July 15, 2016
The UK’s decision to leave the European Union following the referendum has not surprisingly resulted in a period of uncertainty and hesitancy. While the appointment of a new Prime Minister is, the first step on the road to clarity the direction of travel is only likely to become clear after many months. Even then, a further period of uncertainty will result as discussions with the European Community continue on the exact terms of the UK’s exit from the EU.
There seems to be a consensus locally that the ideal result would be continued access to the free market but with controlled migration. Such a position is however diametrically opposed to the beliefs of the remaining EU members and some hard negotiation and compromises will therefore be required to find an acceptable solution.
The uncertainty in the UK is likely to cause a reduction in GDP with forecasts now varying between 1% and 2% per annum growth this year and next (Source: Bloomberg). The significant devaluation in sterling will act as a boost to the export markets but will be painful for those goods imported resulting in inflation pressures over time. In the near term however there is likely to be more monetary policy easing through a combination of interest rate cuts, additional quantitative easing and potentially lower corporate taxes which will help drive economic activity. In time, and assuming a satisfactory trade deal with the EU, our biggest export market, it is expected to lead to a more buoyant less regulated market, and this will ultimately lead to a tightening of economic policy and improvements in sterling. However this is all some way off and there will no doubt be many twists and turns on the way.
The Brexit vote and the uncertain outlook has taken its toll on parts of the market with banks, financial service groups, house builders and REITS all being penalised through their share prices. The real estate markets were already slowing prior to the vote as investors considered the relative yield levels and the prospects for future rental growth. As a result, transaction volumes for the year were already well down on the levels seen previously.
In the private unlisted funds world the general nervousness has manifested itself in those property funds aimed primarily at retail investors which offer daily liquidity. Today we estimate that they represent around 5-10% of the total UK market by value. In an effort to get ahead of possible valuation weaknesses, many of the investors in these funds have submitted redemption notices. Learning their lessons from the last financial crisis and in order to treat all customers fairly, managers have when confronted with sizeable redemptions instituted a gating mechanism and moved to weekly fund valuations to ensure that departing investors are not overly compensated when values are falling. While the papers have tried to make much of these actions, by implying a further financial crisis, it is actually sound management in dealing with the issues of offering daily liquidity with a relatively illiquid asset class.
The immediate hysteria surrounding these funds will pass, indeed Aberdeen announced yesterday that their fund has now reopened although departing investors are likely to see value reductions of around 17% as a disincentive to withdraw.
In order to achieve this liquidity, funds such as Aberdeen will have to sell assets. They will be forced sellers but early indications do not suggest a fire sale. As the markets calm, we expect the yield aspect of property investment to reassert itself and in general, activity to hold up, albeit that we would expect, over time, to see commercial values reduce by around 10-15% with long income leased assets holding up much better as investors adopt a cautious approach. Banks similarly are likely to adopt a more restrained position on lending with more demanding covenants and slightly higher margins generally. That said with interest and swap rates under downward pressure, finance still looks cheap and will be very accretive for the right asset. Unlike the last crisis, leverage is much more restrained today so broken finance structures will be rare.
We do however expect to see some interesting opportunities particularly in Central London. Financial service groups including banks are exposed to the potential loss of access to the single market and there are already mutterings that a number of jobs, particularly in banking, will be moved to other EU countries. However, it is important to point out that since 2010 only 5.5% of Central London take up has been done by banks (Source Savills) so the sirens of doom maybe a little premature.
One interesting point also highlighted by Savills in their recent London commentary relates to the issues of “passporting” of financial services from London to the EU. They highlight the anticipated implementation of MIFID2 in 2018. MIFID2 is a G20 agreement not solely an EU one and will apply to all financial services, other than retail banking, across the G20. Savills suggest, that if this is adopted then the UK as a G20 member will retain its ‘passporting’ and that will allow most broking, trading and commercial property lending businesses to remain in London and sell into the EU and the rest of the G20.
What ever pans out London is an international city and regardless of Brexit will remain so. Many occupiers and investors come here not just for the access to the EU but for its diversity, transparency, rule of law and for tax paying corporates, relatively low taxes. Those attractions remain in place and London, although likely to be buffeted near term, will remain an area for long term investment and wealth preservation.
The Opportunity We Are Considering
Central London – Some investors will take fright at the current position the UK finds itself in and will sell or sit on the side lines. This will result in both price weakness and a less congested marketplace and may present investment opportunities. When coupled with a meaningful sterling depreciation, the next few months are likely to offer some opportunities at sensible pricing.
Regional Cities – We retain our previous investment thesis of focussing on these areas. The continued migration of people from the suburbs to the cities, which are better served by improving infrastructure, will continue. We still favour mixed use developments in these localities or buying good quality assets let on long leases.
UK Residential – Despite the stock market punishing house builders, we take the view that there remains a fundamental undersupply of housing which when coupled with a naturally growing population, regardless of migration, will continue to offer pricing tension over the longer term. The larger house builders may pause to assess the market and their existing land banks but in time, we expect them to resume buying and indeed the Government will likely demand that they do so to keep up economic activity. This pause should present an opportunity to acquire sites, particularly brownfield land and obtain revised planning for residential. We expect to see a much less congested market place for these types of opportunities over the next few months and as a result, some real value opportunities.
The current uncertainties will present opportunities for investors and from a Palmer Capital perspective, this is likely to present a much more interesting investment playing field than a few weeks ago. So don’t be frightened by the doom and gloom reporting, the UK remains one of the strongest and best performing of the major economies amongst the G20 countries, with the UK market forecasted to grow above trend for the next few years. Now is a great time to be seeking investment opportunities in the UK with uncertainty often a prerequisite for outperformance.