The Australian industrial property investment market has been exceptionally buoyant in recent years. Landmark transactions have reset pricing expectations for core logistics assets and large portfolio offerings. As the re-pricing of core assets compresses future return potential, JLL has noted a shift in investment interest toward secondary grade and value-add opportunities.

Good quality secondary assets provide an opportunity to build portfolio scale, while also potentially allowing owners to enhance returns through active management. Investors who have become discouraged by an inability to compete for prime opportunities will focus on secondary grade assets to grow their portfolios.

Wide yield spreads between prime and secondary assets increases the rewards from repositioning and upgrading secondary assets from expected yield compression, increased income potential and reduced letting up assumptions.

Figure 1: Spread between Prime and Secondary Grade Yields (Sydney OCW), Q3 1992 to Q3 2016
Source: JLL Research

Average secondary yields provide historically high spreads to prime assets. Using the Sydney Outer Central West as an example, the spread between the midpoint of the prime yield range and the midpoint of the secondary yield range was 150 basis points in September 2016 (Figure 2). The narrowest spread was 25 basis points recorded in 2007 and between Dec-95 and Dec-07 this spread averaged just 71 basis points. Investors may recognise that an opportunity still remains to acquire secondary assets before this spread is eroded as the asset class is re-rated.

As Figure 2 demonstrates, markets today have prime to secondary grade yield spreads of between 100 bps and 212.5 bps, depending on location. In general, highly strategic locations with alternative use encroachment such as Inner West Sydney (100 bps) and South Sydney (125 bps) generally have a lower spread; whereas markets with a higher proportion of older style manufacturing use such as Sydney Outer South West (150 bps) or easier supply delivery and competition such as Melbourne West (162.5 bps) retain a greater spread.

Figure 2: Prime v Secondary Grade Yield Spread, Q3 2016
Source: JLL Research

Sentiment toward value-add investing has shifted favourably due to improved underlying occupier fundamentals in Sydney and Melbourne at present. Occupier demand is being supported by macroeconomic trends and infrastructure initiatives that are supportive of favourable occupier demand conditions. Occupier gross take-up will be well above the 10-year average in Sydney and Melbourne this year.

Other benefits of secondary assets worth exploring for investors include:

• Potential to achieve valuation upside through planning gain or redevelopment as a property moves through its life cycle.
• More value may be attributable to the underlying land than the existing income stream / built form.
• Shorter lease terms provide new investors with the potential to capture market rental upside on renewal.
• Older assets with capex requirements allow for active managers to use their capital advantages and/or development delivery expertise to unlock further value.

JLL expects investors to rotate capital into secondary industrial property due to favourable tenant demand conditions and to unlock property that can be actively managed to enhance returns through leasing or development initiatives. As a result, we expect greater competition for secondary properties in 2017 as investors look to aggregate assets in this segment.

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