A widespread flight to quality has seen core real estate markets re-price significantly. Does this mean investors should move up the risk curve, into secondary assets and locations? There are no easy answers, Shayla Walmsley finds

Attempts to define core in terms of its essential characteristics have long been problematic. Simon Durkin, head of research for Europe at RREEF, argues that conservative real estate characteristics - long leases, low vacancies, strong covenants - do not, in themselves, do the job. Instead, he opts for investor-oriented characteristics such as stable cash flow, no principal risk, and inflation hedging.

"With real estate or any hard asset, there isn't a bright line that separates core from non-core," says Paul Vosper, EMEA head of client relations for RREEF. "It's more a continuum of risk and return. The industry uses shorthand terms like ‘core', ‘value-added' and ‘opportunistic' as a way to signal the underlying risk. But they're not discrete buckets and they evolve over the course of the cycle."

Some investors would have considered regional UK offices core before the crisis, for example, but wouldn't now.

Another problem with categories based on property characteristics is that they're also overly specific. Greg Mansell, research manager at Investment Property Databank (IPD), points to analysis done by his team comparing investment performance for the top quartile and bottom quartiles. At the extremes - high-end prime and low-end secondary - it was pretty diverse. But in London, the mid-quartile - grade-B properties - was comparable to prime in terms of performance. "London holds its own in secondary," he concludes.

Just as there's core and core, there's risky and then there's risky. What Durkin is talking about isn't shifting from central Paris office to Vietnamese speculative development. It's simply that when markets fail to price risk evenly and capital flows are uneven, there is the potential for asymmetric risk and returns - in other words, the inefficiencies are significantly elevated, especially in a fragmented European market.

According to Durkin, even taking on one element of additional risk - a shorter lease or a requirement for relatively minor asset management in a prime location - could be attractive. "You substantially increase the stock of real estate and face substantially less competition," he says. "But you have to have an in-depth understanding of the local market. In many situations, you need to know which block you need to be on or, in retail, which side of the street."

That ‘element of additional risk' was what Colliers was pointing to last month when it claimed in a report that German investors were expanding their risk profile in the second quarter of 2011 to include, for example, short leases - despite positive macro trends encouraging leasing activity in central locations.

It is also what Olaf Fortmann, managing director at US property firm Behringer Harvard, is talking about when he outlines a strategy for Germany that requires more than a modicum of patience: cherry-picking three or five assets you wouldn't buy on a single-asset basis for a broader portfolio. "Our goal is to buy assets cheap and we're willing to accept vacancies or maintenance issues to do so. But it takes a lot of effort to close smaller deals. We've been working on one deal for more than six months," he says.

So with tweaks rather than total investment in mind, one strategy is to include secondary as an element of a portfolio - rather than, as with the prevalent tendency, to look at secondary properties in their own right. They carry uncertainty but offer diversification, especially if you have a number of exposures to secondary with different lease profiles, says Paul Mitchell, a real estate consultant and former head of strategy at PRUPIM.

"The key factor has been performance vulnerability to lease events - effectively, an expiring or vulnerable tenancy. If you diversify across those, it will dampen the risk," he says, pointing out that the opportunity has only emerged as a characteristic of a weak tenant market and weak economic conditions you wouldn't have seen just a few years ago.

Move on up
If core effectively equates to prime, prime currently equates to over-priced - at least in some markets. But if investors are savvy enough to know the difference, there's a stock-specific discrepancy at the sharp end of secondary, according to Bill Hughes, managing director at Legal & General Property.

"Secondary encompasses both bad and good. Bad secondary is a depreciating asset. Good secondary has the potential for the value to increase if you're willing to spend money on improving it," he says.

The problem is that deciding whether secondary is good or bad demands good judgement. "Bad secondary and tertiary have no takers," Hughes says. "Real estate is naturally evolving all the time. Bad secondary is always becoming prime; prime is becoming secondary; and good secondary is becoming bad secondary."

It is effectively a punt aimed at acquiring assets at a price that is lower than their true value, leaving room for the upside through adding value. "There's no geographical or sectoral theme to it at all," says Hughes. "You see the potential, you build on the potential, and you sell it to someone else who sees it. You're not buying prime, you're making prime."

The same divergent trend is playing out in niche prime and niche secondary. In student accommodation, for example, investors such as Cordea Savills and the Unite Group are targeting assets close to well-regarded universities in capital cities, and offloading secondary assets in provincial backwaters. But there are also new investors, such as Knightsbridge Student Housing, acquiring regional assets selectively in order to spread risk. Far from seeing greater value in major cities, Knightsbridge reckons that high rents in prime locations mean there is a limit to the value to be had from the asset.

