The UK Economy Could Hinge On Whether Real Estate Investors Take Fright After Brexit
It didn’t garner much attention, but in a speech to Parliament the Bank of England’s Alex Brazier made a quietly remarkable statement: A major plank of the UK economy has become reliant on the commercial real estate sector.
Last year, 60% of all foreign capital that came into the UK was investment into commercial property and leveraged loans, much higher than the long-term average, the Bank’s executive director for financial stability strategy and risk told MPs.
“We are reliant, as I think the governor said a few years ago, on the kindness of strangers,” Brazier said.
A reliance on the willingness of those strangers to buy UK offices, shops and blocks of flats, he could have added.
Why is this important? The UK runs the highest current account deficit in the G7, meaning the value of what we import is greater than what we export. Quarter on quarter the deficit is widening.
Big current account deficits are generally seen as unsustainable, as governments have to borrow to make up the shortfall or cut expenditure. That can cause currencies to fall if currency investors think government borrowing will rise, or cause investors to pull their money out of a country because they think its economy does not look healthy in the medium to long term.
With fewer firms investing in research and jobs in the UK, commercial property is one of the few areas still drawing significant international investment. So if international real estate investors decide that they would rather put their money elsewhere after Brexit, it would be bad not just for the property sector, but for the entire UK. If they decided to sell assets and take money out of the country, it would be drastic.
“It’s not difficult to imagine a number of things both external and internal that could change that risk appetite,” Brazier said.
With a little more than a month to go before the UK is (right now) supposed to leave the European Union, how does that appetite look? The answer can best be described as fragile. The pace of investment into London and the UK slowed last year, particularly in the fourth quarter, and 2019 has got off to a slow start, with uncertainty having reached fever pitch about whether the UK will leave the EU without a deal on a future relationship. Investors and lenders are under no pressure to put money into London, and want to know whether a deal materialises, and what happens to the UK if it doesn’t.
The nature of who is buying here has changed: Institutional investors are becoming increasingly absent, but wealthy individuals from across the world remain keen to invest, in spite of the uncertainty, brought to London and the UK by the fact that prices have dropped in the past three years and look favourable in comparison to other global cities.
“The question investors are asking is, is this just a blip, or is this a secular change in the way Britain is perceived and operates in the world,” Brockton Capital co-Managing Partner David Marks said.
Brockton manages several UK opportunity funds and last year set up a joint venture with Israeli investor Alony Hetz to buy lower risk assets in the Greater London area.
“I’ve never been in an environment where there are so many potentially binary outcomes.”
Marks outlined how events like the closure of Honda’s manufacturing plant in Swindon have a long-term detrimental effect that feeds through to commercial property, which can prove difficult if not impossible to counter.
“The thing about something like Honda closing its Swindon plant, is that this manufacturing plant is never coming back. This is not Credit Suisse moving 75 jobs to Dublin, and then when the clouds lift they move them back again. That is never coming back. And that has a huge impact on consumer spending and every aspect of the economy in the local area as a result of the corollary devastation to the auto supply chains, too.”
Investment in the UK was £56B in 2018, about 18% down on 2017, according to Real Capital Analytics. In the fourth quarter that drop was even more pronounced, with the £13B invested a 43% fall compared to the previous year.
London was more resilient, with the £27.6B invested a slight uptick on the previous year. But 2019 has got off to a slow start, with just £300M invested in January, far lower than historic averages, RCA said.
And within those volume figures is a more nuanced analysis. The total number of deals completed in London in 2018 was the lowest since 2009, and is down 35% compared to the 2015 peak. London is relying on a smaller number of larger deals.
“If you look at the number of properties trading then the market has definitely thinned out,” RCA Senior Director of EMEA Analytics Tom Leahy said. “There is still real demand from a certain kind of investor, but that investor has changed. South Korean investors reorientated towards the UK in 2018, and there was a lot of activity from high net worth investors from Hong Kong. There are fewer institutions buying now.”
As an example, Leahy said that in 2016, 60% of overseas investment in the UK came from institutional investors like sovereign wealth funds and pension funds, whereas in 2018 that figure was 40%. The 20% swing was made up almost entirely of wealthy private investors.
“If you’re an institutional investor and you show up at your investment committee with a London purchase or anything in retail, then you won’t get very far at the moment,” Cushman & Wakefield EMEA Head of Capital Markets Jan-Willem Bastijn said. “If you don’t have an investment committee to keep happy, and you want to buy a proper building with a long-term view, then this is a buying opportunity. There is a lot of capital from places like Hong Kong sitting on the sidelines just waiting for the right building to come up.”
If the UK does leave the EU without a deal, then the current hiatus from global institutions is highly likely to be extended.
“If a no-deal Brexit really happens there will be a bit of a standstill,” Bastijn said. “If you see lorries stuck waiting at the ports, then that is a powerful image. But while volumes are low at the moment there is a lot of money waiting.”
The precarious nature of relying on investment in commercial property to shrink your balance of payments is that buildings are fixed and hard to create more of, but capital is mobile.
Indeed, since the Brexit vote, Germany for the first time stole the UK’s crown as the largest commercial real estate investment market in Europe. It did so again in 2018, logging a record £67B of investment, according to CBRE.
However, the same fragility created by the mobile nature of global capital can also be an advantage for the UK. As Marks points out, in the world of investment, everything is relative, and on a relative basis, the UK does not look too bad at the moment.
“There is still so much capital in the market,” he said. “And really it is just about deciding, what is the appropriate risk premium compared to all the other places where you could put your money, because it’s all relative. We’re looking at a deal at the moment, and with 50-60% leverage and a little bit of upside in the medium term, we are looking at about an 8% running return on equity. And you say to yourself, that seems about right. If you look at all the factors that push capital to the UK, the places where this money is coming from, they all have issues that are just as big as Brexit, whether it is China or the Middle East. France has protests, and Germany looks like it could be going into recession.
“Prime yields are about 4% in London, but they are 3% in Paris, 3% in Berlin, about 4% in New York and 2.5% in Hong Kong. So London doesn’t look too crazily priced given there is not much new supply out there."
Those in UK property spend a lot of time looking at data and forecasts from the Bank of England. Right now, the Bank of England, and the whole UK economy, is spending a lot of time looking at commercial property.