Real Estate Research
How resilient is secondary property?
The last 12 months have seen total returns on secondary property start to rival those on prime property, marking an end to the prolonged underperformance which began during the financial crisis.
The last 12 months have seen total returns on secondary property start to rival those on prime property, marking an end to the prolonged underperformance which began during the financial crisis. There are three main reasons for this: secondary property offers a higher income return (6.4% at 2014 Q2) than prime property (5.1% at 2014 Q2)1; secondary properties are now starting to benefit from increasing tenant demand arising from the economic recovery in the UK and, finally, against this backdrop, investor appetite for properties carrying higher levels of risk is increasing.
Looking forward, our central view is that secondary property will probably outperform prime over the next few years as the deficit in rental growth narrows and as the gap in yields shrinks. That would broadly replicate the patterns seen during the long upswing from 1993 to 2006. This in turn assumes that the UK economy will continue to grow steadily and that long-dated gilt yields do not increase to more than 3.5-4.0%2over the next few years.It is of course possible that our assumptions are wrong and that either the UK economy stalls unexpectedly, or that long gilt yields jump to 5%, or even higher, for various reasons: inflation might be higher than anticipated3, or the unwinding of quantitative easing, which is unchartered territory for central banks, might destabilise bond markets. If we consider these alternative scenarios then which type of property would be more resilient – prime, or secondary?
Defining prime, secondary and tertiary property
IPD typically categorise properties according to their type and geography, but they can also further sub-divide the properties within each part of the market into quartiles, according to their equivalent yield. This further split is useful because the equivalent yield is a good indicator of the quality of each property and reflects both its physical condition (i.e. internal specification, location) and the security of its rental income (i.e. the financial strength of the tenant, length of the unexpired lease). Those properties in the lowest yield quartile will typically be relatively new and be let on long leases to strong tenants. The lowest yield quartile is a rough proxy for prime property4. By contrast, assets in the highest yield quartile are probably suffering from significant obsolescence and may also be let on short leases, or have weak tenants. The highest yield quartile is a proxy for tertiary property. Assets in the middle quartiles are secondary properties and form the mainstay of most institutional portfolios. Although they are of reasonable quality, they usually have the odd blemish such as a slightly dated specification (e.g.1980s office), or a fringe location, or a short unexpired lease, or a dubious tenant. This means that to generate attractive returns it is often necessary to adopt a more active management approach and invest capital: to ensure that the building continues to meet occupiers’ requirements; or to extend the lease, or to negotiate a surrender and secure a new strong covenant.
Scenario 1: An unexpected recession
If we consider the first alternative scenario of an unexpected recession in the UK then the likelihood is that prime property will prove to be the most defensive. That was the pattern through the downturn from mid-2007 to mid-2009 and again in 2012, when the sovereign debt crisis in southern Europe nearly tipped the UK economy back into recession. On both occasions prime properties outperformed, because they benefited from stronger tenant demand and suffered a more limited fall in rental values. On a cumulative basis prime rental values fell by 8% from peak to trough, whereas secondary and tertiary rental values declined by 12% and 20%, respectively (Source: IPD, Schroders, August 2014).
1 Source: IPD 2 Please see the article “The Attractions of Property in a Rising Interest Rate Market”, September 2014. www.schroders.com/property 3Annual UK consumer price inflation is forecast to run between 1.7%-2.0% in 2014-2015 and average 2.5% per year between 2016-2019. Source: Consensus Economics, August 2014. 4For further background on how we define prime, secondary and tertiary property please see the article “Does Prime Property Always Outperform?”, March 2010. www.schroders.com/property
Important InformationThe views and opinions contained herein are those of Mark Callender, Head of Property Research, Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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