We’re halfway through the year and much has happened but what has changed!? The recent election may have left Theresa May in a weaker position but we still have a Conservative government leading us to Brexit, it may now be ‘softer’ and there is scope for further political volatility but wasn’t that the case before? We have been poised for volatility and uncertainty as a consequence of the vote to leave the EU a year ago and this election result is in my view just part of that journey, with more disruption to follow.
Taking the real estate listed sector as illustrative of the wider real estate market, the index of quoted real estate companies is broadly flat on the year at the time of writing (though you could have made 15% by timing the trough in December and the peak in May). The index is also down some 15% on the peak in the summer of 2015 (though it has been down as much as 20% a number of times). Volatility is higher when you look at individual companies and demonstrates that there are opportunities to take advantage of if you are patient and you get your timing right.
FTSE EPRA/NAREIT UK Index
Source: Bloomberg
Real estate volumes were c.30% down in 2016 on 2015 and so far this year are in line with the same period halfway through 2016 (Q1 2017 was 20% lower). These volumes illustrate to my mind that there are fewer active buyers ‘in the room’ than in 2015, which should result in a less competitive environment and more attractive pricing.
The bars in the chart below show the UK real estate transaction volumes since 2000 and you can see the recent peak in 2015 surpassed the previous peak levels seen in 2005-2007. I have added the subsequent 3 year total return (which includes the income return) experienced from investments made in each year – it is not surprising to see that in years with high volumes the subsequent return is poor and it is better when volumes are lower! This (and the listed sector index) supports why we were slow to invest MREFIII through 2014 and 2015, accelerated in the second half of 2016, and why we think the uncertainty expected over the next few years will be good for MREFIV.
Source: Capital Economics
Some of the real estate headlines would suggest that nothing has changed since 2015 – for example The ‘Cheesegrater’ (The Leadenhall Building) and the ‘Walkie Talkie’ (20 Fenchurch Street) towers being sold for £1.15bn and £1.3bn respectively to Chinese investors at c.3% yields, well above recent valuations. Asian investors in particular have been attracted to London because of the fall in sterling and an ongoing view that despite Brexit the UK will remain a safe haven and London a global financial centre.
Indeed pension funds, insurance companies, local authorities, private investors etc. still find the income yield that UK real estate offers as attractive, especially relative to other options. And the world is awash with capital because of QE, low rates and growing economies, especially in Asia where the goal is to increasingly invest overseas. As such, long dated income, ie real estate with leases of over 10 years in length, is now even more sought after post Brexit.
On the other hand; short income (lease lengths of under 4 years), empty buildings, land; which are all considered to carry more risk; are all cheaper now. This is because investors are more cautious about the short term risks and will not underwrite as aggressively as in 2015 – and there is less competition to buy. This creates an arbitrage opportunity for the value-add asset manager to create value by turning the land/empty building/shorter income into the long term income that the institutional investment community is searching for.
However, there are a very few forced sellers, LTVs are generally lower than in 2007 and interest rates are so low that interest costs are not causing ICR issues. There is also generally a lack of occupational supply that meets current market needs as in the main there has not been over-development, which might ordinarily be another cause of pressure. Nonetheless, there are some possible exceptions – City of London offices, prime central London residential and retail. These are the sectors that we are most nervous of.
In the City, recent and ongoing development activity combined with slower than anticipated take-up and Brexit risks for the financial sector imply the vacancy rate could head towards 10% from the c.6% today. If this were to happen rents would fall, as would values, and so we think there is more risk on the downside than upside opportunity.
We also believe that too many prime residential apartments were built for off-plan sales, particularly aimed at Asian investors and the combination of the market turning, Brexit, higher SDLT (12% over £1.5m and an extra 3% surcharge for investors), the removal of some CGT/inheritance tax/identity protections for overseas investors, are all propelling a falling market.
The retail sector continues to be affected by the internet and legacy supply issues in the high street and shopping centre subsectors and we prefer to look to the beneficiary of this technological revolution which is the logistics sector.
There are some active sellers, notably the REITs, some of which are trading at discounts to NAV and are being encouraged to refocus on fewer sectors, and the open-ended funds which are holding record levels of cash and are generally waiting for more certainty before being tempted back into the market. Some global private equity investors are also deciding to sell rather than risk extended hold periods eating into their IRR performance.
Our view remains that although there are certain sectors to be wary of and there should be general caution about where we are in the real estate cycle, there are nonetheless (and will continue to be) pockets of systemic undersupply or stress for us to be able to originate attractive opportunities in the themes that we have conviction about.
The themes are (i) Build to Rent / Multifamily (ii) Student Accommodation (iii) Logistics (last mile in particular) (iv) Mixed Use distress (v) real estate that will benefit from new Infrastructure. Of course, there is also senior housing but that is an opportunity for MAREF/Audley. Hence the ‘Beds and Sheds’ label!
Demographics, structural changes, technology and societal shifts are very strong drivers of demand and will continue regardless of Brexit or a changing economic landscape. At the same time these sectors are undersupplied due to many years of a lack of development since the GFC.