and assets well let over a long period and with some income. Rather, as an opportunistic investor, Europa seeks out "higher-risk, higher-reward [ie secondary] assets, where we can add value"."We would rather be in the business of assets with opportunities to improve than locked into long leases where we can't influence them," he says. "We're after opportunities for active management: some are easy, some difficult." He points out that "the skills required [to invest well in secondary markets] are the traditional skills required to manage assets carefully". They include due diligence on the potential for physical improvement, the length of the cash flow, and financing. "Our style is to roll our sleeves up," he says, Back in April, New Star's head of global property, Stuart Webster, attributed what he saw as an over-correction to the so-called ‘availability heuristic' - the tendency for investors to abandon reason temporarily under the influence of sensationalist fear. "While price corrections were overdue, the extent of the falls suggests that irrational fear played a part," he said. Admittedly, markets tend to over-correct - the momentum of a downward slide is the opposite of a bubble but it follows the same dynamic in reverse. But is that what's happening in secondary: where once risk was under-priced, now it's being over-priced? Not according to Handley. Although he doesn't rule out an over-correction, he agrees that secondary has yet to bottom out, with further pricing correction in both prime and secondary in 2008-2009. "Confidence in the economy and especially the banking sector depends on lending. Until the banks are confident about lending to each other, we won't return to stability," he says. Handley describes secondary prices at their peak as "unnatural and unsustainable". Yet simply because secondary repricing reflects a correction, rather than a collapse, there will be no return to the status quo ante - especially not given continued appetite among pension funds for real estate.
"The good stuff that is going to come up will be taken up by equity investors because there are still a lot of pension funds whose portfolios are underweight in real estate," he says.  In the meantime, it's a matter of waiting for the end. "The bottom of the secondary market is difficult to judge," says Manns. "All we can do is buy in the U, though we'll only know if we've succeeded afterwards. Is it a U or a V? A U, I think. We know we're in the U; we just don't know whether we've reached the bottom."The market's clearer than it seemed 12 months ago. We're more able to judge possible investments now than 15 months ago. On our existing assets, we're worried. On our potential ones, we're looking for opportunities."