Good, better, diversified.

Better quality assets do not necessarily generate better investment outcomes.

There is no reason to think that assets that command a relatively high rent in their market should deliver better performance than those that achieve a lower rent.

But many institutional investors seem to have a distinct preference for prime assets. This is understandable perhaps if your investment objective is a stable income. But the bias for prime is apparent for those with growth objectives too.

There are several reasons why a portfolio manager may want a prime asset in their portfolio.

The prestige of owning a top-quality asset could help with the marketing of their fund. Their career might benefit from being associated with a high-profile asset. And they may be more focused on the attributes of the asset than the appropriateness of pricing.

Another driving force towards favouring prime assets is that it mitigates the downside to career risk.

The graphic below frames the outcomes for a portfolio manager when choosing to invest in prime or secondary assets:

A vast oversimplification perhaps, but there is some truth to this framing.

No wonder portfolio managers display a bias towards prime. They sense that Keynes was spot on when he wrote, "worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

Now, many portfolio managers believe that they are playing safe on behalf their clients, rather than themselves. There is a deeply held and widespread belief that prime real estate is less risky than secondary assets.

But I am not clear what the basis for this is, other than it perhaps being a comforting belief to hold.

Secondary assets may suffer from less transparency and a greater degree of illiquidity than prime assets. But this needs to be balanced against the greater volatility of prime assets.

When prime and average quality property indices are compared, prime indices tend to be markedly more volatile. 

So there is a danger that asset selection gets skewed towards riskier assets.

Furthermore, with high-quality tenants and limited income risk, prime assets are generally going to have the same primary driver of returns - interest rates. For secondary assets, growth is likely to be a more significant factor. Portfolio performance may be enhanced by having a balanced exposure to return drivers.

Nevertheless, there may be reasons why certain investors might be right to favour prime.

There are points in the cycle when prime properties might be expected to deliver stronger rental growth than secondary assets, typically at the early stages of an occupier market recovery.

In addition, structural trends may work against lower-quality assets. If you had foreseen the polarisation in retail a decade ago, discriminating against secondary assets would have been very beneficial.

Furthermore, investing in secondary assets is not right for some organisations. Lower quality assets can be asset management intensive. Delivering performance requires the right asset management capabilities. If you don't have these, don't try.

Finally, the variance of potential outcomes may be wider when investing in secondary assets. Perhaps the risk of pro-longed vacancy in secondary real estate is higher. The possibility of being exposed to a very poor-performing asset may be higher than with prime. The cost of making a mistake during the acquisition process might be higher.

There are two mitigants to this.

Firstly, a structured, rigorous and defensive investment process can increase the objectivity of decision-making and reduce the chances of missteps during the acquisition process.

Secondly, diversification. An appropriately diversified portfolio should allow examples or marked underperformance to be balanced with assets that achieve significant overperformance.

Opportunity awaits for those that diversify appropriately and build a defensive investment process to allow portfolio managers to be active where others are less willing to venture.