At a time when investors are looking for safe havens in core prime property, are there rewards for those willing to go off-piste into the secondary markets?
What is secondary property? Everyone agrees on what is prime – the well-located building let on a long lease to a company that appears financially stable over the long term. City centre offices and shops are indisputably in that league, as are major industrial buildings let to the right occupier.
At the other end of the scale is a tired development of buildings needing refurbishment, a long way from the city, with occupiers coming to the end of leases. But away from these clear definitions, the description can be flexible. At the depth of the market in 2009, there were few buildings considered prime, says Matthew Weiner, investment director at Development Securities. With improving sentiment, things have changed. “The capital that wants to get into the market redefines prime.”
And, according to agents DTZ, there is plenty of capital potentially stalking opportunities in non-prime property. Its Great Wall of Money report from late 2011 noted: “With over a third of capital raised before 2008, we expect many fund managers to be under increasing pressure to deploy legacy capital over the next twelve months or risk returning it to investors.” And DTZ expects banks to start releasing more secondary property: “Having made headway in dealing with problematic loans on prime assets, we see a growing level of opportunities emerging from the banks focussing on more secondary assets.”
Charles Smith, DTZ’s head of valuation, London & South, notes: “There is an increasing quantity of secondary stock either on the market or anticipated to land shortly. This combined with a tough leasing market means that investors are becoming increasingly selective and very careful attention is being paid to the capital expenditure that properties require – if so, purchasers are seeking higher returns and lower prices or are walking away.”
“The secondary market is multi-layered ranging from the ‘good secondary’ with well-located buildings but shortening income profiles where opportunities exist to enhance value through refurbishment and re-letting – to the ‘poor secondary’ or tertiary where properties are often suffering from functional obsolescence, are in peripheral locations with short lease terms to poor covenants. The best located and best quality properties within the micro-locations with the best re-letting story will outperform in 2012.”
Peter Damesick, EMEA chief economist at CBRE, warns that it is going to take some tough price cuts to deliver property the market will want to buy: “Conditions are turning against the weaker parts of secondary, particularly properties in weak locations,” he says. “A lot of pricing there is untested. When it is tested, achievable pricing will be less than expected.” In some instances, investors are going to want equity-style returns. “The problematic situation is a single tenant”; whereas a multi-let property has better potential to work the asset.
He warns : “A lot of the stock has been cash-starved,” as owners short of funds cut back on non-essential maintenance. “Those are the type of assets some investors see as an opportunity. We’ve moved from the market where investors were looking to the market to deliver capital growth.”
One big fan of secondary property is Development Securities. The London-listed property company has, in the last three years, invested £350m in secondary property across the UK, as part of a deliberate strategy to uncover value from unloved buildings.
The start of the strategy in 2009 was a to ask shareholders for funds; and this, combined with a second cash call in 2010 gathered £150m ($232m) to get to work with. “We had one slide in that presentation to shareholders that summarised it all,” says Mathew Weiner of DevSecs, “and that showed the gap between prime yields, and secondary yields.”
The DevSecs model has been to invest in geographical areas they feel they understand, but to be flexible about property type; and to choose small lot sizes, limiting the risk on individual transactions. “We stick to our core disciplines of risk analysis and likely return,” says Weiner. “It is a specialist play – capital on the sidelines shouldn’t move into the market without a partner.”
DevSecs has used its own cash sometimes, and where practical has worked with a funding partner or raised bank debt to leverage its buying power. Investors in the top tier of the market are simply looking for capital preservation, says Weiner. “One of the problems investors have is what’s a good covenant these days?”
DevSecs looks for opportunities to create an enhanced return by intensive work – negotiating a change of use, repositioning the property. At the Manchester Arena, bought in the summer of 2010, the company wasted no time in extracting value. “We restructured the lease while we conducted our due diligence,” says Weiner. The $97m purchase was a joint venture with Patron Capital Partners, backed by a $75m loan.
Weiner says any purchase has to have an exit plan: “It’s always about recycling.” Often that means turning the risky product they buy into something that has a place in the portfolio of an investor looking for a safe, steady return. “There is no doubt it is risky,” he acknowledges, and each opportunity needs to be appraised individually. But the risk is spread: the $235m raised has been invested across 40 deals: “We’ve taken lots of small bets.”
In terms of product choice, “we’re very cautious,” says Weiner. The company is comfortable in the south east of the UK, and in other regions such as greater Manchester, where aspects such as a proactive local authority lend confidence. “Some towns will be very difficult going forward,” he says. Property type is flexible, although “to a degree we have avoided secondary offices. We like food store-anchored developments, or those where a food store can be created.” The portfolio has also added a hotel, care home, and student housing. “You’ve got to be like that.”
Weiner also sees a much closer focus than in the last few years, on how occupiers use buildings and how that can influence the property’s fortunes. The prop-co/op-co splitting that was popular in the last decade does not make sense in today’s environment, he says. “We’re going to spend a lot of time putting that back.”
“A lot of stuff is functionally obsolete,” warns Weiner, mentioning one un-named shopping centre that was up for sale in 2007 for $60m. Today, it is available probably for between $15m and $22m. “Would I buy it now? No, I wouldn’t.”