The drawn-out Brexit negotiations finally ended in an EU-UK trade deal at the end of 2020. Will it help London recover its position as Europe’s most liquid real estate market?
At last a tariff-free Brexit trade deal is done, and it is safe for real estate investors to let out a long breath. For many, the outcome in the end was the one they had expected all along. Justin Curlow, EMEA head of research and strategy at AXA IM-Alts, says: ‘In terms of the Brexit process, it has gone very much the way we were expecting it to. Which was: down to the wire, with political posturing on both sides, but ultimately a deal that allows both sides to keep face.’
The view of Andrew Angeli, CBRE Global Investors’ European research chief, is the same: ‘The agreement that we now have is what we anticipated occurring - although our views were certainly challenged continually! But I would say that we expected to be where we are now, and that it represents elimination of downside risk.’
Now that the uncertainty is resolved, will investment surge into UK real estate? Will London see values rise, and office yields start to converge with other top European cities which saw buildings sell at record euros per square metre and sub 3% yields last year?
As a first step, the fall in London investment volumes that began in 2018 will have to reverse. A striking statistic about 2020 is that the approximately €9 bn transaction volume in Berlin last year - and Berlin is only one of four or five German cities attracting significant investment - was about the same as for Central London offices. At its peak, London turns over about £20 bn.
The coming 12-24 months should give a better picture of how much of London’s relegation below Germany and Paris has been down to Brexit and how much due to other factors, including sterling-euro currency and borrowing cost differentials, and especially to Covid.
Renewed investor interest
Views about this differ. Chris Brett, EMEA head of international capital markets at CBRE, says: ‘There is certainly renewed interest from a variety of investors in London and the UK post the Brexit deal signing. There is no doubt that some investors preferred other destinations in the four or so years of uncertainty. Some of those investors have regained the confidence they had in the UK prior to the referendum vote.’
Alex Knapp, European CIO at Hines, says that the general tone of London’s resilience and fundamental appeal is only confirmed by the Brexit outcome. ‘We do expect like-for-like a higher level of investment to come into the market after this agreement, and judging from feedback from our investors, decisions were put on hold until a trade deal had been signed,’ he says.
German investors, including some of the biggest open-ended funds, have been among those staying away. Henning Koch, board member at Commerz Real, says the manager of Hausinvest and other funds has not invested at all in the UK since the financial crisis for a mix of reasons. ‘Commerz was quiet immediately after the financial crisis. And then we had a number of factors including relatively high hedging costs against the pound which meant it was not easy for us to achieve the required returns for the fund. Then the economic outlook and the consequences from Brexit was the topic,’ he explains.
‘The good thing is that we now have clarity on the Brexit situation. It took a while but it is good in the end to now have the situation cleared. This gives us the clarity to really look at the country again and to better understand what the consequences are coming from the trading agreement.’
Fellow German giant Union Investment also largely held back after the 2016 referendum, though it did acquire The Copyright Building in 2017 and bought out JV partner Oxford Properties in City asset Watermark Place last March. Adam Irányi, investment manager at Union, says: ‘Even though a no-deal-Brexit was avoided at the eleventh hour, the British economy will be facing immense challenges which will also continue to weigh on the real estate markets. Current yield levels and a weakened pound make UK real estate values look relatively low by comparison to those in continental Europe.’
One investment manager who didn’t want to name names said large Dutch institutional investors were the most cautious about Brexit, and still are. ‘These are investors who have existing large portfolios in the UK and understand the market but were quite outspoken about their perception of the lasting effect of Brexit, on the economy, on trade relationships, ultimately on demand.’
Borrowing and hedging costs
For some investors, the Brexit uncertainty was less important than other factors causing them to hold back. Invesco Real Estate’s Europe head Andy Rofe says that for euro-denominated investors, it was those high borrowing and hedging costs in the UK which meant there were better returns from Continental core office markets in recent years. CBRE’s Brett says this is a reason for the relatively higher London cap rates.
The filip for the UK is that its borrowing and hedging costs relative to the eurozone have fallen over the last 12 months. ‘I would say at the beginning of last year there was a gap of 150 basis points between the borrowing costs of a prime office in the UK relative to a key Continental city. By the end of 2020 that had at least halved so that the difference is now probably 60-70 bps,’ Rofe says.
If there is a consensus, it is that London can hope for a significant comeback by European investors deploying capital due to both the end of Brexit uncertainty, UK interest rates having converged with Europe and less currency volatility - but with the timing dependent on Covid travel restrictions relaxing.
