Friday, 26 August 2016

An Economist and a Financier - a post-referendum analysis


Brexit: The Story So Far

It is now two months since the UK’s decision to leave the EU. Contrary to earlier fears, the sky has not fallen in and economic life goes on. However, these have been the traditionally quiet summer months so it is hard to say exactly what the impact on the market has been. Properties have traded, but some notable examples are not typical so we will have to wait until September and the end of the holiday period (and possibly beyond that) to get a fuller idea of the vote’s implications.  Given the summertime lull in investment activity, the occupier market and the state of the economy in general provide the best clues to the future.

Occupier Markets and the Economy

Leasing activity also has a traditional summer lull but the data we do have is mildly positive. London take-up increased in July from an admittedly depressed June level. Valuers have either kept rents flat or have cut them only marginally (especially in retail which does not appear to be Brexit related). As with pricing, however, valuers do not have that much post-referendum transactional evidence to go on.

Hard economic data released recently is quite good, but most of it refers to the pre-referendum period. The exceptions were the claimant count unemployment figures, where the July rate matched its June level, and retail sales, which had a bumper month in July. Worries that the Leave vote would usher in a round of job cuts, hiring and capex freezes, which would also depress consumer confidence, were overdone. So it’s been business as usual since the referendum, with the odd surprise on the upside.

Survey data has been more mixed. Like the financial markets, surveys initially reacted poorly to the Leave vote. Steep falls were recorded in both business and consumer confidence. Judging by retail sales data, weaker consumer confidence had little impact on spending behaviour. Recent surveys indicate a move back towards June levels. The end-August vintage of business surveys has yet to appear, but they will probably show some recovery from the July dip.

Despite recent benign economic news, it is simply far too early to tell if dire warnings over Brexit were heavily overdone. Article 50, which will kick off the leave exit process, will not now be served until 2017 at the earliest, maybe even later. So there will be a period of extended uncertainty, which could produce some weakening of rents as companies put off leasing decisions. The new UK Prime Minister, Teresa May, has said that “Brexit means Brexit” but in reality companies do not really know what it will entail –particularly with respect to the all-important ‘passporting rights’ and restrictions on the mobility of labour.

Companies can react to this kind of uncertainty in two ways. They can postpone decisions; or they can adopt a more business as usual approach until things become clear. There appears to be a lot of the latter going on.

However, the London property pipeline does definitely seem to have been affected by the referendum result. There is still plenty of development afoot, but there has been a shake out of the marginal riskier projects. The size of the pipeline and its impact on the supply-demand balance led to some hesitancy in the London investment market; in addition to prime Paris office yields falling below London levels (despite a far weaker growth of the occupier base in Paris). So depending on future occupier demand, rents in London could be higher in four or five years’ time than they would otherwise have been.

UK unemployment shows no signs of an increase

Capital Markets

Although worries about a sudden post referendum hit to the economy appear to have subsided, there is now greater uncertainty over future rental income. This in turn implies high yields and lower prices. It is very unclear how big this adjustment should be (but it is likely to be larger for secondary than prime markets). 

Potential buyers have not disappeared. There is still confidence in the UK market and exchange rate adjustments have made the UK more attractive, but investors are looking for a discount to reflect increased uncertainty. Most sellers, on the other hand, do not need to sell.

It will be September at least, and possibly Q4, before we will sense where prices might settle. The gap between buyers and sellers expectations might not be large. There is already evidence from the UK’s public real estate companies; share prices in UK REITs are currently down by eight per cent since 23 June with bigger falls from the London/value added/development focussed REIT; whilst there is minimal change for the more diversified and logistics focussed REITS.  Leverage by REITS makes it difficult to infer much about direct property from company valuations. REITS shares are only broadly indicative of the eventual impact on direct property pricing. Prices are also still up by over five per cent on their mid-February lows. In other words, the referendum was a negative shock but not as negative as earlier concerns about the world economy implied.

There are many other indicators of capital market behaviour. Some have improved since the referendum. Equity markets are up – and not just in the UK. This is partly because of lower expectations of interest rate rises; and partly because worries over China and emerging markets have abated for now. Long and short-term interest rates are down, as are corporate bond spreads. Remarkably, UK corporate bond yields are now lower than before the referendum.  This may reflect the anticipated impact of the new round of QE on corporate bond yields, but the corporate bond markets may also think we are in no more of a risky environment than we were pre-referendum.


Taking our favourite comparison of the yield on UK property (i.e. CBRE Average Prime Yield) and the real BBB corporate bond yield (i.e. nominal BBB bond rates less inflation expectations implicit in the gap between real and nominal 10-year gilts), the relative attractiveness of property has actually increased despite the fall in corporate bond yields. That makes property more attractive unless investors expect a recession that will more severely impede income from property than from corporate bonds. Despite the uncertainty over Brexit, there is no obvious reason why this should be the case.

Ongoing falls in yields for prime property in many European markets over the first half of the year also add to the relative value argument for UK property. There is still an abundance of capital globally which is looking for yield and a degree of security. This search was interrupted by global economic scares in H1 2016, but that has passed and yields are being driven down, especially for low risk or prime asset classes. This is not to say that there will be no price adjustment for UK property – but it might not be as big as at first feared.