The UK is slowly returning to what is currently passing for normality. The Conservative Party have elected a new leader following David Cameron’s resignation and Theresa May has now taken office as Prime Minister. The speed with which that changeover occurred has helped; at least it meant that the UK avoided three months of a lame duck premiership.
To leave the EU the UK has to activate Article 50 of the Lisbon Treaty. This sets in motion a formal period of two years to negotiate withdrawal. There are three key issues here. First, is that the uncertainty will continue to impact UK. Secondly, that will not necessarily just last two years. The two year period is solely concerned with withdrawal. It is not necessarily the case that all of the future relationship between the UK and EU is confirmed by that point. Finally, while the EU will take priority this isn’t just about that relationship. The UK will also have to confirm relationships in areas such as trade with countries outside of the union. Some countries may agree to a continuation of the EU negotiated relationships currently in place, some may not. It will though be interesting to see what the attitude of other countries is to entering into trade negotiations with the UK. On the one hand it may be that countries are reluctant to confirm trade deals with the UK before the final agreement with the EU is confirmed. Before then it will not be known what access those firms will have to the single market via the UK. That is naturally going to impact upon negotiations. However, there is a counter argument to that. It may actually be in the best interests of other countries to enter into negotiations now as they may feel they will get a better deal from the UK in the current environment. The uncertainty over the final relationship with the EU and the willingness of the UK to negotiate deals quickly may lead to them comprising more. What is however undeniable is that the uncertainty over the UK’s position is not going to go away anytime soon, it is not just a two year horizon we are looking at.
Before we move onto the economic and real estate impacts of Brexit it should be noted that there will be extensive political consequences. It is likely that many of those consequences haven’t come onto people’s radar at this point; we certainly have all been living through a political soap opera the few weeks and months. One issue that did become apparent immediately was that the future of the UK itself is now up for debate. With the exception of London the rest of England, together with Wales voted to leave. However, the majority of the vote in both Northern Ireland and Scotland was to remain within the EU. Scotland only narrowly voted to remain in the UK in 2014. There is a real possibility that a second Scottish independence referendum will take place and at this point it looks extremely likely that the vote would this time be in favor of an independent Scotland and one that remains part of the EU. The issues in Northern Ireland are far more complex, but the disparity in the vote with the UK as a whole does raise many issues and especially the relationship with the Republic.
The immediate impact of the referendum was a shock on the markets, with Sterling falling to thirty year lows against currencies such as the Dollar. The UK equity markets also took a beating and whilst the FTSE 100 has subsequently recovered the more domestically focused mid-cap firms, proxied by the FTSE250 are still well down on their pre-referendum levels. It is anticipated that at least in the short term there will be a negative economic impact. If nothing else the uncertainty created by the result and the length of time negotiations with the EU and others will take, could lead to a postponement of investment decisions. However, as always there are also some positives. The weaker pound will provide some respite, at least in the short-run, for exporters. It should also be noted that this uncertainty will also impact the EU. As one of its largest members the exit of the UK will have a major impact upon the EU. Furthermore, it increases political risk, and especially that concerning possible further departures from the union. These factors can be seen that the Euro also fell significantly following the vote on June 23rd.
The longer-term economic impact is more debatable. The potential loss of access, if not totally then partially, to the EU single market will undoubtedly have negative impacts, however, there will be no doubt some positives alongside. For example, in the short-run exporting sectors will benefit due to the fall in Sterling. Generally, there will be quite different short-term versus long-term consequences as well differing responses across sectors. With respect to many issues there are numerous off-setting affects. Interest rates are a prime example in this regard. A lower pound may lead to inflationary pressure which on its own may suggest potential higher interest rates in the medium term. In addition, the negative impact on the UK’s credit rating will also push market rates higher. This has already been with either actual downgrades or negative outlooks issued by Moody’s, S&P and Fitch Ratings. However, it also needs to be considered how the Bank of England will respond. Given weaker economic fundamentals it may be that interest rates are actually reduced, at least in the short-run to provide a monetary stimulus. The recent statements by the Bank of England’s Chief Economist, Andy Haldane, would support such a view. Therefore, what happens to interest rates is going to depend on the combination of all of the above factors, plus many more. Generally however, the economic outlook does not look too healthy over the short-run. The uncertainty created by Brexit will, by itself, impact confidence in the UK economy. Whilst Brexit may not by itself lead to the UK entering recession over the next 18 months, it will increase the likelihood of that event and more generally reduce economic growth.
