The UK’s decision to leave the European Union is not likely to result in an adjustment in commercial real estate (CRE) values akin to that of 2007-2009. Although we expect a slowdown in the UK economy and, consequently, a downward adjustment in CRE values, we think the risks to UK CRE are manageable. Moreover, we expect these conditions will create very interesting opportunities for private credit investors.
Hard evidence that CRE values have changed is yet to emerge. Assets securing loans in our portfolios, particularly smaller assets (less than GBP 20 million) outside London, are selling above or around pre-referendum valuations. In our experience, smaller assets will regularly find a bid from domestic buyers, while prices in London, particularly with respect to prime properties, are likely to be more volatile due to that market’s dependence on non-domestic capital.
We think the story is more about rental income than yield. The yield on CRE relative to government bonds is very attractive, particularly in a lower-for-longer interest rate environment. However, the uncertainty which will hang over the UK until the terms of its exit from the EU are known will cause many tenants to take a wait-and-see approach to investments, including leasing new space. Anecdotal evidence from agents shows post-referendum mandates to procure new space for tenants have been slow to materialise.
The pipeline of speculative developments, i.e., new construction of buildings which are not pre-let, is not alarming, but it will have an effect on rents and vacancy. The table below illustrates the potential impact of speculative developments on the London City and West End markets. This analysis assumes zero net absorption in the next two and a half years. While not disastrous for Central London offices, this suggests rents will reduce from current levels, placing downward pressure on values.
(Square feet in millions unless otherwise stated)
Regional UK cities have experienced much lower levels of speculative development as rental growth has been slower to unfold in those markets and debt financing for construction projects has been more difficult to obtain than in London. With the possible exception of Birmingham, major regional UK cities have relatively limited speculative development pipelines and/or relatively low vacancy rates.
Concern that open-ended funds will flood the market is probably overblown. Several market participants argue that the managers of open-ended real estate funds will resist selling properties at a loss but we think this is unrealistic. These funds promised liquidity, and to resist providing that could certainly have a negative impact on the ability of these managers to raise capital in the future. The more likely scenario is that open-ended funds carefully manage any liquidation of assets over a period of time and, in future, maintain higher levels of liquidity. The impact on real estate values in that scenario is likely to be limited.
One prime office building in London was sold by an open-end fund at a substantial discount to pre-referendum pricing. The short timeframe in which the seller required the buyer to complete the transaction, a matter of days, invited a discount. We are encouraged that there were at least three buyers able to fund the transaction within the required time period, none of which required debt financing.
In addition, leverage is lower in this cycle which should limit distressed sales. Research produced by De Montfort University shows loan-to-value (LTV) ratios are now in the low to mid-60s, far below LTVs of 80% and above common before 2007. New regulation and other factors have caused banks to constrain new lending both in terms of quantum and risk.
A review of the real estate exposure of Lloyds Banking Group and Royal Bank of Scotland reiterates this point. Both institutions actively worked to reduce their respective exposure to commercial real estate over the last several years. In short, UK banks are in a much better position to withstand a major CRE market correction than they were in 2007. As a result, lender induced sales will be limited.
Constrained bank lending since the financial crisis has created an opening for alternative lenders to exploit. Banks have taken an even more guarded approach post-referendum. This is not surprising given the intensive scrutiny applied by regulators to bank CRE lending activities.
While direct property investors suffer from a fall in values, private credit investors can thrive. Indeed, we are now seeing increasingly appealing direct lending opportunities which offer attractive returns and account for the market expectations described above.
In our view, a decline in CRE values of 10-15% is likely, driven primarily by weaker tenant demand and rising vacancy rates.
We think this decline will be limited for several reasons.
In summary, the post-referendum CRE landscape differs substantially from 2007-2009. Although we expect the combination of weak tenant demand and new supply of un-let space, particularly in London, to lead to a decline in market rents and values, this will not be nearly to the same degree as the market experienced between 2007 and 2009. In our view, the risks to UK CRE presented by the expected slowdown in the economy are perceptible but manageable. Moreover, we expect these conditions will create opportunities for private credit investors to flourish.