Mind the gap….The prime / secondary yield gap as an indicator of risk

01 September 2014

In the years preceding the Global Financial Crisis (GFC), the concept of risk was downplayed as property investors sought to achieve huge returns on the back of cheap debt and a growing economy. Following the dark days of 2007 & 2008, as an industry we now carefully consider risk in all areas of property investment from letting to transactional liquidity to location.

Pretty high up the risk agenda, obviously, is pricing….what is the risk of a decline in value for the asset/market I’m buying into? There are several measures we use at KFIM to make as assessment for exactly this, including the spread of property yields over gilt yields, the volume of new construction activity, the vacancy rate and the spread between prime property yields and secondary property yields. 

Historic series of prime and secondary yields across the main commercial sectors (shops, shopping centres, retail warehouses, offices and industrial) show that over the past 15 years, secondary assets have, on average, traded at a 210 basis point discount (higher yield) than prime which seems like a reasonable additional return for the additional risk. As one would expect, over time there have been large fluctuations around this historic average.

For example, in the heady days of early 2005 (a year in which the all property total return was recorded at a colossal 19.1%), the prime/secondary yield spread was squeezed to just 85 basis points as investors competed for exposure to a market in which it seemed values could only go one way – even on higher risk assets. Warning signs should have been flashing that there was an acute risk of values going the wrong way….

As signs started to show that the global economy was teetering on the edge of a potentially major collapse, sentiment towards secondary property quickly turned and spreads sharply widened. During 2007-2009 the spread more than tripled and continued to rise steadily higher thereafter.

Secondary property values were on the floor and at a peak of 415 basis points in mid-2013, the market was screaming “low risk!” on the basis that the higher yields are over their long run average, the lower the chance of a further fall in value.

Sure enough, soon after, values started to climb. The prime/secondary yield spread has narrowed quite sharply over the past year and has plenty more room to continue – a further fall of 80 basis points would take the market back to trend, implying capital value growth of over 15%. More is possible given that markets rarely just ‘return to trend’. 

In the short term at least, with rental values rising, the road ahead looks pretty safe with a low risk of the market being moved off course – enjoy the ride! But keep a careful eye on our risk measures….warning lights will flash ahead of a change in the terrain.

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