Commercial Real Estate
The big issue at the forefront of the debate in the commercial sector is what will happen to the City of London and the financial services sector. These concerns are centered on whether London based institutions will still receive what is referred to as “passporting” rights, allowing them access across the EU. Whilst it is by no means the main reason why firms base themselves in London it is an added advantage. The likelihood is that some banks may reduce their London operations, but in all likelihood this will be at the margins and most institutions will keep the vast majority of staff in London. The City is by far the largest financial center in Europe and that isn’t going to disappear overnight. It also has the advantage in that it can appeal to institutions via its light touch regulatory environment. This will no longer be constrained by EU wide policy, for example on bonuses. The big question mark is with those European institutions, such as BNP Paribas and Deutsche Bank, that have major London operations and if they will be tempted to repatriate large numbers of staff back to Paris and Frankfurt respectively. In the long-term a market that could benefit, depending on the outcome of various negotiations, is Edinburgh. In a scenario, which is not beyond the realms of possibility, where Scotland leaves the UK but remains in the EU, then financial institutions may move some operations north and join the strong fund management and insurance sectors already based in Scotland. Outside of the UK Dublin may also be another beneficiary of any outflow of the financial services sector from London. Given the differences in scale, even if there is outward movement from London it will not be that large from London’s perspective, however, the positive impact on cities the size of Edinburgh or Dublin could be substantial.
The provincial markets outside of London are probably those most vulnerable to both any adverse economic affect and in therefore from a property perspective. A number of markets are already seeing weaker letting conditions, which in turn will obviously impact the development sector. However, any reduction in new supply will obviously have a positive effect as it will mitigate any decline in occupational demand and therefore provide some protection for rental values. The fall in Sterling may have some short-term positives, and this may be especially seen in the industrial and warehouse sectors. However, this needs to be offset against the long-term outlook which is perhaps less positive. In general it will be a common refrain that there may be quite different impacts over the short versus the long term.
Retail Real Estate
Economic uncertainty is not coming at the best time for the retail sector which is already under pressure from a wide variety of issues, including the continued impact of non-store channels and new entrants together with reduced margins. Fashion retailers are in particular suffering and also, due to their reliance on imported products generally invoiced in Dollars, are most exposed to Brexit and the fall in Sterling. Longer-term any rise in inflation due to both a weaker pound and increased tariffs obviously would have a further negative impact. It is going to intriguing to see how consumers are going to respond. If there is a negative impact on consumer confidence and spending it is most likely to impact high value discretionary goods, meaning the likes of electrical, furniture and department stores may see the biggest impact.
From a property perspective the retail sector has had to depend in recent years on the growth in food and beverage to prop up the declining footfall observed. However, even before the referendum was announced many analysts felt that the growth rate in food related outlets was unsustainable. It may have got retail through the immediate aftermath of the financial crisis but it far less encouraging this time around. Overall, the UK retail sector was facing major long-term challenges. The realignment of UK retail was happening anyway. Brexit may merely speed up that process.
More generally though it will be interesting to examine how retail spending patterns do respond to Brexit. It will provide commentators with an indication of the economic sentiment in the UK population; indeed generally retail will be one of the key indicators of the health of post-Brexit Britain.
Residential Real Estate
Whilst there are without question medium and long term economic concerns the housing sector may actually do okay in the short-run. The fall in Sterling does benefit overseas buyers, who especially in markets such as London have been important players in recent years. The London market had been quieter this year anyway due to a combination of concerns over the level of prices, a lot of supply coming onto the market and economic uncertainty. However, early indications are that there are some short term buying opportunities. Whether this actually materializes and if it is sufficient to prop up a jittery market is still to be determined, but it is not a foregone conclusion that the London market will see major price falls. What however does not help is that we are entering the quiet summer months and very small changes in sentiment could have a major impact.
The positon outside of London is far less rosy. The share prices of home builders have been particularly affected in recent weeks. In a parallel with the financial crisis of a decade ago it may be that those markets that see the largest negative impact are the former industrial areas. A decade ago this was due to their preceding house price appreciation being less underpinned by strong fundamentals and more by credit and mortgage market conditions. In contrast, in London stronger demographic and economic fundamentals meant a largely flat 2007-2009 rather than any meaningful declines. The irony of course here is that those regions that voted to leave are those most exposed economically and therefore potentially will see the largest fall in house prices.
The Investment Market
As already noted the underlying fundamentals looking forward vary quite significantly across the main property sectors. However, that is only one side of the equation and just as important is how will investors respond and this has already been quite interesting. Irrespective of ones view about Brexit and the underlying economic impact, it is unquestionable that it has caused uncertainty. If there is one thing that investors, irrespective of asset class, hate it is uncertainty. This was evident even before the referendum with investment volume in UK real estate down for the first six months of the year. We’ve already seen a widening of the yield gap between real estate and government bond yields. This is in part due to the fall in bond yields; however some property sectors are also seeing a softening in yields due to increased risk premiums as well uncertainty concerning future changes in capital values and the exit values that can be achieved.
