The impact of Brexit on real estate
6 July 2016
The days following the EU referendum have seen a vacuum in UK politics, both in the government and the official opposition. This is likely to continue until agreement has been reached on what type of relationship the UK wants to negotiate with its European neighbours and other trading partners.
It is also possible that there will be a new referendum on Scottish independence and neither a snap general election, nor a second EU referendum can be ruled out. The situation is likely to remain fairly fluid at least until the end of the summer.
If the next prime minister does invoke Article 50 to take the UK out of the EU, then it seems likely that London with its specialisation in international financial and business services will suffer a drop in occupier demand.
There are rumours that investment banks will re-locate certain operations such as trading in euro denominated securities to the eurozone and it is possible that some asset managers and insurers will follow suit, in order to be certain that they continue to comply with EU regulations.
At present, no non-EU country has full passporting rights to sell financial services across the single market. Furthermore, if financial service companies start to switch operations away from London, then it is inevitable that the lawyers and other consultants who work for them will follow.
However, even though some jobs are likely to be re-located, London will continue to be Europe’s leading financial centre. It is worth noting that London currently employs as many people in banking, insurance, law and accountancy as Frankfurt, Milan and Paris combined.
The issue for tech companies based in London is not so much access to the single market (the main focus of EU regulation has been data privacy), but the freedom to recruit IT staff from anywhere in the EU. London has become a magnet for European IT staff over the past decade and a lot of tech entrepreneurs have moved to London to tap into this deep pool of labour. The risk is that in future they will be deterred by the bureaucracy of obtaining visas and decide to set up in Berlin, Dublin or elsewhere.
By comparison, demand for office and industrial space outside London should be more resilient, because businesses there tend to be more focused on the domestic economy.
However, this is a generalisation and there is clearly a risk that towns and cities which are a base for multi-national manufacturers exporting to the EU will go into decline over the long term, as new investment is re-directed to factories inside the single market.
In addition, it is possible that the demand for office and industrial space outside London will drop temporarily, as businesses hesitate and postpone decisions until there is greater clarity about the outlook for the economy.
While in theory retail could also be relatively defensive, because people carry on shopping even in recessions, in practice we think this is unlikely for two reasons.
First, the current political uncertainty is likely to dent consumer confidence and households may decide to save more and delay purchases of big ticket items such as electricals and furniture.
Second, we believe that the retail sector is still struggling to adjust to the rapid growth in on-line sales and the recent failures of Austin Reed and BHS will add to the stock of empty shops and put downward pressure on town centre rents.
Central London is the one part of the retail market which could buck the trend, because the sudden sharp depreciation of sterling could attract more tourists.
One concern though, is that there is currently a lot of new retail space under construction at Battersea, King’s Cross and Westfield White City and that could impact on rents.
Turning to the investment market, it is possible that the drop in sterling will attract more foreign investors, given that UK commercial real estate is now 8-10% cheaper in dollar and euro terms than it was before the EU referendum.
Furthermore, the vote to leave means that it is now very unlikely that the Bank of England will raise interest rates in the next 18 months, even though the fall in sterling will temporarily push up inflation.
However, it is worth noting that foreign investors already own around £125 billion of UK commercial real estate, equal to a quarter of the total and that in common with domestic investors, their appetite is heavily influenced by prospects for the UK economy and for rents.
For example, purchases by foreign investors halved between 2007 and 2009, in line with the wider market, despite a 20% depreciation in sterling. While we cannot be certain, we think it more likely that both domestic and foreign investors will sit on their hands in the short-term and that there will be a significant drop in transactions until the dust settles.
In light of all these moving parts it is impossible to be precise about the outlook for total returns on UK commercial real estate.
In all likelihood office rents in central London will fall over the next 1-2 years as companies switch some of their operations to EU countries and attempt to sub-let the surplus space.
The City and Docklands are probably most exposed given that financial services account for between 40-50% of office space in both sub-markets. Rental growth in other sectors will probably pause, as businesses put off signing leases.
In addition, it seems likely that real estate yields will rise as investors downgrade their expectations for future rental growth and shift their attention to other countries with less political risk.
Tracking prices and estimating values over the next few quarters is likely to be complicated by a lack of transactions. While it is too early at this stage to say how far capital values will fall, we know two things.
First, the UK and in particular, the London investment market is very transparent and prices tend to adjust and find a new equilibrium fairly quickly.
Second, the market is better placed now to withstand a shock than in 2007, given the low level of vacancy in most office and industrial markets, the large premium in yields over 10 year gilts and the fact that most recent purchases have been funded by equity rather than debt, so that there should be relatively few distressed sellers.
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