The longer the Brexit negotiations take, the more negative the outcome for London and the rest of Europe, according to Andrew Thornton, CEO of Internos Global Investors. In this commentary, he explains why.
The length and nature of the negotiations are likely to cast a shadow over London valuations for as long as they last. In the meantime, occupiers renewing leases will have the upper hand, either to cut leases by more than 5%, probably closer to between 10-15%, or to force landlords into accepting shorter leases. There will be fewer building starts and as stock ages, London will lose its attraction.
As some in government predict that Brexit talks will go on until the end of 2019, there will be a three-year blight on central London offices without a guarantee that the gloom clears once the deal is done.
We believe that while some parts of the Brexit negotiations will be agreed in principle during the early skirmishes, it's the must-win issues for each side that will go down to the wire. For example, even those we have spoken to in the City are pessimistic that the UK will be able to retain the financial passporting rights without yielding on budgets and free movement.
Shift of power
The shift of power in Europe and the UK's absence from the negotiating table means that the Financial Transactions Tax (FTT), which already has nominal approval from nine EU countries but was vigorously opposed by the UK, has a much higher probability of being implemented.
According to Oxford University’s Said business school, implementation in Europe would simply drive trading to Asian centres such as Singapore or Hong Kong. Also, what if the FTT became a condition of a passporting deal between the UK and Europe? The risk to European cites of losing many high-paid finance jobs to Asia is obvious.
As the negotiations rumble on, the outflow of highly paid staff from London will lead to a fiscal 'double whammy' for the economy as the UK continues to pay into the EU budget while bleeding tax revenue from its most lucrative region. In the period from 2014 – 2015, London accounted for 28.6% of the UK's tax income (Source: Oxford Economic Forecasting, Centre for Cities).
Before the Brexit vote, we were urging caution against signs of the rental cycle reaching maturity; however, since the vote capital flows into continental European property have intensified further.
Low interest rates that are seemingly here forever, the German carry trade allowing asset buyers to borrow at 1% at 50% LTV against yields of +4% and growing Chinese awareness of eurozone opportunities are all contributing to the influx of capital.
More buyers on the Continent
There are now many more buyers seeking German, French and other eurozone property, although there is no reason to believe that the occupier outlook for most German and French cities is any better than mediocre.
In the UK, with the pound at a near 21st century low, we believe that manufacturing centres and tourist locations should begin to show economic and real estate growth. We could be optimistic for some Midland and Northern cities while being very bearish about London offices.
Investors likely to gain from the current market include pension funds with hefty non-UK portfolios, and closer to home, London based fund managers with largely non-UK AUM.
Economics is not a zero sum game. If Brexit represents loss for the UK, it will affect continental economies too. The economy is at the heart of occupier demand and Brexit has worsened continental prospects while institutional investors (in growing competition with retail investors) are putting upward pressure on valuations, perhaps bringing forward the end of the rental cycle.
Looking ahead, asset purchase strategies should aim to mitigate cycle risks and increasingly be based on demographic certainties, complex opportunities and solid knowledge of what makes an asset attractive now, as well as in the future.
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Internos Global Investors is a pan-European real estate investment manager with €3.5 bn of assets under management