It has been argued that the fall in Sterling could mean that overseas investment increases. In the core commercial sectors we are looking at a market with potentially prolonged economic and financial uncertainty, weaker fundamentals in a number of sectors and not much upside on capital values coming from yield. Yes a combination of softer yields and a weaker currency may be leading to 15-20% reductions in values in foreign currency terms. However, it effectively becomes a pure currency play and it is going to take a brave investor to increase exposures purely on that, especially as these are unlikely to be short-run positons. Furthermore, it needs to be remembered that given the amount of foreign investors already in the UK, and especially in London and the South East of England, they will need to offset any current opportunities with the fact that their existing UK portfolio has, in their domestic currency, just taken a big hit.
We also don’t know at this point how overseas investors will continue to view the UK. The real estate sector especially that in London has frequently been seen as a safe haven. However, we’ve already have had two Singaporean banks send negative signals in this regard. United Overseas Bank suspended underwriting new loans on UK property, whilst DBS issued an advisory note to clients highlighting the increased sovereign, economic and currency risks present. Generally on financing there is always the concern that if a correction in pricing does occur this will have knock on effects not only on the willingness of institutions to lend but also on the value of existing collateral. This in turn has negative connotations for the banking sector. UK banks were one of the equity sectors most affected in the immediate aftermath, in part due to this potential exposure. This is especially relevant as in some case they have not yet fully dealt with all of the problems arising from the financial crisis a decade ago. However, this in itself makes the views of overseas lenders that much more important. It is estimated that in 2015 overseas lending accounted for 42% of the UK market.
Very shortly after the referendum we saw significant events taking place in the fund sector. Within a couple of weeks a number of open-ended vehicles (managed by Standard Life, Aviva, M&G Real Estate, Columbia, Threadneedle, Canada Life and Henderson Global Investors) announced that they were limiting the withdrawal of funds by investors due to a rise in redemption requests. In itself this is not necessarily a sign of weakness in the underlying real estate market; rather it is a function of open-ended funds in real estate. Such vehicles have always faced the risk of a redemption run. Given real estate’s illiquidity it has meant that they are more vulnerable than comparable funds in more liquid sectors such as equities and fixed income. In these cases institutions are able to liquidate assets in a timely manner in order to cover redemption requests. In total we’ve seen seven funds with assets in excess of £7bn suspend trading. Other fund managers have addressed the issue by discounting the value of the fund, for example TH Real Estate by 5% and Aberdeen Asset Management by 17%. This has effectively made making a redemption request sufficiently unattractive. It may however have negative consequences if the broader market takes this as evidence of falling values. There is some preliminary evidence that these reductions are being used for re-pricing deals. On the positive side the speed of the response overall probably means that we will avoid the scenario seen in 2007 and 2008 when funds were forced to dispose of assets to satisfy liquidity needs. This in turn helped contribute to the major fall seen in UK commercial values.
Despite this in some respects being a technical restriction it does raise concerns. Firstly, the degree of redemption requests was obviously of sufficient magnitude that fund managers felt they had to act and do so quickly. This in itself raises question marks over investor sentiment. Secondly, that negative sentiment may itself be made worse by the actions of the fund managers. It has, if nothing else, reminded investors of the liquidity risk present in real estate, especially with open-ended funds. But let us be honest, this should not come as a surprise to a sophisticated investor. Less than a decade on from the financial crisis, much of which was associated in some shape or form with real estate, investors don’t really have any excuse to not be aware that real estate is an illiquid asset class and that this brings certain types of risk to the table. Individuals realize housing is illiquid, why can’t professional investors recognize the same issues apply to commercial property.
A medium-term implication of the redemption issue is that it may further encourage a growing trend towards “Blended Portfolios”. There has been in recent years a move in the UK for funds to have an adequate amount of liquidity. There has therefore been an increase in funds combining both private real estate market assets with a higher than normal amount of liquid securities. In some cases these
are real estate related (e.g. REITs), in some cases cash or bonds. Some instances have been seen of pure replication portfolios. Blackrock, for example, launched an ETF that attempts to replicate the performance of the MSCI/IPD UK index purely with liquid securities. There has in recent weeks also been an increase in interest in funds using the real estate derivative market, in combination with short-term loan facilities, to provide the necessary liquidity.