Volker Wiederrich, CIO at Swisslake Capital, makes two observations on the value-added and opportunistic trend. The first is that fund managers will only move up the risk curve if they are certain they can secure the capital, not if they are paying prices way above what investors want to pay. The second is that opportunistic doesn't mean what it did a couple of years ago, any more than core does. "This is not €200m invested in a from-scratch development. We're now seeing attractive prices and restructuring. It's adapted to the market environment," he says. "The risk level is still higher than for a core fund - but it's still attracting capital."

But this begs the question: what price should investors be willing to pay? Mitchell points out that, fundamentally, secondary has poor growth prospects with higher voids and poorer liquidity, and there has been a substantial shift in secondary yields, from 150-200 basis points (bps) above prime two years ago, to 300-400bps more recently.

Secondary properties have also borne the brunt of a weak tenant market characterised by uncertainty over the future of rental growth. "The market has marked it down and it's pricing in a much higher risk premium, relative to prime, than in the past. That's what markets always do to the most risky assets in uncertain times," says Mitchell. "The question is whether the current market conditions affecting secondary are just a feature of a weak economy, which will correct, or whether it's structural."

So is the lack of appetite for secondary characteristic of an ailing market or a longer-term phenomenon? "It's very difficult to make a judgement, but we have been seeing a high level of risk being priced into secondary at the moment. There's a high-risk premium for a reason; secondary is uncertain," says Mitchell.

Furthermore, a pushed-up premium accounting for higher risk has strengthened the correlation between secondary and equities - although Durkin points out that, in core, an over-reliance on geographic diversification can mean that core offices, "even if strong, stable, well-understood assets in London and New York", can have strong performance correlations as a result of their heavy reliance on the financial services sector, for example.

Mitchell argues that what the secondary market "has done is a version of what happened in 2008", with the appetite and pricing for property moving strongly in the same direction as equities, because there is a range of common influences behind the elevated risk. "That greater correlation will continue in future," he says.

In the meantime, just as investors are prone to underestimate the risks associated with core, those who have opted for slightly more risk are likely to do the same with secondary. "Based on the numbers, secondary looks like the way to go because there's an extra initial yield," says Mansell. "But how long is that yield going to last? That's the point. You need to have either additional equity for value-added or extra cash to mitigate the loss."

The issue of price-versus-punt leads back to core. Ben Habib, CEO of First Property, reckons the appetite for prime is a result of momentum or sentiment-driven investment that has very little to do with fundamentals - and that, as a result, it is bursting with bubbly risk.

Habib points out that in the UK property market of the early 1990s yields stayed pretty much north of borrowing costs until 2004. In those days, he says, investors learned "almost as dogma" that you don't buy a property on a yield lower than the interest cost because, if you did, the only way to make a profit would be via rental growth and, therefore, capital gain.

That sacrosanct yield gap disappeared in 2004. After that, all property investment meant taking a view on capital growth because only a future increase in value could justify the (then) current price. "That seems to me a dangerous proposition, at least as far as property is concerned, because it requires either rental growth, or for yields to drop," says Habib. "In the UK we've had cycles of rents going up, but they usually come down. I've always viewed buying into rental growth in a big way as slightly dangerous."

By the end of 2004 the fundamental investor could and should have stopped buying property in the UK, he adds.

"What I find remarkable is the speed with which the central London market has corrected itself," he adds. "Unless there is a dramatic rental growth, it seems to me unjustifiable that lending yields can be 4.5% when yields on gilts can be 4%. We've already forgotten the lessons of the bubble and created a new one in the London market."

In any case, here is the thing about moving up the risk curve to secondary markets or secondary assets: institutional investors - both funds and pension schemes - are likely to have no choice.

Hans Vrensen, global head of research at DTZ, points out that fund managers have made promises to end-investors to deliver a level of return they aren't able to deliver based solely on buying prime.

"Many fund managers are moving towards the end of the commitment period. That's another reason to be looking at secondary," he says. "They don't want to hand the commitment back to their end-investors because it means they won't have done their job. Either investors trust the manager to invest in secondary, or they won't be able to invest."

There are equally compelling reasons for investors to rethink their absolute commitment to core. "It's the eternal trade-off," says Vrensen. "My sense is that greed will ultimately win over fear. A pension fund wants to avoid losing money but the CIO will want that investment in place. If they're allocating 15% to commercial real estate, they want that investment made and they won't be happy if it isn't."