In 2015, prime yields in the UK fell to new record lows across a number of property sectors and, in those sectors where prime yields remain above the 2007 nadir, it is now by only a marginal amount.
But, despite the advanced position in the cycle that prime property pricing would indicate, secondary yields remain elevated compared to historic levels. While historical trends suggest the spread between prime and secondary should converge towards the top end of the cycle, the pricing of secondary property continues to offer a substantial yield spread over prime property.
Does this mean that there is relative value in secondary property in the UK market, or are there fundamental reasons to justify this continuing polarisation in pricing?
There are three factors to consider. First is the age-old prospect of a market shock. If we were to experience a full-scale crash affecting both financial and occupier markets, prime real estate would be expected to significantly outperform secondary.
In the current geopolitical environment there are a number of risks which may have an acute impact on the market, with Brexit the most pressing. While the most likely outcome remains a vote to stay, should the leave campaign achieve an unlikely victory the short-term consequences are likely to be significant for both the occupier and investment market in the UK.
Taking the geopolitical risks aside, however, if consensus forecasts are correct we are heading towards a gradual correction in property pricing driven by rising government bond yields (assuming a strengthening economy triggering interest rate rises), rather than a correction which affects the economy and occupier markets. If such predictions are correct, the impact on occupier markets and rental values would be minimal, with outward yield movement accounting for the vast majority of the correction in property values.
Therefore, there is an argument for the outperformance of secondary versus prime property. In a strong occupier market secondary property should be able to sustain a higher income return than prime, particularly given the yield differentials between the two at existing levels. Furthermore, the secondary market offers a substantial spread over gilt yields, which gives it a larger prospective cushion to absorb rising bond yields, compared to the very low yielding prime segment which will see the spread narrow rapidly.
However, a final factor is the changing underlying fundamentals. Structural occupier changes in the office, retail and industrial sectors are showing an adverse affect on secondary property – particularly in retail, where the growth of e-commerce means retailers don’t require the same amount of space they once did, and are concentrating on larger, locations. In most markets, secondary property is still struggling to attract new demand.
However, active demand for good quality stock has recovered strongly. Office occupiers, for example, are showing a strong preference to locate in modern, high quality buildings and environmental concerns are also pushing demand towards more modern and energy efficient buildings. Any decision to invest in secondary property, therefore, should follow a close examination of the asset management potential, as well as location.
This cycle is showing different characteristics from its predecessors, which have put secondary property into a position whereby it has the potential to outperform primary. However, investors would be advised to remain highly selective in their deployment approach, with a strong preference for asset risk over location risk.
While the pricing of secondary property holds a strong attraction, in our view strategies focused on properties with the potential for value add and, importantly, in areas with high employment growth expectations, may provide the best long-term returns.
Zachary Gauge is associate director at UBS Asset Management
