Brexit and mortar: London real estate risks and opportunities

More than four months on from Brexit, uncertainty still stalks London's real estate market. So where are the risks and opportunities in the UK capital? And why are some experts issuing stark warnings about a “catastrophic” impact? David Turner reports

On Monday, 27 June, four days after the UK voted to leave the EU, Basil Demeroutis, managing partner at Fore Partnership, a London-based commercial real estate investment club for family offices and wealthy private investors, received three calls from Asian families saying: “I have $100 million to spend on London, where should I invest it?” On the same day he called to check in with a Fore investor.

“He picked it up after an unfamiliar ringing tone”, says Demeroutis.

“He then said he was in Manchester with a planeload of other Chinese investors looking to buy flats—after booking a flight following the Brexit vote.”

Demeroutis' reminiscence neatly encapsulates the excitement and sense of urgency among wealthy foreign investors in the immediate aftermath of the Brexit vote. But this sense also worked the other way.

“In the three months following the vote there was panic, and we saw some deals at quite dramatically discounted levels, because they were done in a real rush”, says Rasheed Hassan, London-based director in the cross-border investment team at Savills, the property consultancy.

Hassan cites 10 Hammersmith Grove, an office block in the inner London suburb, sold by Aberdeen Asset Management to property firm Brockton Capital a few weeks after the Brexit vote, at a yield of 6.1%, rather than the 5% or 5.25% which Hassan says Aberdeen would probably have achieved before the vote.

“Usually deals take six to eight weeks: three or four weeks to agree terms, and three or four weeks to complete”, says Hassan.

“But this deal was closed in four days. It was dramatic.”

As the dust begins to settle over property portfolios following the feverish immediate reactions to the referendum result, marked differences of opinion remain.

A fierce debate rages over commercial property—which is noteworthy since close to 9% of an average family office portfolio* is allocated to this sector. Jonathan Bell, chief investment officer at Stanhope Capital, the London-based wealth manager, sees greater opportunities in the eurozone. The firm has, for example, just completed a direct investment in Dublin for a client in student accommodation—an interesting choice of location because this has been a big growth area, in the past few years, in London and the UK.

Bell's scepticism about the capital is, strictly speaking, only partly Brexit-related: He notes that Orion, a private equity-style manager used by Stanhope for property investments, has been more cautious for about a year, because of the oversupply created by new commercial developments in London—and Bell agrees with this assessment. Following the vote, “on top of the existing oversupply issue, there are concerns that Brexit could lead to a cutback in tenant requirements, with the move of staff to Paris and Frankfurt.”

Bell thinks that uncertainty and a lack of market confidence could bedevil commercial real estate even two-and-a-half years from now, given the long likely timetable for negotiations that will determine Britain's trading status with the EU.

Theresa May, the UK's Conservative prime minister, told the Conservative party annual conference in October that the government would trigger Article 50, the official legal notification to its EU partners that it was going to leave the bloc, “no later than the end of March”.

Once this formal process begins, Britain will have two years to work out the details of its future relationship with the EU before it must leave it. Some investors fear that if Britain settles on, or is forced into, 'hard Brexit'—taking back full control over immigration and various other policy and legal areas, but at the cost of partial exclusion from EU markets in goods and services—commercial and residential property would take a severe hit. This will be due to the damage to financial services in particular, and the economy in general.

However, other investors argue that by taking back total power in these policy fields, the UK could boost financial services and the economy through deregulation. Regardless of the outcome of negotiations, even after the UK does leave at some point in 2019, economic and market uncertainty may continue because the exact effect of Brexit will take time to become apparent.

The argument that Brexit has made the future murky has also been accepted by Ross Satterwhite, executive managing director at Arcturus, the New York-based real estate investment adviser—which is therefore sceptical about UK property.

“Brexit has obviously injected some uncertainty into the future of the British economy and it will be some time before the exit parameters will be established and the effects fully known”, Satterwhite says.

“Those looking for less volatility, strong liquidity, and attractive risk-adjusted returns may feel the US offers a more attractive environment at the moment than the UK, or other parts of Europe.”

Within commercial real estate, experts harbour the greatest doubts about the City of London and Canary Wharf, where the capital's international financial services are located.

