Much recent investment in prime real estate was triggered by an overreaction to perceived risk and an insufficient appreciation of the alternatives. Many investors overemphasise, indeed, misunderstand, the risks associated with real estate and have consequently undervalued the opportunities available outside prime markets in Europe.
Close to all-time lows in bond yields and the consequent yield gap between real estate and bonds make the case for European real estate. Indeed, real estate transaction levels, driven by the need to find a performing home for accumulating funds and concerns over inflation, remain healthy. The issue, though, as so often happens when risk avoidance is dominant in the investor’s mind, is that opportunity cost considerations of investing in prime real estate have been overlooked and risks misunderstood.
Bond yields will not remain low forever and very low yielding real estate is at risk of significant falls in capital values when gold loses its shine. Comparisons with other asset classes, notably equities, demonstrate the opportunity cost of an addiction to prime real estate. For example, in all the key European real estate markets, there has been long-term narrowing of the yield gap for prime offices versus equities. Given the added management costs and lower liquidity of direct real estate, a yield gap above 3% might be thought essential, a figure that is not achievable in current markets.
Too often, though, we hear the simplistic counterargument that in complexity lies risk. However, if we were able to argue that better understanding and better management ability removes risk to levels on a par with prime grade investments, secondary real estate looks attractive. It is true that secondary property does have that added degree of complexity. And it is granted that investment judgments, and therefore decisions, are much more difficult to reach, but it is indeed out of complexity that superior performance can be created.
In the above table, top core and prime real estate buildings are represented by quartiles one and two, secondary and tertiary by quartiles three and four; standard deviation is used as the measure of risk and the coefficient of variation as an index of attractiveness. From this we can see that, historically, secondary real estate has been no more risky than prime and that in statistical terms it is an even more attractive investment. We posit three reasons:
? As today, there were periods when prime was bought as a safety net, not as a rational investment. Downside is therefore greater than upside. Apparent “risk-off” is an illusion.
? For secondary real estate, there is a potential upside. Good secondary can be managed to prime. Prime, because of obsolescence, shortening lease lengths and the creeping impact of sustainability agendas, has nowhere to go but sideways or downwards.
? Higher returns from secondary provide an “unfair” headstart.
The key with secondary real estate is the management. It requires effective asset managers who are “close to the dirt”, capable of handling the complexities of finding and/or retaining suitable tenants and assessing refurbishment and value-added redevelopment. These managers need to be closely involved with the life of the building and understand the community and its tenant base, which means we need asset managers living and working in our key investment countries. Doing so allows them to:
? ensure that the tenant mix of retail assets continually provides for the needs of its immediate trade area;
? understand that logistics real estate dances to a different tune from industrial in being trade route centered, and understand the triggers of trade route buoyancy;
? realise that a unique set of drivers should lead Germany to develop the strongest green premium in Europe, and build the know-how to manage secondary buildings to be prime green performers; and
? realise that real estate can provide operational leverage when financial leverage retreats.
Are we saying that we prefer secondary real estate to prime or opportunistic? No – real estate is too complex to draw such general conclusions. However, we do feel that the pendulum has overshot, and that good secondary real estate could well prove to be the shrewdest call in today’s markets.
