Jacques Gordon, global strategist at LaSalle Investment Management, explains how looking at areas just a tiny bit “off the beaten track” can yield superior returns for savvy property investors.

Jacques Gordon, global strategist at LaSalle Investment Management, explains how looking at areas just a tiny bit “off the beaten track” can yield superior returns for savvy property investors.

Investors’ appetites for property rise and fall; how and why this happens is a mysterious process. Ever since the financial crisis unfolded in 2008, institutional investors have been very risk-averse. In many countries, that means that more money has come into the most expensive commercial property markets, not less.   Secondary markets are ignored, and these capital flows create distortions in value that an astute investor can take advantage of.

Large institutions remain nervous because the aftershocks of the crisis continue to be felt in Europe and structural problems remain unsolved in many G7 countries. This means that only “core” assets (fully leased, dominant buildings in major markets) have full access to liquidity. In other words, cautious investors seek safety in the most expensive property markets in the world (for a recent article on Prime Central London property click here).

Like investment grade bonds, these core properties have traded up in price, even though fundamentals are weak. But the low-risk reputation of these assets may be illusory. Investors seeking a safe haven in property have bid up the prices, and driven down the yields, to levels that may be unsustainable, especially if and when interest rates rise again. In London’s West End, a luxury retail flagship store traded recently at a near-record low yield of 2.9 per cent.  In New York or California, mid-rise rental apartment buildings in trendy, urban neighbourhoods routinely trade at a 4 per cent yield or lower.  In Shanghai, while the government tries valiantly to reduce the pressure on luxury residential prices, office buildings on either side of the Pu River trade at 5 per cent yields - lower than government bonds.

Real estate debt: the answer?

Risk-tolerant investors (of which there are very few) find that some of the best values can be found by investing in real estate debt. The mountains of real estate debt accumulated during the credit bubble era are starting to crumble. NAMA, the Irish government‘s “bad bank” for property development debt, is auctioning large chunks of its €72 billion ($91.4 billion) pool of performing and non-performing loans across Europe and North America. In December large portfolios of discounted real estate loans were sold by RBS and Lloyds.  Barclays and HBOS have already exited their North American and Asian loans through secondary market trades.

The French, Spanish, and German banks are next to start selling, as more restrictive capital reserve requirements force institutions to focus on domestic, conservative senior debt. US banks face a similar mountain of expiring debt and are steeling themselves to start packaging it up for sale.  Meanwhile, the smart money is moving into “mezzanine” real estate finance, where yields can be twice, thrice or even four times as high as the yield on senior debt or on direct equity.  Many secondary markets can also produce higher yields and better risk-adjusted returns relative to the great “money centres” of the world. 

Look to “core-plus” properties

How will trading in discounted real estate debt affect the underlying commercial property market?  Barely performing, “zombie” debt rarely has prime, leased assets as collateral. Many of the debt purchasers hope to wrest control of the collateral from the original borrower. As they do so, more of these “not-quite-core” assets will start to trade, as they are priced out of limbo land. Investors willing to take on a degree of complexity, or who are willing to shift focus from Knightsbridge to Hammersmith (in London), or from Park Avenue to Third Avenue (in NYC), will find much better value in these “core-plus” properties, as investors call them.  

Commercial property is clearly divided into the “haves” and the “have-nots” when it comes to liquidity and pricing. Returns look quite different on either side of this liquidity gap. In geographic terms, the West End of London, mid-town Manhattan, Central Paris and La Defense, Hong Kong-Central, and Shanghai’s Pudong and Puxi districts are all firmly in the “have” category. They exert a strong pull, accounting for an extraordinarily high proportion (by value) of all activity that took place in major markets in 2011, according to Jones Lang Lasalle research.   

Unfamiliar sectors

Yet, there is a great, wide world of real estate beyond these ultra-expensive, low-yielding districts. The gradual expansion of the core market will occur, as frustrated would-be buyers continue to be out-bid by “safe haven” money. Partially-leased buildings that need to be fixed up and filled before they attract the attention of core buyers represent one example. Then there are the sectors offering higher yields because investors aren’t familiar with them, such as healthcare real estate (laboratories, doctors’ offices, clinics) or student accommodations near major universities. 

When will these trades be seen as worth doing?  It won’t be long; there is only so much Knightsbridge property to go around.