By Mark Unsworth, Head of EMEA Forecasting
Although a UK-EU withdrawal agreement still looks possible, there is an increased risk that it would not gain UK parliamentary approval. This could push the UK towards a more extreme Brexit scenario – either remaining in the Single Market and Customs Union or leaving without a trade agreement and reverting to WTO rules (no deal). Oxford Economics has recently assessed that there was an even likelihood between the two scenarios at 30% each.
The concern for the commercial real estate industry is that the no deal scenario becomes reality, having been largely discounted as a low risk until now. In July, the IMF estimated the impact of a no deal would be a reduction in UK GDP of 4% and the EU of 1.5% over the long term. In addition to the economic effects, the disruption to supply chains, trading and travel could cause severe problems for businesses, government and individuals alike.
However, it’s important to remember that the no deal scenario itself could take a few forms. Firstly, the most insidious form would be a “cliff edge” whereby the UK and EU fail to agree and talks end with an abrupt departure in March 2019. This is the doomsday scenario that evokes images of long queues of lorries, stockpiling of goods and grounded planes. The more probable no deal option, would be an agreement between the UK and EU that no deal will be reached before the deadline. This could potentially allow the transition period to be extended to help manage the consequences of the UK’s departure.
If the UK and EU seek to minimise the economic impact of a no deal and pursue a managed departure, our view is that the economy will continue to gradually slow down, as has been the case over recent years, as businesses and investors adjust to the new environment. Although this is clearly not a positive economic scenario it is not a shock event such as that which precipitated the global financial crisis.
In this environment the commercial real estate market will continue to function as has been the case since the EU referendum but with ever-greater certainty which, importantly, allows longer-term decisions to be taken. Those that need to operate from the EU will step up plans to relocate or expand their business in alternative markets, while businesses that do wish to remain or expand in the UK, such as the tech sector, will do so, but may struggle to attract and retain EU talent. The two factors combined will lead to a slowdown in office-based employment growth which could reduce occupier demand in key UK office markets.
Structural and cyclical factors are often intertwined and difficult to distinguish. An example of this is the UK retail sector which is already under immense pressure due to the ongoing structural shift from physical store sales to online sales. Some parts of the UK retail market, notably secondary, are significantly oversupplied. A no deal scenario is likely to cause further Sterling depreciation, which will push inflation upwards and raise costs for consumers. On top of that, many consumers may experience increased job uncertainty as the economic environment changes, leading to higher saving and reduced spending. UK house prices, which are an important factor in supporting consumer confidence, have already been declining on an annual basis in London – it’s difficult to see this trend reversing in the short term under a no deal scenario which would further weaken retail sector prospects.
The structural shift in retail is supporting logistics. However, if total consumption slows then logistics demand will also likely slow although, with e-commerce accounting for half of current take-up, it is likely to fare better than other commercial sectors.
It is also possible that under a no deal scenario, supply chains will need to be redesigned to cope with delays at customs, leading to increased demand for logistics space near major transportation hubs. The losers from this scenario are likely to be manufacturing, especially industries where pan-European supply chains are the most developed. The most-widely quoted is the automotive industry which, if businesses follow through with public warnings, will look to reduce UK operations decreasing the demand for manufacturing space.
Following the EU referendum vote in 2016, the UK commercial property market suffered from a short-term reduction in liquidity. Open-ended funds closed to redemptions while many investment transactions were delayed or cancelled. Although there were limited distressed sales, there was a minor correction in pricing for prime product in core locations, adding up to 25 basis points to the yield. It’s worth highlighting that currently a no deal is not factored into property pricing, meaning that, in the event that this scenario becomes the only possibility, there could be a similar reduction in liquidity and a degree of re-pricing while valuers and investors take stock.
Given the extreme uncertainty and speculation necessary to envisage a no deal scenario at this stage of negotiations, the best advice that we can give to investor clients is to engage with the occupiers in your portfolio and understand what no deal would mean to their business. Every business will be impacted in a different way depending on the market for their goods / services, the size and health of their business, the regulations that impact their operations and their ability / willingness to adapt to a changing environment. Only then will it become clear where void risks may emerge and where future income growth may still be achievable.
In terms of opportunities, we should remember that we are at an advanced stage of the property cycle making future performance particularly sensitive to external factors given the current high pricing relative to long-term averages. However, looking ahead, investors will need to assess how an expected weaker short-term economic growth trajectory and an uncertain trade outlook would play out in different business sectors and locations. For example, although demand in London will be uncertain in the short-term (potential job losses in the City are forecast to range between 3,000 and 12,000 according to City of London Corporation), it does have a global business base which should be able to quickly adapt to the changing environment – particularly in submarkets favoured by tech-related industries. Indeed, overall it will be European, as opposed to global or local businesses, which face more uncertainty and investors should focus on cities with a global tenant base and appeal, or on property servicing a local and ongoing need, such as housing or distribution.
UK hospitality could be a defensive sector if a weaker Pound deters domestic tourists from overseas travel and attracts a greater flow of foreign visitors, assuming excessive border delays are not commonplace. Similarly, sectors such as logistics (due to a need for greater efficiency) and PRS (due to uncertainty holding back owner occupation) could benefit, while manufacturing could look to reduce cross-border trading costs / delays by bringing some production back to the UK.
In summary, the long-term impacts will be driven by new trading and economic circumstances which will only emerge once the shape of Brexit develops. We believe that larger and more global cities, led by London, will be the first to correct but their responsiveness and adaptability will also help them to exploit any new patterns of demand that emerge. There will be opportunities to reduce risk and align a portfolio for growth, but in all cases, this will need to be with close attention to relative pricing and risk premiums in the UK and competing markets. Above all, a ‘no deal’ with a managed departure will mean further uncertainty that will need to be priced into the market – increasing the risk premium for some assets but pushing more buyers towards the most secure and liquid market segments.
Mark Unsworth, Head of EMEA Forecasting
David Hutchings, Head of Investment Strategy, EMEA Capital Markets