Brexit and UK Real Estate

There has been substantial speculation of the far-reaching implications of the UK referendum vote to exit the European Union, otherwise known as Brexit. The British public voted for Brexit in June 2016, and the UK Government triggered the official EU exit process in March 2017 by invoking Article 50.

The exit process will involve a two-year period of negotiation and implementation of the exit. Unwinding four decades of membership of the EU, and all the adopted laws & regulations, is a mammoth task. There is talk of hard & soft exits, the former being a clear cut of ties with the EU with potential for costly trade tariffs, and the latter still being a cut from the EU but attempting to keep free trade in place while taking back full control of border & immigration policy.

With a two-year process to the actual exit, but an almost three-year window from the referendum to exit, this creates a very long period of uncertainty as to the final terms of the exit, and the knock-on ramifications. Markets hate uncertainty and the real estate market is no exception.

London Exodus

London is the European Financial Capital. Every financial institution involved in international business has some sort of presence here, be it a representative office, to a European Headquarters. Once Brexit is in place, the UK will be a completely separate jurisdiction to the EU and will be by consequence a much smaller market than the EU. In order to transact within the EU jurisdiction all these same institutions will have to have an EU presence. For the most part, all large institutions already have this covered with multiple EU office locations already in place. What is perhaps more significant is that key management and trading offices will likely exit London for Frankfurt, Dublin, Luxembourg, and elsewhere.

Frankfurt is already the second largest financial hub in the EU, after London. They are also home to the ECB (European Central Bank). They have their eyes firmly set on becoming the financial hub powerhouse that London currently is. Dublin is another city vying for London financier refugees. Dublin has the advantage of being in the same time zone, the same language, and a very similar legal system. There is also the intangible factor of heritage and culture.

German authorities have so far been contacted by hundreds of banks regarding opening or expanding their presence in Frankfurt. Thus far, Morgan Stanley, Goldman Sachs, Standard Chartered, Daiwa, Sumitomo Mitsui, Nomura, VTB, and Woori Bank, are all expanding in Frankfurt due to Brexit.

London has a financial services workforce of 750,000 approx. These are not positions that will disappear overnight, nor will a substantial institutional London presence diminish, however there will undoubtedly be some impact felt. Bruegel, a Brussels based economic think-tank, has estimated that 30,000 jobs could be lost in London because of relocating offices and positions.

Office Market Implications

There are positive impacts to the cities benefiting from any influx of banking offices. Frankfurt has seen 5.6mil square feet of office space leased in 2016, an increase of 34% over the prior year, and an increase in rents of 4.2%. Meanwhile London leased 10.1mil square feet in 2016, a drop of 14% over the prior year, and landlords have introduced more free-rent periods and other incentives to attract tenants. London still has a vacancy rate of 4.2% versus 9.1% for Frankfurt. This is comforting for a London landlord, but it also offers plenty of expansion opportunities for tenants eyeing Frankfurt.

On the supply side, London developers delivered 3.9mil square feet of new office space in the six months to March 31st, the highest delivery since 2004. There were 28 new construction projects started in this same period, expecting to deliver a further 3.2mil square feet. This above average delivery of new office space is expected to continue for another 5-years, resulting in levels not seen since the early 1990's. Most of this new development is speculative, that is, proceeding without guaranteed tenants in place. The potential weakening of demand for office space due to Brexit, compounded with an oversupply of new space, could have detrimental effects on rent rates, occupancy, and values.

Real Estate Investors

Already, UK offices sold in 2016 were traded at an 18% discount over 2015 prices, compared to a 7.5% discount over all real estate classes. Additionally, the volume of transactions decreased by a whopping 43% in 2016. This could be the result of the uncertainty present, and investors taking a "wait and see" approach, not necessarily a deterioration in the underlying fundamentals. The market slowdown could also just be cyclical. Since the 2008 financial crisis, London has benefited from pent up demand for quality real estate investments producing safe yield. This demand has increased property valuations substantially to a point where yield has been compressed and investors are searching for higher returns elsewhere.

Chinese investors have found the recent uncertainty and volatility to be an attractive entry point. Typically favoring the US market, the Chinese have begun to focus on London and are taking advantage of the recent significant currency swing post-Brexit. While the office Cap Rates (yield) have been compressed in London, to an average of 4.2%, in contrast they are 2.6% in Hong Kong.

Publicly listed Real Estate Companies, and REIT's (Real Estate Investment Trusts), appear to be taking a cautious outlook on the situation. Some of these entities have significantly reduced the LTV's (Loan To Value) on their portfolios. For example, Great Portland Estates PLC have the lowest LTV in the sector at 11%, down from 45% in 2008. Land Securities PLC, the UK's largest landlord, now has an LTV of 23%, down from 50% in 2008. Keeping a low LTV enables these entities to weather any extreme volatility in Capital Markets, and it also sets them up to take advantage of buying opportunities should there be a significant drop in market pricing.

The sooner the British Government negotiate the terms of their EU exit, the better for all markets. In the meantime, cautious institutional money seems to be sitting on the sidelines, while speculative investors take a punt!