UK Commercial Property – post-referendum thoughts

Investment Notes

The Brexit vote of 23 June 2016 has prompted some investors to seek to reduce allocations to UK commercial real estate. Since then, the share prices of listed property companies such as British Land and Land Securities have fallen around 10%, and dealing in some property funds has been temporarily suspended; the managers have made this move so they are not forced to dispose of properties at fire-sale prices to meet increased redemption requests. This note sets out our thoughts on the current situation, and restates why we believe it is appropriate for clients to continue to invest in UK real estate.

There are some valid reasons why the referendum result has challenged confidence in UK commercial property, but there are also several positives. It is likely the UK economy will be adversely affected by Brexit, which could reduce companies’ requirements for office, retail and industrial space; this could in turn restrain rental growth and lead to lower returns from UK property than had previously been expected. In addition, the London office market, which is an important element of many property portfolios, could be particularly tested by Brexit; some financial and other institutions may move staff from the capital to countries that will remain in the EU, so they can continue to operate efficiently in the single market.

Other moves in the financial markets since the vote are likely to be positive for property in due course. Sterling has declined by around 10% relative to the US dollar and the euro, and therefore the UK becomes a lower cost destination for tourists, which should support the retail and hotel sectors. It will also reduce the cost of UK properties for international investors in their own currencies; the UK property investment market has always attracted strong interest from overseas due to its attractive yields and lease structures. In addition, the decline in gilt yields should support the income attractions of property; the IPD UK property index yielded 4.4% at the end of June 2016, a premium of 3.7% relative to gilts, which is close to the all-time high of 4.1%.

Managers of property funds have reacted to the increase in redemptions in one of two ways. Most have temporarily suspended dealing in their funds so that they are not forced to dispose of properties at distressed levels; they have taken the view this would be against the interests of long term investors, and would not meet their regulatory obligation to “Treat Customers Fairly”. A minority of funds have taken a different stance. They have asked their valuers to re-price their portfolios to a level at which they could dispose of properties in today’s market and then keep their funds open for daily dealing. Whether open or closed, most funds are now valuing their portfolios on a weekly, rather than their usual monthly basis, so that transactions in the marketplace are promptly reflected in unit prices; funds will continue to distribute income to investors.

There are signs that the bearish sentiment towards the sector is easing; the share prices of property companies listed on the stock market have been rising for two weeks and buildings are being bought and sold again. As investors become more comfortable with their assessment of the UK economy, we would expect activity in the real estate sector to rise, giving everyone more confidence in the pricing of and prospects for property funds. Meanwhile, many appear to have forgotten that several property funds have changed their corporate structure to become Property Authorised Investment Funds (PAIFs) in recent months; this change removes the 20% tax charge on rental income, which was imposed in their previous structure, and this may enhance investors’ returns from property.

We have been recommending that clients have an allocation to UK commercial property for two main reasons. First, we believe that property should continue to deliver competitive returns over the long term; over the last 20 years the IPD UK property index has returned 2.2% p.a. more than the UK stock market, as measured by the FTSE All-Share index. Secondly, we believe that investing in property improves the diversification of portfolios; during the stock market setbacks of August 2015 and February 2016, real estate was a resilient asset class. It is likely that the property fund market is going to take a few more months to settle down, but we continue to believe that commercial real estate is an attractive asset class for long-term UK investors.

To discuss this note, or any other matter (we are preparing to send a note on other asset classes), please contact Nick Fletcher on 020 3696 6801, or any member of the London Wall Partners investment team on 020 3696 6805.

 

 

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