Post-Brexit Stress Hits UK Property Markets
The first open-end property fund suspended trading on 4 July, putting UK property stocks under pressure.
With the Brexit vote behind us, the commercial and residential property markets in the UK are declining. It is not the beginning of a crisis but not an opportunity to buy either.
How is Brexit affecting open-end property funds in the UK?
Even though visibility is currently very low, due to the considerable uncertainty over the Brexit, the first signs of “post-Brexit stress” have come to the surface in the UK.
Indeed, Standard Life Investments, the fund arm of insurer Standard Life, suspended trading of its open-end Standard Life Investments UK Real Estate Fund and associated funds on 4 July (after it had reduced the fund’s value by 5 per cent just after the referendum). The company cited “exceptional market circumstances” for the decision (source: The Guardian, 4 July).
Other UK property funds have lowered the estimated value of their holdings, aiming to deter investors from withdrawing cash. Property funds in the UK managed by Henderson, M&G Investments, Aberdeen, Legal & General and Kames Capital have all reduced the market value of their property portfolios by between 4.5 to 5 per cent using a fair value adjustment (source: Financial Times, 3 July 2016). The latest news is that Aviva Investors, the fund arm of insurer Aviva, suspended trading activities of its Aviva Investors Property Trust (invested in UK real estate) on 5 July.
As a reminder, open-end property funds issue new shares to new investors and buy shares when investors wish to sell. Open-end real estate funds may face liquidity problems if many investors redeem their shares simultaneously in the wake of uncertainty or panic. As a result, the fund manager may decide to (temporary) freeze his fund to avoid a forced sell-off of property (often at much lower prices). The German saga of open-end property funds during the financial crisis of 2008-2009 is a clear reminder of this. Of course, not all property funds are open-end; many of them are closed-end.
What about closed-end funds and REITs?
Closed-end funds have a fixed term of between 7 and 10 years, during which they offer little or no liquidity. The lack of liquidity may be perceived as a disadvantage, yet it might be convenient in times of uncertainty, as fund managers do not have to deal with massive redemption during a fund’s lifetime.
Many property companies are listed on a stock exchange, such as Real Estate Investment Trusts (REITs). REITs are property stocks: they are invested in real estate, yet they have the characteristics of common stocks in the short term (for example with respect to volatility). They usually provide reasonable dividends and offer daily liquidity in stock markets. Major examples (by market capitalisation) in the UK include Land Securities Group, British Land Co., Hammerson, Segro, Shaftesbury and Great Portland Estates. This list is not exhaustive.
The end of June was very volatile for listed property companies in the wake of the Brexit vote. This was particularly striking on 27 June. We believe that the market somewhat overreacted to the UK referendum on that day, because many REITs have since started to recover (at least partially).
We believe that the ECB’s loose monetary policy will continue to privilege investors looking for yield. The spread between gross dividend yields of REITs and risk-free long-term nominal interest rates remains attractive, generally around 300bp). But further volatility cannot be ruled out.
The consequences for the markets
Suspended trading in open-end UK property funds will fuel uncertainty among investors. We believe the current nervousness relates more to upcoming valuation multiples – for example the fair value of office premises in the City in the coming months –than to total panic.
It is reasonable to assume that investors are factoring in a capital loss of roughly 10% on highly-valued London-based commercial property (in particular offices). The UK’s regional office markets may be less negatively impacted given their less demanding valuation multiples. Much will depend on investor appetite, primarily of international investors (who may be attracted by a cheaper pound in the longer run).
We believe that volatility in the UK real-estate market will continue for a while. Thus, the adjustments are not over yet.
With respect to Continental Europe, we believe some locations may capitalise on stronger investment sentiment (coupled with a relocation of staff working in the financial services sector). Dublin, Paris, Frankfurt and Luxembourg are expected to benefit most.
The impact on these prime locations is difficult to measure, although it is reasonable to assume that rents and market valuations will rise (depending on local vacancy rates, availability, etc.). This should be closely monitored in the months ahead.