A general election campaign was underway as the participants met for PERE’s annual UK roundtable, but it was an indication of how widely the result is considered a foregone conclusion that it did not even merit a mention in the discussion.
With a victory for the ruling Conservative administration all but certain, the vote that really matters for UK real estate took place last June. Britain’s decision to leave the European Union has cast a shadow over the market for almost a year, even if the unexpected result has, so far, been less calamitous than many feared.
Instead, some indicators point to a market nearing, if not already at, its peak. It may be that Chinese investor CC Land’s purchase in March of the City of London skyscraper known as the ‘Cheesegrater’ at an eye-watering price comes to be regarded as marking the high point of this cycle in the same way the sale of HSBC Tower at Canary Wharf in 2007 was emblematic of the last.
The combination of high cap rates and Brexit-induced uncertainty has led many UK investors to take a cautious stance over the last year. “Risk-off” soon became established as the theme of a discussion that featured representatives from four managers that focus mainly on core and core-plus investments: Michael Neal, head of UK investment TH Real Estate; Andrew Angeli, head of UK strategy and research at CBRE Global Investors; David Diemer, head of UK institutional funds for Aviva Investors; and Tim Sankey, a fund manager at Aberdeen Asset Management. Joining them was David Ryland, partner in charge of corporate real estate in Europe at law firm Paul Hastings.
From the start there is a consensus among the roundtablers that the UK real estate market is near its cyclical peak. “We are aware that we are late cycle and we are in a de-risking strategy,” says Angeli. “We can definitely anticipate a lower-growth outlook, although probably not recessionary. Couple that with very toppy rents in parts of the London market in particular, then all the cranes I saw on my walk over here today worry me.”
Sankey agrees: “We have felt the markets have been expensive on an absolute long-term basis for a good couple of years now. From a retail fund perspective that period has been relatively easy because investors have been taking money out so we haven’t had to reinvest. In the earlier part of that period, it was easier to sell risk and buying more defensive stock was less competitive. Since the referendum, more investors are thinking about risk-off and defensive strategies. We have fewer investors buying our risk except for the private equity money, which is less competitive due to the higher cost of capital. The market for defensive strategies has become much more crowded.”
In a market where many investors are adopting a cautious stance there are plenty of buyers for assets with defensive characteristics, but deploying capital and driving returns is much more difficult, argues Diemer. “Finding liquidity for core real estate is relatively straightforward, but if you have to reinvest that, covering the round-trip costs and finding something that will outperform is very tough and requires expert insight.”
That makes life particularly challenging for private equity investors looking for higher returns. “Broadly speaking private equity is quite frustrated over getting access to stock,” says Neal. “There is a lack of distress and very few areas where you can go fishing for genuine value-add. There is a temptation for some of the value-add plays to end up as nothing more than quite leveraged income strategies.”
Ryland adds: “Private equity investors are generally more focused on continental Europe than the UK at the moment, partly because it is seen as earlier in the cycle. Their return requirements have made them less competitive for certain types of deals and this is compounded by the fact that a number of the funds have similar business plans. Some managers have mature funds, which they are in the process of realizing, and also new funds that they need to invest at the same time, and this can create its own complications. However, a number of the new funds have pretty long investment periods so they are not under significant pressure to invest.”
Push and pull factors
In spite of the high cost of UK real estate, capital markets remain supportive of the market. That is principally because of their desire for diversification, argues Sankey. “Everything is expensive, but the value of investing in property is the diversification,” he says. “If you look at property returns there is no correlation with REITs and no correlation with fixed income. The performance outlook in the next few years for property may not be great, but it does give investors somewhere different to put a chunk of their money and I think that is a very compelling case.”
“There are many different pots of capital with different return requirements chasing real estate investments,” adds Ryland. “Some have long hold periods and are potentially less concerned about where we are in the cycle at the moment. There is significant interest in alternative asset classes such as healthcare and private rented sector housing, which is a reflection of the increasing emphasis on income, demographic trends and diversification from assets that are not correlated with the general economy.
Pricing has clearly benefited from the distortion caused by quantitative easing.”
Meanwhile, investors that were overweight in real estate have been selling, but because other asset classes are also pricey, they have generally done so without lowering their preferred long-term allocation levels to the sector, says Sankey. “They recognize they’ve been on a good ride for three years and have now reduced their exposure by returning to neutral property positions. They are risk-off.” Asian investors have been the most bullish buyers of UK property, particularly in central London. “Last year they accounted for 85 percent of the value of deals in that market,” says Diemer.
The sharp decline in the value of sterling in the wake of the EU referendum has encouraged foreign buyers to fill the gap left by risk-off local investors. “UK institutional investment in central London offices in the first quarter of 2017 was at a historic low,” says Angeli. “Fortunately, there are various push and factors compelling overseas investors to the London office market, with a currency angle often being cited. The question is: how long does this last, especially if Brexit becomes something more than it currently is?”
