The vote to the leave the EU was a surprise to many: the general public, commentators, bookmakers – as well as the broader capital markets.
The UK’s property market cycle was at a more advance stage than the rest of Europe.
Property investment volumes had been slowing – down nearly 15 percent quarter-on-quarter and 40 percent per annum in the year to June 2016. But good levels of liquidity still existed and deal flow was still 15 percent above the long term average.
In the immediate post referendum period, UK REITs pricing shifted between 20 percent and 40 percent discounts to NAV, UK property funds targeting retail investors saw suspensions and the IPD Monthly Index saw 2.3 percent wiped off in July.
However, since then, a more mixed picture for the UK economy and thus property market has emerged. We saw retail sales surge in July, but consumer confidence survey data deteriorate and the Nationwide House Price Index was up in August, yet Bank of England mortgage approvals and RICS housing market survey data fell. Nonetheless, the Bank of England felt it necessary to cut base rates and recommence asset purchases.
But I wonder if the biggest monthly swing back in the manufacturing PMI in its near 25 year history in late August might mean their decision would have been different? There is little doubt UK property is worth less today than in June. However, for now, the outlook for core commercial real estate pricing remains stable. This is mainly because there is much reduced leverage in the UK, thus little prospect of a leap in distressed sellers; lower interest rates for even longer than previously expected; paltry yield and significant reinvestment risk into other assets classes; and a still low sterling that will attract overseas investors. While we face a protracted period of uncertainty in the country, all of the above limits the downside for core UK property.
Don’t get me wrong, risk aversion towards UK property assets has increased with the referendum result. Basically, a more sluggish UK economy than previously anticipated means headwinds in occupational markets are likely and active management opportunities, inherent in value-add opportunities, can become more challenging – we may well see further capital erosion in these types of assets. The long term ‘mega trends’ are also driving location concentration favouring core over sub-optimal locations.
The most immediate and obvious concern is the City of London and access to the single market – loss of ‘passporting’ rights and/or ability to trade Euro financial products outside of the zone. While cities such as Amsterdam, Berlin, Dublin, Frankfurt could take business at the margin, probably only Paris can rival London for scale and people/skills.
The standout winner, on the other hand, is probably private property debt, although UK interest rates have fallen, lending margins have increased 25 to 50 basis points, but the total cost of debt remains broadly the same to the borrower. Higher debt margins, secured on the right assets to reliable long term borrowers, is never a bad thing for institutional capital managers like us.
Bigger picture, we are only anticipating limited market re-pricing in the UK, perhaps 10-15 percent off average quality product. Core stock should remain stable. Regardless, some of the most risk averse capital flows previously bound for the London, will divert to the major capital cities across the mainland: Paris, the Big German five and Amsterdam. Rental upside in Madrid might tempt those looking for a little more return.
But the key issue here is, providing economic activity in the UK isn’t derailed, then it will be business as usual across the continent and, at the core end, assets will remain competitive. As the Eurozone economies recover, occupier markets will pick up.
The upshot? Value-add strategies look increasingly attractive in numerous markets across Europe. In contrast, where value-add was swinging back into focus in the UK in recent times – this strategy will likely be delayed. For the UK, the required return for value-add deals in the UK has now increased – anything is ‘doable’ at the right price. If we are wrong, and a significant re-pricing does happen, then I’d advocate overweighting the country. Fundamentally, the attractions of UK property assets haven’t changed. At the moment, the data and the forecasts don’t suggest that a significant UK correction is a likely scenario for core assets, but for value-add asset we may see further capital deflation which should represent an interesting opportunity for investors.
Investment markets don’t like uncertainty, and we are under no illusion that the UK market will enter a prolonged period of that. But those anticipating securing prime assets at knock-down prices will be disappointed.