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With Brexit uncertainty hitting the economy and good value difficult to come by, it is time for UK real estate investors to implement defensive strategies, writes Tom Goodwin.*
The UK economy continues to suffer from the uncertainty surrounding the “Brexit” negotiations. On August 3, Mark Carney, Governor of the Bank of England (BoE), said a lack of clarity about the eventual shape of the UK’s economic relationship with the European Union, “weighs on the decisions of businesses and households and pulls down on both demand and supply growth.”¹
Household spending growth slowed to 0.1 % in the three months ending June, the slowest rate of quarterly growth for three years, according to the Office for National Statistics. And business investment has stagnated since the EU referendum in June 2016. The BoE’s Monetary Policy Committee now expects investment in the UK economy to be 20 percentage points lower in 2020 than it had forecast before the vote.
Yet valuations of real estate assets in many parts of the country have not adjusted to reflect this uncertain macroeconomic backdrop, and much of the market consequently looks overpriced (see chart). We expect to see pricing soften over the next 18 months, and are forecasting modest total returns of 4.5% per annum on UK real estate between 2017 and 2021. The marginal returns of moving up the risk curve, to take on leasing risk or invest in development projects, for example, are becoming increasingly squeezed.
The outcome of the Brexit negotiations should become clearer during 2018. Any sign that the trading relationship between the UK and the EU will be materially weakened is likely to impact real estate pricing, especially in London offices, as uninhibited access to the EU single market is critical for the city’s financial services sector.
For now, it makes sense to implement defensive strategies; including focusing on income returns, reducing credit risk and selling assets where appropriate. In the absence of attractive acquisition opportunities, investors should build up cash and be ready to deploy it when the market turns and a better entry point emerges.
So when will the market turn? It is difficult to say, but there are certain indicators real estate investors should keep an eye on. Foreign institutions – particularly those from China – have provided strong support for London’s property market in recent years and investors should be alert to any sign of a slowdown or reversal in capital flows.
Recently a major Chinese conglomerate dropped plans to buy a 10-acre plot in Nine Elms Square in London for £470 million in late August as a result of pressure from Beijing to curtail its foreign acquisitions. A second Chinese buyer stepped in at the last minute, but such withdrawals may be a sign of things to come. 2
If London property has been buoyed by overseas capital, real estate markets in the rest of the UK have been skewed by the activity of another class of investor. Local government authorities have accounted for more than £700 million (US$905 million**) of property transactions in the UK year to date.3 These entities have been purchasing assets in markets where there are few other buyers, often higher up the risk curve, and in a number of instances they have been particularly aggressive bidders. If the UK government clamps down on such acquisitions by restricting access to the cheap finance on which they have been based, the impact on assets in some parts of the UK real estate market could be severe, especially secondary shopping centers given the existing structural weaknesses in the retail sector.
Rising bond yields
Real estate investors should also monitor developments in fixed income markets. Perhaps the principal risk to UK property is the prospect of higher bond yields, which would affect the relative attractiveness of real estate for those investors whose yield-seeking activity has held up the market in recent years.
The risk of a sharp correction in bond yields remains low, but it is possible that growth and inflation in the US, coupled with the rate hikes that the Federal Reserve has long been trailing, may drag Gilt yields higher. In this scenario, we would expect cyclical growth assets to outperform, while low-yielding sectors such as retail real estate in central London would look particularly expensive and likely suffer capital outflows.
Opportunities in regional offices and industrials
For investors focused on income, property pricing currently remains attractive on a relative value basis; the property yield spread over fixed income still looks considerably more attractive than it has historically. Total return investors face a greater challenge, with much of the market appearing overpriced – but there are still pockets of opportunity in some regions, particularly in markets where the demand/supply balance remains favorable, such as Cambridge and Manchester.
Manchester offers perhaps the best prospects in the short term: fundamentals look positive thanks to a constrained development pipeline, which is supporting rental growth. Strong investor demand has put pressure on pricing in recent months, but expert investors should be able to source and structure transactions to create attractive opportunities.
Parts of the industrial sector continue to offer healthy returns, but intense investor demand is a concern, and the sector is not immune from the pressures facing the UK consumer; high inflation continues to drag on real wage growth this year. A slowdown in the consumer economy could hamper the growth in online shopping and hit retailer demand for logistics facilities.Share of the UK real-estate market that looks attractively priced
* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").
** Based on currency exchange rates as of August 31, 2017.
 To carry out this analysis we calculated hurdle rates (required returns) for the UK market for the beginning of each year from 2001 to 2017. By comparing the hurdle rate at the start of
the year with the total return over the subsequent five years, we developed an over/under pricing estimate for each year.
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