Downward revision of UK economic growth expectations
Markets are trying to digest the political and economic ramifications of the surprise result of the UK referendum on EU membership. The vote to leave was arguably one of the UK’s most important political decisions of the past 60 years, and will have deep and profound political and economic implications. The negative impact on equity markets and sterling was immediate, as was the change in the UK’s political leadership. Markets remain volatile given the uncertainty over the potential timing and terms of a managed UK exit from the European Union. Downward revisions to UK output have been swift and severe, building on financial market turbulence witnessed early in 2016, and softer global growth. Stagnant output in H2 2016, and the expectations of just 1.1% growth in 2017, are a significant departure from earlier estimates; a theme set to linger to 2020. Business investment, which had faltered prior to the referendum, looks set to remain weak as firms await some clarity on the UK’s future trading relationship with the EU. Access to the single market is a key requisite for UK financial services, so the unclear road map for Brexitwill act as a notable drag on corporate confidence and employment. Combined with a bout of weak sterling-induced inflation, and continued government fiscal tightening, household expenditure, which has been the engine of UK growth, looks set to be squeezed near term. The pound’s depreciation may boost export growth, but less so if European output slows from some degree of political contagion. The Monetary Policy Committee (MPC) has been vocal post-Brexit, and has promised to ‘look through’ temporary higher inflation, and provide further monetary support if deemed necessary. This is a material shift in market expectations, but indicative of continued ultra loose monetary policy being deployed across the world’s major Central Banks, and reflects the acceptance of a lower growth and inflation backdrop. With a return of a ‘risk off’ investor mantra, UK 10-year government bond yields and five-year swaps have achieved new record lows. As such, the case for real assets, and essential quality real estate, should not diminish materially in what remains an income-starved investment climate.
European markets should not be affected by Brexit
The surprise UK decision to exit the European Union sent political shock waves through Europe. What impact Brexitwill have on the European economy remains to be seen, but falls in stock markets, and especially bank shares, coupled with heightened political uncertainty, are likely to dampen European output expectations somewhat. Second quarter slowing confidence was sufficient to shift German output to 1.4% pre-Brexit, from an initial guide of 1.7% -and sets the tone for the Eurozone, whereby business and consumer expectations have been moving sideways. Talk of political contagion in Europe, with impending elections in Italy, Netherlands, France and Germany, are most likely overdone. Despite the EU’s challenges, anti-EU sentiment on the scale seen in the UK over the past two decades, is not present in other European countries. Furthermore, widening bond spreads between northern and southern Europe, emerging in the aftermath of the UK referendum, have since receded, with the European Central Bank (ECB) continuing their policy of unconditional support, aided by the lack of inflationary pressures. European bond yields have continued to contract, with long and short duration bonds now at record lows and, remarkably, in negative territory. As such, whilst growth might be slightly weaker than expected pre-Brexit, the relative pricing argument remains compelling across Europe.
UK market correction amidst occupier and investment uncertainty
H1 2016 recorded a marked slowdown in investment and occupier demand, linked to economic and political uncertainties and concerns relating to historically keen real estate pricing. Changes to real estate taxation in the Chancellor’s March budget, which eroded 1% of capital values, also dampened investor activity given the higher all-in transaction costs. Brexitand the associated volatility in financial markets, slump in business confidence, and heightened liquidity needs, has magnified property market pricing uncertainty. The immediate sell-off of UK REITs and the subsequent suspension of a number of open-ended property investment funds, under pressure from growing redemptions, has led to a significant change in valuation assumptions for H2 2016. Although this is not envisaged to be as damaging as the listed sector, pricing will suffer. Deciphering what is a liquidity-driven sale and managed asset disposal is pivotal in forming a market forecast, as any market correction will not be uniform, differing in magnitude, timing and meaning for all sectors and markets. This is not 2008, and whilst there will be some short-term market volatility, much lower leverage and the number of well-capitalised domestic and overseas buyers of UK property, aided by sterling's weakness, should provide a floor for valuations. Notable downward revisions to economic growth and market confidence will have detrimental consequences on property investment flows, occupier demand and ultimately pricing –but by how much is greatly debated. However, real estate still offers very favourable yields compared to other asset classes, and thus strong defensive income assets are likely to outperform. The IPD initial yield of 5%, as of Q2 2016, still offers a premium against a UK 10-year bond yield of 0.9%, whilst five-year swaps have fallen to 0.6%.
