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23/09/2016

Is the bubble deflating or just stalling?

Since the Brexit vote, the UK commercial real estate market (CRE) has suffered panic withdrawals from open-ended property funds and valuers adding ‘uncertainty clauses’ to their valuations. CRE values (as recorded by IPD) fell by 2.76% in July, the largest monthly decline in capital values since 2009 (figure 1).

Initially, there was concern that panic and a wholesale rush for the door could trigger the start of a new UK commercial property recession, or a ‘deflating bubble’. Surprisingly, however, as we near the end of the third quarter of 2016, a number of signals are suggesting that the vote to leave’s bark was worse than its bite. Capital values, as measured by IPD, are flat from the start of the year to the end of August.

Some valuers have recently removed ‘uncertainty’ clauses from valuations. However, they continue to reference ‘special market conditions’ paragraphs in accordance with Royal Institute of Chartered Surveyors (RICS) regulation, to highlight the risks of valuation in markets highly susceptible to change.

Suspensions were placed on a number of open-ended property funds post Brexit as the number of investors seeking to exit exceeded cash available and the managers sought to protect investors in their funds. A number of managers have now lifted suspension on their investment funds, with others retaining special pricing adjustments while they advance a managed disposal of assets.

Direct property trading was also impacted by Brexit, with some declines in investment volumes in core property assets classes and regions. The RICS UK Property Market survey shows significant sentiment deterioration following the Brexit vote and occupier demand has failed to rise for the first time since 2012 (with some regional variation). There are some signs of modest pick-up, but there remains a lack of transactions – central London, for example – causing further challenge to valuers seeking comparable evidence. Investment activity in alternative property classes (such as logistics, student accommodation) appears to remain more buoyant.

Listed real estate investment trusts (REITs) – the listed property companies – have also suffered from poor sentiment. Historically, the REIT sector has been considered alongside financial companies, but recent classification changes have split sectors. This has made identification of property companies easier and may well be positive for investment. The core UK closed-ended property investment companies, another proxy for direct property investment in the UK, have been surprisingly unaffected by Brexit over the longer term. After an initial sell-off, most have recovered, with some increasing in value.

Despite relatively buoyant equity markets and macro indicators, we consider that the UK CRE market will continue to deteriorate, and the longer-term impact of Brexit remains unknown. We expect capital values to fall and lower rental growth this year and in 2017. The decline of sterling continues to support overseas investment into UK real estate, but we remain cautious on the sector and are content with our decision to sell our positions in May. We expect the sector to continue to deliver bond-like returns, but with increased risks around redemption values. We continue to monitor the asset class, looking for an opportunity to reinvest in the future.

*All figures Investment Property Databank (IPD)

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