Real estate will be illiquid during negotiations on terms of UK withdrawal says Aviva

29th June 2016

The hit to UK real estate sentiment sparked by the UK’s vote to leave the EU may be limited by easier monetary policy, says Chris Urwin, head of global research at Aviva Investors.

A majority of UK voters, 52 per cent, voted to leave the EU on 23 June with profound consequences for the UK real estate market.

While uncertainty caused by the poll has had little effect on domestic real estate pricing this year, investment activity has slowed. This hasn’t been exclusively caused by referendum fears; it largely reflects greater investor caution as the market reaches the top of the cycle.

Nevertheless, the vote to leave suggests there is now little hope of any bounce in sentiment. Indeed, it may be many years until we have clarity on the UK’s constitutional arrangements and trading agreements.

Market reaction

The financial markets’ reaction to the vote to leave the EU has been swift and dramatic. For instance, sterling fell to its lowest against the US dollar in over 30 years and 10-year gilt yields reached a record low. And, as equities plunged, real estate shares were particularly badly hit.

The sell-off is being driven by:

  • Mounting fears of an economic shock. In the short term, uncertainty as to the UK’s constitutional arrangements and trading agreements will dampen activity and may trigger a recession by the end of 2016. In the longer term, the economy is likely to be impaired by reduced access to European markets and poorer demographics (weakening the UK’s fiscal position and potentially damaging productivity growth).
  • Heightened political risk. The prime minister has already resigned. Whoever takes his place, it is questionable whether the rather divided Conservative party can govern effectively. In the near term, political paralysis is likely. In the longer term, more populist policies look likely.
  • The UK’s worsening creditworthiness. However, more expansive monetary policy from the Bank of England is on the cards.

What happens next?

Negotiations for exit do not start immediately. For that to happen, the UK needs to inform the European Council of its intention to invoke Article 50 of the Treaty of the European Union.

However, the government may choose to start negotiations before triggering Article 50: once invoked, negotiations are limited to two years unless there is unanimous agreement of the European Council to extend them.

So there is going to be a prolonged period of time during which the terms of our withdrawal from the bloc are unknown. It could take even longer for clarity on the UK’s terms of our trade with trading partners around the world.

Furthermore, calls for a second referendum on an independent Scotland will grow. Implications for the rest of EU are unclear, but a weaker UK economy would be another headwind for an already fragile economy, while the success of the leave campaign may encourage nationalistic tendencies across the continent. Risk aversion has descended on government bond markets with ten year German bund yields falling into negative territory in the wake of the vote, while ‘peripheral’ European bond yields jumped.

Implications for UK real estate

Domestic capital values now look likely to decline moderately over the remainder of the year. It is worth noting, however, that some commentators believe Brexit will hit real estate returns, and the economy, more severely. By contrast, we had expected to see a slight increase in capital values over coming months had the UK voted for the status quo.

We expect to see:

  • Prolonged illiquidity in real estate markets pending renegotiation of international agreements. Transaction activity to be low.
  • Heightened risk aversion reflecting lower growth expectations and political risk. To compensate, some widening in yields is probable. Secondary assets are likely to be hit even more.
  • Sterling depreciation to support demand from overseas investors. This needs to be balanced against the UK real estate market’s diminished ‘safe haven’ status.
  • Additional caution in Scotland resulting from pressure for a further independence referendum.
  • UK occupier markets to be affected significantly less than investment markets. In the short term, a rapid deterioration in the labour market is not expected. Demand for space is not set to fall rapidly.
  • If the weakness of sterling is maintained, UK retailers could be hit, particularly those operating on low margins. On the other hand, it may boost prospects for markets dependent on tourist spending, like prime central London.
  • Central London offices (specifically in the City) are particularly exposed to leave risk. Some activities currently undertaken in central London, such as euro-denominated wholesale banking, are under threat. But London remains a leading global centre for a broad range of activities, many of which would be relatively unaffected. It continues to benefit from a low corporate tax rate, a diverse talent pool and relatively low regulation.
  • Looser monetary policy is likely to support pricing. The pricing of UK real estate relative to government bond yields was attractive before the fall in bond yields. With spreads relatively wide, the asset class is likely to continue to appeal to domestic income seekers.

Clearly, the referendum result will weaken UK real estate prospects, both in the short and medium term. However, the deterioration may be limited somewhat by easier monetary policy. And, if interest rates remain even lower for even longer, high-quality real estate assets may benefit from their safe haven status. Remember that in times of heightened uncertainty such as this, attractive investment opportunities will arise.

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