Partners Group recommends non-core real estate

With yields for trophy properties having fallen to low levels, investors should be shifting their focus to non-core real estate assets and markets where capital is scarce, according to new investment recommendations by the Swiss firm.

Core real estate is attracting significant amounts of capital, but these types of assets offer lower relative value for investors because of the high price levels and low yields for such properties. Therefore, investors should focus on non-core assets and markets where capital is scarce, said Partners Group in its new Private Markets Navigator report for the second half of 2011.

While cap rates have remained relatively stable in the past six months—and are below 5% in markets such as the US, UK, France, Germany and Japan—pricing for trophy assets in Tier 1 markets has surged and is now based on metrics similar to those during the peak year of 2007, according to the firm.

Partners predicted that once interest rates rise, investors may find the yields and yield spreads of trophy properties to be less attractive and shift to real estate with higher risk-returns, such as Class A assets in Tier 2 and 3 markets, as well as non-core properties, which currently are in comparatively low demand.
The strong demand for trophy assets has been fueled by bond yields remaining near long-term lows, which has driven institutional investors to shift some of their fixed-income allocations to real estate, since core real estate trades still command higher yields than bonds. But Partners predicted investors may lower their real estate allocations once bonds begin to provide higher yields.

Investors also have flocked to core assets for protection against the negative impacts of inflation, but “they can likely obtain better protection through non-core strategies and assets, which are available at significantly more attractive prices,” the firm said.

Investment in emerging markets also has strongly favored core real estate, with development projects in Tier 1 cities attracting substantial capital, while smaller markets and Tier 2 and 3 cities continue to lack capital flow despite similar or even stronger fundamentals than core markets.

“Once again, we believe that opportunities are more attractive on a risk-adjusted basis where capital is scarce,” said Partners, which is continuing to focus on emerging markets with strong GDP and consumption growth and where current supply is insufficient to accommodate real estate demand.

Meanwhile, the secondary market continues to offer “exceptionally attractive returns” for certain buyers, with new opportunities coming from secondary directs—in which a new investor buys an existing direct investor’s interest in a property or portfolio at a discount.