The attendees are reluctant to criticize Chinese investors for overpaying, however. “It is a relative game in a globalized market,” says Neal. “In Hong Kong you might be buying locally at sub-3 percent so the Cheesegrater at 3.5 percent with a currency play could present good value in terms a long-term hold of a core trophy asset. The cost of capital from different sources and views on currency distort the market in ways that were never the case in previous cycles. The changed interest rate environment is the root cause of where we stand today.”
Following the EU referendum, some retail fund managers in the real estate sector, including Aberdeen Asset Management, were forced into selling assets to meet redemptions. The market recovered sooner than most observers expected, however.
Sankey says: “Values held up better than expected. Between referendum day and the end of the year in broad terms asset values were not that different. There was a market for the assets that were sold. We found investors wanting to come into the market pretty quickly and so did the other open-ended funds. Price discovery didn’t take that long and values held up.”
Angeli interjects: “We are coming to accept that Brexit is not the biggest threat to the UK economy. It is going to be exogenous, whether it is adapting to higher inflation, adapting to a geopolitical event or the fading ‘Trumpflation’ trade. The US is very much later in its cycle than the UK and Europe. A slowdown there will have a knock-on effect here. So far, Brexit is a political construct that hasn’t really influenced business decisions, but it definitely will. Over the past couple of weeks, we have seen some of the big banks begin to voice their concerns.”
Ryland says it is difficult to know whether the banks’ more recent comments are part of their lobbying process. “There will certainly be more focus on the issues as we get nearer the date and this may increase the sense of uncertainty because people are likely to adopt polarized positions as part of the negotiations,” he says. “People mention [World Trade Organization] terms as a backstop, but it is not just about tariffs, it is also about compliance of goods and services.”
None of the participants can name a major occupier deal that has fallen out of bed as a direct result of Brexit, but Diemer observes that tenants are still reluctant to make long-term commitments. “Whilst we are getting them to stay in their existing space, sometimes on a short-term basis, getting corporates to move and make a big investment is much more difficult. So far though we haven’t seen a big impact on headline rents,” he says.
Depth of demand
If occupier markets begin to turn, either as a result of Brexit or other economic factors then that is the greatest threat to continued investor demand for UK real estate, argues Sankey. “When overseas investors start seeing those numbers change is that when caution starts coming in? We had concerns about the economy before the referendum. In terms of GDP growth this cycle peaked in mid-2014 and had been slowing. Inflation was creeping up and so was household debt. We are still heavily reliant on consumer spending, so what is the impact on GDP of a rate rise at some point in the future?”
Neal says TH Real Estate has continued to lease space at a “fairly rapid” rate. “We have seen incentives move in the tenants’ favor, but, if you have a good quality building, and you are sensible about pricing, you can do deals. On the retail side there is some nervousness, but I think that is more structural than Brexit-related.”
Sankey and Diemer acknowledge that in some office markets incentives have increased, but have seen headline rents hold up well. Meanwhile, in the UK industrial sector, the attendees agree that occupier demand remains robust, which has caused yields to harden. “Industrial deals are transacting at sub-5 percent. We have entered a space where it now behaves more like retail, low yielding with a perspective for real rental growth,” says Angeli.
Retail presents a mixed picture. “It is a very polarized market,” says Neal. “For good quality prime shopping centers we are seeing significant rental growth for the right-sized unit and pitch. You get a depth of demand for those types of assets and the fundamentals are really strong. Convenience retail is also desirable in some areas, but because of structural change there are too many shops, particularly in the regions.”
While the UK market continues to be dominated by London, Ryland says some of his clients see value in some of the regions: “They are further behind in the cycle than London and there has been less development so there is more potential for rental growth. That has been reinforced by devolution initiatives including the combined authorities and the powers of the new mayors, as well as the relocation of government offices into regional cities such as Bristol.”
Britain’s split with the EU might also provide regional markets with a relative boost, suggests Angeli: “If you believe that Brexit will disproportionately impact financial services in London then maybe the regions look a bit defensive. They are more nationally orientated.”
All four of the fund managers say they are willing to invest in the regions, although some have a shorter list of target cities than others.
“The annuity-type capital that we manage is completely agnostic about locations, it is about the security of the income stream. For our core funds we are not completely focused on the south-east, but we are very particular about the geographies in which we will invest,” says Diemer.
Despite of the political tumult of the past year for much of the UK economy and property market business has continued as usual. “You sort of instinctively feel the market shouldn’t be quite as robust as it is,” says Ryland. “And yet it is.”
Instead of causing an earthquake, the Brexit vote has prompted merely a brief tremor so far. Investors in UK real estate will hope that the other uncertainties encroaching on the market too will fade, as the country’s greatest poet might put it, “leaving not a rack behind.”