UK markets have entered a four-month period of volatility after prime minister David Cameron fired the starting gun last Saturday on whether Britain should remain in the EU.
Whether the impending historic referendum – confirmed for June 23 – has lasting implications for UK commercial property asset prices, future occupancy demand and rental growth prospects, as well as funding costs, remains to be seen.
This is a dividing issue for companies, banks and investors as much as it is for politicians.
On one side we are told a Brexit would lead to a collapse in the value of the sterling relative to other major world currencies, which in turn would hurt imports and reduce GDP. In real estate, the London office market would be hit hardest, with a GDP slowdown hurting rental growth.
The counter argument is that a UK departure from the EU will be negligible to a modest net positive for GDP growth and job creation.
Experts are deriving opposite conclusion from stress testing the same variables. So which account is the more convincing?
The Macro Backdrop
Predictably, the early strain has been absorbed by the pound which has fallen to a seven-year low against the Dollar – to below the “psychologically important” $1.40 level in early trading this morning.
A bearish research note by investment bank HSBC predicts that Sterling could lose as much as 20% against the Dollar – sending the pound towards $1.10, which would be a 40-year low.
HSBC predicts further that up to 1.5 percentage points would be knocked off the GDP growth rate in 2017 – wiping out around two-thirds of the median GDP growth rate for next year, according to a comparison study of independent forecasts by the Treasury.
The HSBC research note says: “Our central case in the event of a vote for Brexit is that uncertainty grips the economy. This could take around 1.0-1.5 percentage points off the GDP growth rate by the second half of 2017. This would push our 2017 growth forecast, currently 2.3%, into the 0.8-1.3% range.
“And if sterling were to fall by around 15-20% (as our currency strategists predict), UK inflation could rise by up to 5 percentage points (our end-2017 inflation forecast is 1.8%). In the event of a vote for Brexit, concerns about deflation could swiftly give way to worries of stagflation.”
How could a Brexit affect UK commercial property?
Capital Economics, in a research paper commissioned by Woodford Investment Management, examined the impacts of a Brexit on the UK commercial property market.
Foremost, is the concern that a “Brexit could damage the City by forcing institutions to re-locate to the continent”.
Capital Economics suggests, in this scenario, vacancy rates would likely rise and the premium commanded by Central London office space could shrink.
The report concluded: “It seems likely that leaving the European Union would hit the health of the City and it is plausible that a number of overseas institutions would close or scale back their London operations, putting a dent in occupier demand.
“That drop in demand could come at an unfortunate point in the development cycle. Over the next few years, the office development pipeline in central London is likely to run ahead of recent rates of net absorption, with the bulk of that surplus space destined for the City. A sharp drop in demand could see vacancy rates spike higher and rental values start to fall.
“If that was to happen it is possible that investors might begin to reassess the price premium commanded by City office space. A rolling 5-year average of the difference between City office yields and the yields for regional office markets shows that this premium has been growing steadily over the past 20 years – it has more than doubled over that period.
“If investors felt that the City had been permanently damaged by the United Kingdom’s departure from the European Union, a jump of between 50 and 100 basis points in City office yields, knocking 8 to 15% off capital values, would not seem implausible.”
An up to 15% fall in the City of London’s capital values is a meaningful price correction and one that could arguably affect future overseas capital flows. After all, by value, overseas buyers have accounted for roughly half of all transactions in the British commercial property market over the past few years.
We should expect a raft of negative sentiment survey’s released in the coming days, and weeks imploring that a Brexit would affect sentiment in UK commercial property negatively.
However, indeed, this is an argument which Capital Economics is not persuaded by. “If we are right that overall foreign direct investment flows will hold up rather better than is sometimes suggested, there is little reason why those same factors would not continue to support the demand for British property.
“After all, most purchases of commercial property in the United Kingdom by overseas buyers are for investment rather than for operational purposes.”
There is no consensus yet as to what scale of the “demand shock” for the UK property market and indeed whether it would be a sentiment-led short term blip or a structural change. In short, no one yet knows.
Moreover, Capital Economics argues that financial services firms have not been the key driver of central London office take-up in recent years, even in the City.
“It is therefore quite possible that occupier demand has been held back in recent quarters by a shortage of suitable space. If that is the case then, even if demand from financial services firms was to fall, increased demand from other sectors could help to mitigate the overall impact on vacancy rates and rents.”
It is argued that leaving the European Union would damage property markets and the macro-economy, resulting in lower consumption.
Based on Capital Economics’ analysis, on balance, the independent macro research firm concludes it remains “sceptical of the more extreme claims made about the costs and benefits of Brexit for the British economy”.
They conclude: “It is plausible that Brexit could have a modest negative impact on growth and job creation. However it is slightly more plausible that the net impact would be modestly positive.”
Neil Woodford, founder of Woodford Investment Management, the equity fund management house which commissioned the Capital Economics research, said the significance of the vote lay in politics rather than economics.
“I think it’s really hard to see any significant credibility in an argument to stay or to leave that’s constructed around economics. I think it’s a nil sum game frankly, whether we stay or whether we leave. If we stay or leave the fundamentals of the economy will be relatively unmoved.”
At the very least, this period of short term volatility, which has seen markets price in a Brexit into the value of the pound, UK commercial property looks set to be artficially lower for not-Sterling demoninated investors.
But then markets have been operating somewhat artifically for years now, due to interest rates and Quantitaive Easing and government bailouts. Perhaps it is just another short term layer of complexity which could lead to a rebound post referendum.