With so much public and private capital chasing commercial real estate investment opportunities in the primary markets, is this the right time to focus attention on the secondary markets? Yes, according to Sam Chandan, Ph.D., president and chief economist of Chandan Economics. But in a Development ‘13 session titled “Performance and Timing of Secondary Market Investment Activity,” he presented numerous warnings about assuming too much about the risks and rewards of doing so.
Chandan advised that the time to buy in secondary markets is not early in the cycle, because these markets experience a lagging recovery. Rather, the time to buy is late in the recovery, when secondary markets offer higher returns than primary markets.
Despite the hunt for yield, there has not been a mass migration of investors from primary to secondary markets. Chandan noted that primary and secondary markets have experienced a bifurcated recovery, with flows of capital lighter and price improvements slower in secondary markets.
He offered a half dozen reasons why investors should pause before jumping into secondary markets:
1) Secondary risk-return trade-off is not always efficient. On average, the greater risk is not offset by greater reward.
2) Secondary markets have fewer investors, lenders and trades during downturns, even after adjusting for market scale.
3) Recovery in secondary markets lags recovery in primary markets, resulting in a shorter window for investment opportunity.
4) Later recoveries and sharper con-tractions in secondary markets mean that timing plays a bigger role in calculating returns.
5) Without a liquidity premium, secondary market value trends are more dependent on property fundamentals during periods of risk aversion.
6) Industry concentrations drive bigger boom/bust cycles in prominent secondary markets.
Sam Chandan cautions Development ‘13 meeting attendees about the risks and rewards of investing in secondary markets.
Secondary markets have a distinct investor profile: smaller, private investors; relatively smaller assets; and lower leverage but higher prevalence of financing. “In secondary markets, there are borrowers who can’t get financing in the $5 to $10 million range,” Chandan noted.
“Some disadvantages are immutable,” he added. In secondary markets, fewer assets imply fewer trades, which means slower price discovery and a less efficient marketplace. The bid-ask spread closes more slowly. Smaller transactions are less attractive for institutional and cross-border investors and deterrents to investors are also deterrents to lenders.
Chandan’s presentation was based on his NAIOP Research Foundation report, “Performance and Timing of Secondary Market Investments.”