Demeroutis of Fore puts this concern into numbers. He suggests a 10% reduction in this sector's workforce is eminently possible because of Brexit—creating a loss of 40,000 jobs. Assuming each employee takes up about 9 sq m, this would reduce demand for office space in these districts by more than 371,000 sq m. This would boost the current vacancy rate from 5% to 12%–12.5%, and catapult it way beyond the 7% level marking the borderline between whether tenants or landlords have the pricing power, in most London markets at most points in history.

In other words, “the City could pretty quickly get to a double-digit vacancy rate, which would be catastrophic”, warns Demeroutis.

He notes if City rents are capable of rising so fast—they have doubled to a peak of £80 ($99) per sq ft since the bottom of the market—they are also capable of falling fast. Given the high current level of rents in the City, Demeroutis describes the sector as “a tightly coiled spring”—not a reassuring metaphor for property investors. Looking more broadly across sectors and cities, he estimated in October that leasing activity was down 25% to 50% year-on-year; rents had not generally fallen, but unless leasing recovered he saw such a fall as a mere matter of time.

And yet the sceptics also acknowledge the attractions of different markets, in particular for wealthy foreign families. Bell of Stanhope thinks West End offices will be affected less by Brexit than Canary Wharf, the City, and big developments near the City in Southwark and Holborn. But retail property in the West End “will have the same attraction as before”: the tourists will still be there.

Fore's Demeroutis testifies to the interest from foreign buyers—attracted largely by the sharp fall in sterling after the vote. By October the pound had fallen to a 31-year low against the dollar of $1.1841.

Hassan of Savills thinks this slide has made clients extremely hungry for deals.

“Our overseas investors are not interested in what discount property is trading at relative to the level six months ago”, he says.

The post-Brexit discount has already more or less disappeared anyway, asserts Hassan.

“They are all saying is, 'we want deals now at whatever the market price is, because we are getting marked discounts through the currency.”

This ample overseas interest from Asia and the Middle East is, he says, “driving the market a lot”. Hassan cites a Singapore family office that bought a £220 million City property before the vote, and is discussing further deals with Savills.

“The view among Asian and Middle Eastern private investors is that London is still London, after the vote. What has changed?” he asks rhetorically. “They are taking the long view.”

Experts think that investors are also taking the long view of the extremely expensive residential properties that family offices buy as investments, while sometimes living in them for part or all of the year too. Residential property direct investments make up 6.6% of the average family office's portfolio*–equivalent to $50 million.

“In the high-end market—£15 million-plus, these days—I have never seen so many high net worth individuals buying properties, whether as investments or private homes”, says Andrew Philips, head of the Wealth Partnership, which deals with family office investments, and of central London sales, at Hamptons, the estate agency.

“Interest is much more to do with the security of the legal system in the UK, and the market's long-term track record—which shows extremely strong rises over a generation—than with the barriers which residential investors have to deal with now, such as stamp duty and land taxes.”

In April 2016 the UK Treasury raised the top rate of stamp duty, for properties worth more than £1.5 million, from 12% to 15%.

However, “billionaires would not think too much of paying £2 million or £3 million in stamp duty, knowing that in five or 10 years' time they would have recovered that through capital appreciation”, he explains.

Philips also cites London attributes that will be utterly unaffected by even the hardest Brexit, including “the heritage, the history, and—a big driver—the education, where we are number one in the world.”

Elite private schools in London and the Home Counties [the counties of England that surround London] are increasingly popular with Chinese and Russian families in particular.

Bell of Stanhope Capital agrees about the robustness of the top end of the residential market. However he expresses doubts, also shared by Philips of Hamptons, about the blocks of cheaper apartments, in the £1 million to £5 million category per unit, which many foreign investors like buying.

“We are slightly less concerned about very high-end residential, where the Chinese, Russians, and Kazakhs are paying £20 million for a secure bolthole”, says Bell. “However, when it comes to two-bedroom flats with limited space, rented out at 2% yields, in places like Nine Elms in Battersea, the price may be twice as high as it should be.”

This market was, several experts suggest, overbid even before Brexit; the uncertainty engendered by Brexit, which could lead to the departure of tens of thousands of highly paid financial services workers, merely reinforces their point.