The viability of the City of London as a global financial market post-Brexit has come into question, causing commercial real estate investors to reassess, writes Joe Valente, European Head of Real Estate Research at JP Morgan Asset Management – Global Real Assets, in this commentary.
Short-term uncertainty in advance of tangible negotiations between UK and the EU is inevitable. Occupiers will be cautious and investors will be uncertain until there is a little more clarity surrounding the nature and form of negotiations. That is to be expected. But does that mean we should write off the City of London property market?
We think not. The reality is that the key building blocks underpinning the City’s position are not being challenged by Brexit. Notwithstanding the Brexit negotiation uncertainties, the City was, is and will always be highly a volatile market. Against such a background it is important to distinguish between cyclical re-pricing and the possibility of more fundamental, structural change.
Liquidity to the sector has contracted globally over the past 12 months. Capital flows will continue to target the European market, guided not just by a background of uncertainty in the UK, but potentially a very different political and economic landscape in the rest of the EU. Much of the debate to date has been couched in terms that envisage increased risk and volatility in the UK and relative stability across the EU. The fact is that the political and economic landscape of Europe is liable to be very different over the next one to two years. This too will be an important determinant of investment capital across the region.
Occupiers have become more cautious
Occupier demand in the City has fallen by 26% over the last three months as occupiers adopted a more cautious stance to events surrounding Brexit. Similarly investment activity fell by 20% relative to the post- 2008 average. Neither event is particularly surprising or rare. Occupier take up in the City has fallen by bigger margins of 40% of quarters since 2000, for example. Moreover neither event should be seen as reflecting a structural change to the City but rather the inevitable impact of uncertainty and risk aversion.
Whilst occupier demand remains fragile, there is better news regarding the supply side. Development activity has remained fairly muted, certainly compared with previous cycles. Moreover, one of the side-effects of the referendum has been that the size of the overall pipelined has been pared back further.
Vacancy rates which are currently 4% in the City could rise to 7-8% in 2018-19. However, this assumes the loss of a significant number of jobs from the City (60-70,000) which is largely associated with the loss of passporting rights and access to the single market. This is viewed as a crude assumption and unlikely to materialise.
Office rents in the City were already forecast to fall in 2017-18 as a result of lower economic growth and increasing supply. Brexit has sped up that process. Post-Brexit forecasts point to a rental decline of 15-30% over the period to 2019. However, these should be seen as a worst-case scenario and, to put these forecasts into context, they compare with a 35% fall in rents during the recession of the early 2000s and the GFC in 2008 when the supply/demand balance was far worse than it is today.
Prime yields drifting towards 4.5-5%
Prime yields had also began to drift out well in advance of the referendum. The available forecasts point to a new level of 4.5-5.0% over the course of the next year or so. This feels more plausible given the pricing levels of the relatively few transactions concluded at the prime end of the City market.
Pre-Brexit forecasts of capital values were pointing towards a fall in capital values of around 10-15%. This was subsequently downgraded to -15-30% over the period to 2019. Once again, this should be seen as a worst-case scenario, unlikely to materialise. The projected 30% fall in capital values compares with a 35% decline in the early 2000s and around -60% following the GFC.
Indeed, our expectation is that values will fall by much less than widely expected. There are various reasons for this view, namely the resilience of the UK economy thus far, the more competitive currency, the overly dramatic forecasts for employment loss not materialising and the likely mitigation effect of MIFID II providing single market access to non-EU financial services, just to name a few.
Perhaps most important of all, if the worst-case scenario materialised which is highly unlikely it would leave pricing of European markets at unsustainable levels with prime property in Germany and France at sub 4% and central London at 5% plus. At those sort of levels I would definitely be a buyer especially against a background of a weak and depreciating currency.
Assuming greater clarity and progress with negotiations over the coming months and further improvement in economic fundamentals, we expect occupiers and investors will become more confident about the prospects in the City and this is likely to become evident in the first half of 2017.
Joe Valente
European Head of Real Estate Research at JP Morgan Asset Management – Global Real Asset
