UK commercial property – A post-referendum update

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Background

Just over three weeks after the UK voted to leave the EU, the impact on the financial markets, economy and political landscape is becoming a little clearer.

The FTSE 100 is up 5%, the FTSE 250 is down -3% and real estate equities (measured by FTSE EPRA/NAREIT UK) are down -12%.  In the direct market, only a limited number of transactions have happened since the vote, so it’s too early to draw strong conclusions.

So how does one make sense of what’s going on? In my opinion there are three things you should be aware of when thinking about commercial property, all highly relevant in today’s environment:-

• Liquidity of the asset class
• The impact of supply and demand – in both the occupier and investment markets
• Asset backed income

I will cover each in turn:-  

Liquidity

As anyone who has bought or sold a home before will know, it takes a long time. At best, from start to finish the process could easily take a month or two.  Commercial property is no exception.

I have believed for many years that, due to it being an illiquid asset class, commercial real estate is best managed in closed-ended structures, like Investment Companies. In the short term, this might mean greater volatility in terms of the share price, relative to an open-ended equivalent, but there is no mismatch between the liquidity of underlying asset and the structure. In addition, they allow assets with relatively high trading costs, (stamp duty, legal fees etc.) to be owned and managed with a medium-term outlook.

The relatively slow movement of prices in the direct market creates a natural arbitrage between the pricing of the closed vs open-ended sectors and it’s perfectly logical to try to exit at yesterday’s price in one structure and buy into another at tomorrow’s discounted price. This mismatch is further exaggerated if property equities are providing the short term liquidity in open-ended structures as a cash proxy.

It does feel like the real estate open-ended sector has scored somewhat of an ‘own goal’. The negative sentiment towards the sector as a result of many open-ended funds halting redemptions and/or dramatically lowering pricing has undoubtedly weakened confidence in the market.

We are where we are however, so we can’t go back and it’s likely that in the coming months there will be selling from these funds to ensure liquidity, which leads nicely on to supply and demand.

Supply & Demand - Investment markets

The CBRE monthly index to 30 June just released, showed capital growth across the market of 0.13%: still positive, but weaker than the 0.24% recorded in May.

Landmark deals to have concluded after 23 June include the £400 million Oxford Street sale at a sub 3% yield, which doesn’t appear to reflect a mark-down in pricing. But then, this is a trophy asset and the vendor was not managing redemptions.

We know some transactions have fallen away because of the outcome, others have happened and some have been renegotiated.  In simple terms, it is just too early to see the real impact, but again it’s not unrealistic to expect a correction in pricing in the coming months against a backdrop of greater uncertainty and as we see additional selling from open-ended funds.

This may have an impact on the valuation of standing investments. The definition of valuation is “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion”.

I wonder, with daily liquidity and a sales process that usually takes 2 months from start to finish, the FCA now publicly involved, and wider brand reputations to think about - if those transactions truly reflect the above definition.  As ever, valuers are going to have to interpret this evidence as it arises.

More positively, gilt yields have fallen and a weakening of sterling has made acquisitions in the UK cheaper for overseas investors. Much will depend on the direction of travel in the occupier markets.

Supply & Demand - Occupier markets

It would be unrealistic to assume, with more uncertainty on the horizon in the next 24 months, that this won’t have any impact on the occupier markets. 

There will be some businesses that will want to adopt a wait-and-see approach, but in our own direct experience, both in the run up to and after the EU referendum, occupiers have been relatively relaxed about the impact of Brexit. Clearly, different occupiers and different regions might be affected to a greater or lesser extent, but as we see it, and from a UK-wide perspective, the occupier markets are taking this in their stride.

Our own feedback, having spoken with many occupiers both pre and post-referendum is that they have a business to run today and cannot defer business decisions for two years until the outcome is fully known.

We have seen very few occupiers put transactions on hold and for the most part it’s broadly business as usual. This is a good sign. Combined with relatively low supply of good quality floor space, a low development pipeline and rental levels in many markets still below where they were 10 years ago, choices for occupiers are limited and we don’t think this is likely to charge in the short term.

Asset backed income

In a world of ‘lower for longer’, 5% plus income, which is asset backed, is still in my view attractive. As I have said before, supply of good quality space is relatively limited in many markets and outside London pricing remains close to the cost of construction.

By way of example, at the start of the year we acquired a modern high quality office building in Manchester for close to its development cost (8 years ago). With a diversified income stream yielding close to 8% and rental levels that do not support economically viable construction, we see this as having strong defensive characteristics.

Conclusion

The direct market is likely to go through a period of repricing over the next few months, not helped by liquidity issues in the open-ended fund sector. Listed markets have already repriced and on the whole reflect a discount to spot NAVs.

Bank lending is much more conservative, occupier markets are robust and capital values on average are still at levels 20% less than their 2007 peak. In markets outside of London, the discount remains much, much wider.

With falling bond yields and a strong demand for income, we believe the sector will be more resilient than the media headlines might appear. That’s not to say there might be some bumps along the way.

For the reasons explained above, we do not think this is a repeat of 2008.