Is a secondary market investment strategy a no-brainer in the UK given the yield spread over prime? Lynn Strongin Dodds explores
While prime commercial real estate may continue to be the favourite, secondary assets in the UK are slowly starting to come onto the investment radar screen. The yield chasm that has opened up between the two is offering enticing returns, but investors are advised to heed any warning signs. There is a reason they have been relegated to the second division, and choosing the right property is not easy.
According to research from Fidelity Worldwide Investments, the good secondary market in the UK is worth about £120bn, although only £35-40bn of high quality commercial properties is likely to be mispriced. This compares to the prime segment, which at £38bn comprises a small chunk – 7-8% of the overall property market. In terms of the yield gap, there has been a significant widening from 120bps in the third quarter of 2007 to an unprecedented 581bps in the fourth quarter of 2012, mainly due to risk aversion.
“This is the biggest dichotomy in pricing that I have seen in my 25-year career,” says Neil Cable, head of European Real Estate at Fidelity Worldwide Investments. “People were looking at safe havens such as prime assets and were ignoring everything else. The result is that yields are now back to peak levels while good secondary properties can offer a range of 7.5% to 12% yields.”
Breaking it down, Savills figures show they range from 7.5% to 10% for industrial, 7.5% for office and 7.5% to 15% for retail.
Joe Froud, managing partner at Columbus Capital, part of Schroders’ real estate business, also believes there is a compelling opportunity provided by the wide spread between prime and good secondary yields. “It does, however, come with a greater level of asset risk, partly as the returns are not insulated by the long, secure income streams typical of today’s prime investments. As a result, careful and informed stock picking, together with a genuine hands-on asset management capability, should be considered mandatory for anyone wanting to take advantage of this opportunity.”
Anne Breen, head of real estate research and strategy for Standard Life Investments, is another advocate of treading carefully. “The pricing between secondary and primary assets may be at their highest levels in historic terms, but that doesn’t mean that they offer value. The risk is in the pricing. I do not expect to see a recovery in income in a number of secondary markets anytime soon and I think there needs to be a better economic environment.”
One of the main problems though is that there is no simple or acceptable definition of what constitutes secondary real estate, according to Joe Valente, head of research and strategy in JP Morgan Asset Management’s Global Real Assets Group. “In our view, there are three different types – those that are obsolete and need to be torn down, assets that have been in suspended animation for the past five years and those that are on bank’s balance sheets. They do not want to inject capital or have the resources to add value. These are the assets we are targeting because we can add that value.”
The economic fundamentals are also high on the agenda. “It is important to be comfortable with the market stories and that the income lines are strong,” says Kim Politzer, director of research, Europe at Invesco Real Estate. “Also, the general view and one that is supported by IPD (Investment Property Databank) is that long leases perform better than short ones. The classic type would be logistics, because the leases are around 15 years, they have strong covenants, are done on sale-and-leasebacks and are linked to inflation indexes.”
Analysis by the IPD found that, in 2012, secondary properties with a good tenant and long lease delivered a 3.6% return, higher than better quality prime properties on short leases, which generated 2.7%. However, long-lease prime still outperformed them both on 4.1%.
Views differ though. Richard Merryweather, head of Savills UK investment division believes that, in regard to prime, the quality of the property and location is much more important than the length of the lease. “Taking it to the extreme you can have a new office building in a strong location that has a short lease, but it will still be considered as prime due to the quality and location.”
For now, there are more debates and discussions about the merits of these assets than actual deals. As Merryweather puts it: “In terms of secondary property there is a growing awareness of investors to consider the sector, but I do not expect a gold rush. In the great scheme of things the majority still want prime.”
The danger, of course, is that the gap will narrow and the chances will disappear. “You need to be an early arriver and secure the best price, because once you have an increase in deals we will see the herd mentality kick in and everyone will be chasing the same location,” says Politzer.
Not surprisingly, the more prosperous Southeast has captured the most attention. “There are more opportunities in this area,” says Robin Martin, director of research at Legal & General Property. “We have bought secondary properties in Staines, Southampton and Oxbridge because they do not command a London premium but have strong local economies and occupier demand.
“There are bigger discounts in cities such as Manchester, which is becoming a media hub, and Leeds which has a financial centre but the stock selection is not that great.”
One of the biggest transactions to date has been US real estate firm Kennedy Wilson’s £62.75m purchase last year of the 29-property Ruby Portfolio. It was part of Noel Smyth’s Alburn REC 6 commercial mortgage-backed security and embroiled in a long court battle. Smyth, a solicitor, sought to persuade investors in the debt secured against the portfolio to extend the loan for three years. In the end, Rothschild appointed Savills as receiver to sell the distressed properties, which included industrial assets in Fareham and Swanley, and offices in Guildford, Doxford and central London.