COMMENT It has long puzzled me why so many funds and institutional investors target their acquisitions on larger lot size properties, typically those more than £25m in value, when there is often better performance and liquidity to be had from smaller properties. I firmly believe that small cap property is an overlooked area that deserves greater attention.
So what is it that makes smaller properties in the £3m-£20m size range more appealing than larger ones?
Well, in many ways the opportunity in small cap properties is similar to that in small cap equities, with the market being less efficient and there being less quality research and analysis.
According to MSCI, this has led to smaller properties in aggregate offering 70-140bps -higher yields than larger properties of £50m or more. This is significant when research shows that over the very long term, income is the dominant driver of UK commercial property returns.
The opportunity in small cap properties is similar to that in small cap equities, with the market being less efficient and there being less quality research
It is hard to explain why this happens when many of the largest UK funds have large research teams and the capability to properly cover this area of the market but still choose not to focus on smaller properties.
But perhaps I should not be surprised as these are typically the same large investment funds that despite their research capability retain an exposure of 50% or more to a retail sector that has been in decline for some time – and is likely to drag on their investors’ returns for some time to come.
For cash buyers there are also greater opportunities to acquire “off-market” in a small cap market that is more “relationship” orientated.
Rules of attraction
A further attraction of smaller cap properties is their often improved liquidity over equivalent larger properties. I believe this is a function of the greater diversity of buyers operating in this area of the market, for example smaller pension investors, high-net-worth investors and property companies.
In contrast, outside of London the market for larger properties is typically dominated almost entirely by the UK funds that often operate as a bit of a herd, either all being in the market together or all out of the market.
A good example of the impact of lot size on liquidity is in the period immediately after the vote to leave the EU in mid-2016. At the time I was running a UK property fund with a specific focus on smaller lot size properties.
This fund, like many of its peers, suffered very extensive redemptions in the third quarter of 2016 but was able to continue to trade its smaller properties at sensible prices and stay open by selling into a market that remained active.
In contrast, the institutionally dominated market for larger lot size properties outside of London became very illiquid and contributed to many of the largest retail funds having to close their doors and defer redemptions.
So what small cap opportunities are there now in the run-up to the period when we will probably leave the EU?
I can best illustrate this with the purchase of a small lot size industrial estate in the South East that I recently completed for a client. The property, for which we paid £11.5m, was a 190,000 sq ft estate in Hitchin, Herts (pictured). The price equated to an initial yield of about 7.2% and a low capital value of about £62 per sq ft.
While Brexit will, of course, have had an impact, I have a strong hunch that had the estate been valued at more than £20m, the pricing would have been very different as it moved into the sweet spot of many of the UK funds.
David Wise is co-founder of Active Value Capital
