When the times get tough… cautious optimism towards UK real estate

By Peter Hobbs

The immediate panic that followed the referendum decision has been followed by a period of cautious optimism over the UK real estate market.   There has been a raft of leasing and investment activity, the decline in the value of sterling has encouraged a number of off-shore buyers to invest in the UK, and many of the funds that were closed following the decision have now re-opened.

The improvement in market sentiment has been welcomed by property owners and the range of participants whose livelihoods depend on a resilient property market.  The market was already slowing prior to the referendum and the recent optimism could form the basis for a ‘soft landing’ as the market corrects from its recent cyclical highs.  This soft landing, based on a benign Brexit process and continued confidence in UK property, could lead to a further period of positive returns for the UK market.

Although a soft landing remains a possibility, there are many reasons to expect a far harder outcome, including:

1. The UK being one of the world’s most volatile property market. Although the market is one of the most liquid and transparent, it suffers from volatility in both market fundamentals and its capital markets.  The openness of the economy and the tendency for waves of new supply (whether through new construction or sub-leasing following economic downturns) drive big cycles in the rental market.  The liquidity of the market contributes to volatility in capital values, particularly given the significance of overseas buyers whose appetite for the UK can be incredibly fickle.
2. The pricing of the market which had reached historic levels by the end of 2015. Although real estate pricing might be relatively attractive compared with other asset classes, such as Government Bonds, the yields on UK property had fallen to historic lows.  Over the past 40 years yields have also compressed to very low levels but, on each occasion (whether 1973/4, 1988/9 or 2006/7), this has been followed by a period of significant correction.
3. The Brexit process is likely to create a period of economic and investment market uncertainty which is likely to lead to a slowing of leasing and investment activity.  In turn, this is set to reduce the prospect for rental growth and any yield compression driven by the reduction in government bond yields.

The combination of these factors – a volatile market, aggressive pricing and an unprecedented economic shock, could lead to a period of market weakness over the coming years.  Although values would decline, this would have most significant impact on investors needing liquidity through any downturn.  Conversely, the value declines could create significant opportunities for those seeking to invest in the market, as was clearly demonstrated during the great investment vintages of 1990-92, of 2000-02 and of 2009-11.

It is in the context of this huge uncertainty that increased attention is being placed on the experience and discipline of managers with whom to invest.  Although no-one can predict the outcome of the Brexit decision on the UK property market, the best managers are considering the range of scenarios and likely implications. Rather than responding to prevailing market sentiment, these managers are working hard to position their portfolios to withstand any potential downturn, to maintain high levels of liquidity and to exploit the opportunities that any downturn might provide.

Peter Hobbs is a managing director, private markets at bfinance