‘We will see increased engagement probably in the latter half of this year and into 2022 by European investors due to removal of these financial and emotional barriers’, Rofe continues. ‘Which is important. They are a hugely important investor base for us and the market. For them not to be engaged in London and the UK, for their cost of capital not to be as competitive as other global capital has put them at a major disadvantage. If you equal all those things out, then you have by definition stronger demand in quite a supply-constrained market... I would be surprised if over the next 12-18 months we don’t invest there.’
Travel restrictions
The drop in Asian investors in London has more to do with travel restrictions, brokers say. A handful did buy in London last year even with very limited opportunity to view assets. Sun Venture, advised by Savills, was one. The Singapore group bought One New Oxford Street and 1 & 2 Ludgate.
Angeli says: ‘There is a hunger, a pent-up demand for European real estate in general, and London assets specifically and I would single out Korean investors. They were much quieter last year and I put that down just to the practicalities of running around the globe. Talking with our Korean clients, they are energised, they have capital to invest and London is a market they understand.’
While they may want to re-acquaint themselves before investing, Angeli adds that Korean investors view London now as offering ‘a compelling cyclical opportunity’.
Stephen Down, Savills’ head of central London and international investment, points out that already late last year there was ‘a flurry of deals in the West End which saw its best final quarter since 2014’. They were led by separate British Land sales, to Deka, GLL and Allianz Real Estate, and ‘are good examples of where the market can be if you offer the right product’.
Hines was another which specifically saw an opportunity open in the West End, Knapp says. After an absence of 13 years the US investor made three office acquisitions, two for its value fund and one for its core fund, all before the Brexit outcome was completely certain and while competition was thinner. ‘This commitment reflects a view that we had and still hold that the fundamental infrastructure and appeal of London was a little mis-priced at that time,’ Knapp says.
‘We have acquired in Mid Town, and in the City and Docklands, but the West End, where we would see the greatest long-term value appreciation, had been a market that was largely closed off to us.’
Softening office rents
Hines may continue to see relative value - but for a different reason. ‘We would expect to see some turbulence in the office occupier market without question in the year to come. But that’s not due to Brexit but to Covid and the big economic contraction we have had,’ Knapp continues. ‘That of course ripples through the residential market, and the retail market is as we know already troubled. The only product type where we are not expecting to see turbulence or dislocation is logistics.
‘We are expecting office rents to soften in London and many other office markets. And residential rents at the higher end as well, for sure. That will have an impact.’
With services not covered by the Brexit trade agreement and financial services the beating heart of the City, investors in the Square Mile and Canary Wharf have additional cause to fret about softening office rents. The Financial Times kicked off 2021 reporting that almost all of London’s €6 bn daily euro stocks share trading had moved out to exchanges in Paris, Frankfurt, Madrid and Amsterdam. This at a time when companies are reviewing their future floorspace requirements after Covid homeworking.
The counter argument, which AXA’s Curlow and others put up, is that the City’s occupier base is evolving. ‘It is a misconception that the City is reliant on finance - it was historically, but over the past decade it has become more diverse,’ he says.
So what about those London yields. Will they tighten? ‘We think the London market is stronger than it was pre the Brexit deal being signed and it is weakened by the fact we have further travel bans due to Covid,’ says Brett. ‘But ultimately it is strengthened by the fact it is still one of the top global cities that investors want exposure to. For quality real estate, with decent and defendable income streams that are durable in length and covenant strength, the cap rates, from what we can see now, are going to harden through the course of 2021.’
Logistics sees some early disruption
EU-UK post Brexit trade may be tariff-free but it is not ‘friction’-free as stories about customs officers confiscating ham sandwiches from haulage drivers demonstrate. Travellers from the UK are no longer allowed to bring animal products into the EU.
The flow of trade through the UK to and from Ireland has experienced disruption, leading to Dublin-bound cargo ferries re-routing directly with the Continent to avoid the friction of operating in the UK. Bloomberg has reported that Scottish fisherman are landing catches in Denmark to avoid UK border delays.
Sorting out implementation of customs checks over transition periods will still require additional work in 2021, says AEW’s European head of research Hans Vrensen. ‘In the short-term, economic growth seems artificially boosted by the need to cushion these uncertainties with businesses wishing to prevent shortages of parts and products by building up their inventories.’
‘Once again, it can be difficult to differentiate between Brexit effects and Covid effects because Covid is also affecting supply chains,’ says Justin Curlow of AXA IM-Alts. ‘I have seen the phrase “just in time” inventory management changing to “just in case” and that is a dynamic that may continue to play out.’
AEW expects to see positive trends in UK logistics, as shipping from Asia and the US will have to come directly into the UK, requiring increased port and warehouse capacity.