Secondary grade industrial asset pricing: a rising tide lifts all boats?

March 26, 2013 / By

The commercial property investment market in Australia is heating up. Industry practitioners and commentators are again focused on yield compression. Most discussion has been about how much yields will compress this year, not if it will happen.

The majority of analysis has focused on the prime segment of the market. The Jones Lang LaSalle Research view is that further moderate yield compression for prime grade assets is likely this year; better quality assets – or ‘super prime’ assets – will see the majority of yield adjustment, resulting in wider spreads in the prime yield range and wider spreads to secondary assets.

What of secondary grade asset pricing? What ever happened to the phrase “a rising tide lifts all boats”?

I have outlined three reasons why secondary grade industrial asset re-pricing could occur in 2013:

  1. Yield spreads. Average secondary grade yields are at historically very high spreads to prime grade assets and government bonds and the spread within the secondary grade yield range itself is historically wide.
  2. Changing sentiment. More investors are indicating they will go up the risk curve this year. A number of institutional investors plan to start value-add style industrial funds. Sentiment toward both value-add investing and the industrial sector as an asset class is shifting favourably.
  3. Demand and supply. The volume of secondary grade asset sales decreased in 2012. The sell down of ‘non-core’ assets by institutional investors is winding up. At the same time, private investors – who dominated the purchaser environment in 2008 and 2009 – are coming back into the market. The debt market is now more favourable for leveraging into higher yielding assets. Meanwhile, the return on fixed interest investments has deteriorated in line with lower interest rates.

Purchasers of industrial assets will review three key factors when assessing opportunities:

  1. The tenant – income quality and duration of lease term
  2. The building – age and specification of the building
  3. Location – close to major road infrastructure, ports, customers or workforce

Investors may decide two out of three isn’t bad and accept a shorter lease expiry profile for a good building in a good location. Or decide a poor building in a good location with a strong covenant and long WALE is acceptable. We generally don’t expect firmer pricing for assets that are only strong on one of these criteria.

Watch closely for evidence of secondary grade price firming throughout the year. This may result in even wider spreads in the secondary yield range as better quality secondary assets are re-priced. We don’t expect that there will be a sufficient shift in the risk appetite of investors this year to warrant significant tightening at the upper end of the secondary yield band in most markets, given it remains a tough selling environment for this type of asset.

We retain our central house view that prime grade yields will firm this year and the average yield spread to secondary grade assets will widen further. At some point though, investors will step in and absorb some of this growing spread. Time will tell.

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