Occupier markets: Three-speed Europe
European real estate investment volumes edged up in Q2 2016, although this is more a reflection of a precipitous decline in the first quarter. Rolling annual volumes were nevertheless lower for a second consecutive quarter, suggesting the market peaked in 2015. Despite economic unease, prime property yields remain either stable or under downward pressure across the EU-27, reflecting even lower sovereign bond yields. Attention should now focus on the occupier outlook, which pre-Brexithad been in recovery mode. Effects on occupiers will vary across regions and across sectors, but the most likely scenario is marginally slower growth. A three-speed Europe is emerging. Core European markets (Germany, France, Sweden and Austria) will see their advanced recovery continue, potentially at a more modest pace. The second-speed countries are the southern recovery markets of Spain, Portugal and Italy, which are at a point in the cycle where real rental growth is starting to pick up. The largest risk here is currently the Italian banking system.
The third-speed is the UK market, with a short-term, bleak economic outlook. Take-up and investment volumes, as witnessed in H1 2016, have been slowing and will stay restricted whilst EU negotiations take place. Paris, Frankfurt, Dublin, Luxembourg, Stockholm and Berlin have been touted as potentially absorbing some UK Brexit-related company relocations, and could profit in the medium to long term. Presently, however, occupiers are adopting a ‘wait-and-see’ approach, with any significant occupier decisions relating to the UK being postponed until uncertainties about the future of legal operating environments are more clear.
Headwinds, but market speculation to create opportunities in the UK
At this historic juncture, it is difficult to quantify near-term UK real estate performance.There is little real evidence to date to confirm a valuation adjustment, but market uncertainty will reflect an added risk-premium for perceived riskier assets in non-core locations, Scotland and Central London offices -a sector prone to greater pricing volatility and where investors are deliberating the City’s financial clout within or outside the single market. Whilst we appreciate that the EU referendum has raised the possibility of a second future Scottish UK referendum, it is believed to be remote given the economic uncertainty linked to oil’s re-pricing and unanswered questions surrounding both currency and monetary policy powers. In contrast to the broad market that is likely to undergo a pricing correction in H2 2016, prime, defensive assets may benefit from increased investor interest, especially from overseas investors benefitting from sterling’s weakness, in what is likely to prove an even lower global growth, inflation and bond yield environment. As such, given the number and fire-power of real estate investors reviewing the UK market, it is difficult to gauge the window of opportunity created by Brexit. Investment sentiment will depend on how far or swift prices adjust, and the economic context. Investors can take comfort from the knowledge that the UK is an innovative, open and flexible economy; but an unwillingness by domestic and overseas businesses to make long-term capital commitments to the UK will have a detrimental impact on occupier demand. One can assume lending terms, whether for non-core assets or development, will become more stringent, but overall investor insecurities should fade as headlines around retail fund suspensions quieten and valuations stabilise.
Market inertia across Europe expected –medium and long-term outlook unchanged
In the case that we do see an economic slowdown, we will likely see a return to more defensive, quality assets and a heightened risk premium to certain markets and assets. Capital flows into European real estate in H1 2016 were uniformly lower across all markets and sectors, a product of heightened risk aversion, but also due to a lack of supply in the market. There will be some short-term market volatility until there is greater market clarity, and one can expect a period of market inertia, both from an investor and occupiers’ perspective. It is clear that political and economic reform will remain high on the EU agenda, but one should also remember that Europe is not one homogenous region, and it includes many economies, diversified by strength, maturity, foundations and demographics, at a national, regional and city level. Long-term investors in European real estate need to understand the megatrends that are shaping the industry. Investors should not be overly-focused on real estate market cycles, which could mask the long-term erosion of value in locations that become negatively impacted by demographic trends, technology or environmental changes. Far better to seek selective exposure to those locations and assets that will emerge as winners through structural advancements.