Real estate debt investors must build around Brexit

For decades the UK’s real estate market has been one of the most profitable areas of investment available in Europe. High demand for office space, particularly in London, is bolstered by a residential property sector with a severe supply-and-demand imbalance to create a market that has provided excellent returns for equity investors.

Since the 2008 financial crisis the regulatory regime faced by banks (of which the UK has only a handful of giant players) has also provided the opportunity for alternative lenders to generate attractive returns secured against real assets that command a dependable income.

But recently the real estate market has begun to slow, driven by political uncertainty around the UK’s 2016 decision to leave the European Union. The uncertainty of ending this decades-old relationship was compounded by a botched early election called by the governing Conservatives which cost the party its majority and has seen the country’s parliament deadlocked over how it will withdraw from the EU.

The slowdown in real estate investment is a global phenomenon. Fundraising figures from PDI’s sister title, PERE, show that 2018 was the worst year for private real estate capital raising in the last seven, with total capital raised down from $127 billion in 2017 to just $104 billion last year. Research by commercial real estate specialist Cushman & Wakefield also found that total investment in UK commercial property fell by 18 percent between 2017 and 2018 to £42 billion ($54.9 billion; €48.5 billion).

The fundamentals

While Brexit uncertainty is impacting the sector, market fundamentals are also driving the current slowdown in investment activity. Daniel Austin, chief executive and co-founder of private real estate debt specialist ASK Partners, says some of the problems facing UK real estate pre-date Brexit.

“In the last few years, one of the issues facing private debt providers in this market is that there has been too much competition among real estate equity providers,” he says.

As competition has increased for real estate assets, prices have been driven up, which has in turn increased macro risk in the market. This has pushed many investors out of real estate equity and into real estate debt.

“In this market it makes more sense to lend than to acquire, because, right now, equity investments haven’t made any more money than debt, but you’ve taken a lot more risk in the process,” Austin says.

Although this may seem positive for real estate debt investors that are fundraising, it makes deploying capital much more challenging. Less money in the hands of equity investors means fewer transactions take place and it is more difficult to source lending opportunities.

Debt fund investors also face the challenge of a growing amount of competition within real estate debt itself. This is driven by growing investor demand and a number of new entrants in the space that have been attracted to the UK market, both domestically and from further afield.

“The main source of capital that may potentially become a meaningful source of dry powder in Europe is actually the US-based private debt funds,” says a spokesman for real estate debt specialist Cheyne Capital. “While their firepower is significant, they do lack, at present, the origination platforms and relationships in Europe to effectively deploy here. Some of this competition will be provided by RE funds which also have debt strategies.”

David Sarfas, global head of private equity and real assets at MUFG Investor Services, is concerned that recent market conditions, which have favoured debt funds, could start to cause the pendulum to swing the other way.

“Investing in real estate equity versus debt is not predicated on an either/or choice but rather on market dynamics of supply and demand,” he says. “The effect of regulation has created a financing gap conducive to debt funds. But even then, the weight of capital is suppressing returns. Another sign of excess deployment is the standards of debt covenants and that general terms and conditions are slipping.”

The interest rate outlook is also likely to play a role in investment decisions. Like other major economies, the UK is coming off a decade of very low interest rates, which reached their lowest level with a cut in the base rate to 0.25 percent shortly after the result of the referendum on EU membership. Although rates have since been increased twice, at just 0.75 percent there is only one direction they can realistically go: upwards.

Increased interest rates will have a knock-on effect on valuations, according to Sarfas, as higher debt costs will make it harder to finance projects and acquisitions and remain profitable, thereby dampening demand. However, he believes other factors in the real estate market could take the edge off this.

“Rental market growth is expected to continue in the short to medium term,” he says. “The availability of bank credit has been restricted … which means that levels of development have been relatively low and there are very few places where an oversupply of stock leads to actively reducing rents.

“Rents will either stagnate or continue on an upward trend in the world’s most buoyant economies. It is in these countries that rate rises are most likely, so rising cap rates will often be counterbalanced by rising income for investors, keeping capital values stable.”

The elephant in the room for UK real estate investors, however, is Brexit. As of the time of writing, the country has accepted a delay to the process until the end of October. Yet it remains unclear how Westminster can reach a consensus.

Uncertain future

Austin says Brexit has dampened investor demand due to the uncertainty it causes, but believes reaching a deal could turn things around: “If we see a Brexit deal get done then market prospects will turn around very quickly and investors will return to the market.”

Cheyne adds that Brexit uncertainty has already been priced in by investors, with prime residential valuations dropping significantly since 2016, though a “hard” Brexit could lead to further falls and a period of constrained liquidity while the market adapts.

It adds that the impact is highly dependent on the sector: “The press readings on Brexit have been almost universally bad and alarming. Investors’ expectations of the Brexit impact on real assets transactions do not meet with the reality on the ground in all instances. Cheyne sees a substantial amount of real asset transactions. [Our] view is that transactional evidence on the ground is very granular and specific to asset types.”

For example, outside London’s financial district, office rents have held up well, driven by sectors that are less sensitive to Brexit and a shortage of high-grade accommodation. In addition, a weaker currency has reduced rent and employment costs.

However, the recent extension of the Brexit deadline has led to renewed calls for Prime Minister Theresa May to resign and could lead to a general election, something Austin believes is the biggest risk to UK real estate. “If we end up with a hard left government, that would cause a real problem for investor confidence because real estate assets can’t be moved and this means they would be a prime target for new taxes.”

The UK’s Brexit woes seem unlikely to end any time soon. While uncertainty persists it is likely to have a damping effect on a real estate market that has long been a reliable place for investors to put their money, with knock-on impacts for both equity and debt providers.