Real estate assets focusing on non-financial sector tenants & located outside London will provide further protection
The British public has voted to leave the EU in a historic referendum that has taken place last Thursday 23 June. The general consensus leading up to the vote was an expectation of a narrow ‘Remain’ victory which has been priced in to stock, bond, and currency markets. Therefore, the media and market response to the official results was immediate and turbulent, especially in terms of the speculation on the GBP (which, as of Friday 1st of July 2016, the closing of the first week after the announcement, is down around 12% against USD) and on the nature of the future economic and trade relationship between the UK and the EU.
The subsequent stage in the implementation of the leave process involves a vote to be taken by the UK Parliament to formally initiate its exit from the EU. Following this vote and providing it is passed, the British Government will send an EU withdrawal notification or ‘EU termination letter’ to the European Council. This effectively activates Article 50 of the Lisbon Treaty to set in motion the formal legal process of withdrawing from the EU, giving the UK two years to negotiate its withdrawal. Extending matters further is David Cameron’s comments that he will step down as PM in October and that this responsibility will be assumed by the next PM, elected from Cameron’s Conservative Party. On the other hand, European leaders have called for Cameron to start the process immediately.
That said, despite the negative political and financial reactions to the historic vote and speculation in global capital markets, policies and legislations associating the UK as a member of the EU will not change immediately. After the agreement and execution of the EU termination letter, the UK will need to repeal, amend, or retain thousands of pieces EU derived legislation, including trade and labor agreements, where the current estimate for the completion of this process can take up to ten years. Therefore, until further insight and clarifications are provided and the uncertainty ultimately recedes, markets will continue to be volatile and most likely expressed by investors through their holdings of GBP, London-listed equities, and Gilts (UK government bonds).
In light of the political and financial risks, the Bank of England (BoE) is expected to respond quickly and prudently to provide sufficient liquidity to avoid any funding stresses, especially with the experience of the 2008 Global Financial Crisis still present in their collective memory. The magnitude and volatility of the GBP’s fall will likely dictate further responses. An interest rate cut of 25 basis points has become a strong possibility at the Monetary Policy Committee’s July meeting, or earlier if required. Moreover, a return of quantitative easing could be on the table, depending on the decrease in the levels of public and private investment. This has been a useful monetary policy tool in the past and is expected to restore confidence in investors across all asset classes, if the need arises.
Inevitably, the BoE will have to improve sentiment towards the GBP to avoid a protracted depreciation of the currency leading to an overshoot of the BoE’s 2% annual inflation target. That said, the re-emergence of inflation, resulting from the Sterling’s devaluation, could influence investors towards growth assets by next year. In addition, the combination of the exchange rate effect as well as the lower asset prices as a result of the Brexit concerns could attract overseas investors to acquire real estate and other physical assets in the UK due to its untarnished position as a G7 economy with a track record of achieving strong economic growth.
Evidently, the primary risk to the UK economy is that of a macroeconomic recession. Given the high level of uncertainty as to the direction of this process and the vast amount of discussions that are required to take place, many questions still remain. From a macro perspective, adverse terms of trade for the UK could impact its economic growth as its access to its major export markets is reduced or made more costly. In a Goldman Sachs report evaluating the potential economic impacts of the UK referendum, an estimate of the rise in macro uncertainty associated with a Leave decision would reduce UK real GDP by 1-2% over the next 12-18 months, leaving the UK close to experiencing a recession. Expectations of inflation in the long-term could also lead to a reduction in consumer and corporate spending, further adding to the economic challenges that could arise. That said, the structural UK economic strengths remain in place and financial capital regulations imposed after the Global Financial Crisis should prevent a prolonged slow-down in the UK economy.
Nasser Alkhaled, the head of Global’s Real Estate Asset Management unit commented on the implications o this event on the property market in the UK saying “as the volatility in the capital markets due to the Brexit result ebbs and flows, the commercial property market remains as fundamentally sound as it is before the vote. Existing within reasonable expectation, some deals will be kept on hold, while others will be cancelled altogether as real estate investors come to grips with the uncertainty over future economic conditions in the UK, as well as the reconsideration of occupiers of the amount of space required outside of the EU. Moreover, not all property sectors will be equally affected, as some are more exposed than others.” He referred to a study conducted by HM Treasury indicates that the sectors most at risk include financial services, professional services, and technology. That said, however, the impact on these sectors could only be measured once further clarity is achieved relative to the ultimate association between the UK and the EU. He added: “Once the initial correction has occurred, a depreciated GBP and falling property values could be a very attractive buy sign for overseas investors. This would also lead to a widening yield gap as real estate yields rise and bond rates fall from further monetary easing measures employed by the Bank of England.”
Over the longer term, the impact of Brexit on the EU as a whole could be more profound than that on the UK independently. The UK has been one of the most economically stable (along with Germany) constituents in the EU, and as a G7 economy, its exclusion from the EU could dilute the EU’s impact on the global scale. The Brexit result could potentially lead to a second Scottish referendum to decide whether to remain or leave as a member of the UK. This scenario is unlikely at this time due to perceived Scottish government budgetary constraints as a result of the economy’s exposure to oil prices and its recent descent.
Furthermore, the Brexit process has created the concept of an “a la carte” Europe, meaning that member states now believe they have the leverage to remain or leave the EU on their own terms; a sentiment that has been negated by major European leaders. Key issues that require to be addressed by the EU to prevent this argument from gaining momentum include fiscal integration and the free movement of people. Crucial subsequent events in Italy and France include Italy’s referendum on constitutional reform in October, and France’s National Front has positioned themselves in a strong position before the country’s presidential elections in April and May 2017. The leader of the National Front, Ms. Marine Le Pen, has called for a French referendum on its EU membership, raising the anticipation of a “Frexit”, as the Brexit uncertainty dissipates.
On the implications this event has on foreign investors, Alkhaled commented: ”for investor domiciled in countries with currencies pegged (or closely linked) to the USD, currency fluctuation and volatility would have the most significant direct and immediate impact. Investments made in the UK property during the past 12 months would have witnessed an unrealized FX loss ranging between 6% and 15%.” He added that “for Investors whose strategy of investing in UK property, with rich yields, sustainable long dated income from financially robust tenants have paid off. Furthermore, real estate assets focusing on non-financial sector tenants and located outside London will provide further protection from the brunt of defection by financial institutions to the EU and any cuts in interest rates will enhance the cash income.”
Further GBP weakness and volatility could reasonably be expected as the events unfold and further clarity and certainty becomes observable. Over the medium term and as a result of the measures taken by the BoE, the GBP should be expected to stabilize as investors and observers are currently at peak pessimism. Coupled with the political nature of the campaign, this could lead to further weakening in the GBP that is not fundamentally rational. Moreover, economic and financial uncertainty in global markets could delay the US Federal Reserve’s decision to increase interest rates before next year. Such a decision is supportive of GBP strength and of investor holdings exposed to the value of the Sterling. The low interest rate environment which the UK and Europe will sustain should provide further stimulus to the respective property markets.
On the way forward Alkhaled concluded: “We urge investors to remain cautious for the coming 3 months and observe the markets as political matters unfold and as a new support level for the GBP is established. We believe that the low interest rate environment and a weaker GBP, combined, will soon present an attractive buying opportunity. Moreover, the vote will likely result in increased demand for long term income, which will serve to add floor to any yield expansion; particularly in light of the wider arbitrage created by lower swap rates.”
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