Steven Grahame, manager of the North Row Liquid Property fund, writes for What Investment on the likely impact of Brexit on the UK commercial property market.
The date has been set: on Thursday 23rd June the public will vote in the most significant UK referendum since 1975. Polls are suggesting a 50 per cent chance the vote will be to exit, while betting markets (which we believe are more accurate) suggest a 30 per cent chance. Either way, there is now a serious possibility that the UK will be the first major country to leave the European Union.
Over the past few years, the main rationale and discussion points for leaving have shifted much more from economics and markets to immigration and benefits. Here, we look just at the possible economic impact.
There would be many benefits to the UK from leaving the EU, including an annual cost saving of up to £10 billion, freedom to negotiate bilateral trade deals and freedom from EU-imposed laws, such as the proposed financial transactions tax. Arguably, a fully independent UK could function even better as a financial centre than it could within the EU.
Also, an exit does not have to be a complete exit: for example, the UK could choose to stay within the European Free Trade Association (EFTA), although this would require the UK to continue to contribute to the EU budget, but without a seat at the table, as in the case of Norway. Finally, the Lisbon Treaty gives an existing country two years’ continued membership to allow for transition.
However, there are clear downside risks, and they are also hard to quantify. No major country has previously left the union. The remaining EU countries would be even keener to avoid a full break-up of the EU, and could well apply punitive measures against the UK pour encourager les autres, particularly with national elections in France and Germany due next year. This could further exacerbate a domestic slowdown.
Uncertainty ahead of the vote is likely to lead to a slowing of investment, as it did before the Scottish referendum, and a consequent (slight and temporary) slowing of GDP growth. If the UK did vote to exit, we would expect to see around a 1 per cent drop in GDP growth, a 5 to 15 per cent weakening of sterling, a 10 to 20 per cent drop in the FTSE 100 and a flight into the safe haven of gilts, further reducing yields, possibly to below 1 per cent.
And these events could well happen before the vote, if polls shift in the direction of an exit. Indeed, we have already seen moves in these directions, and moves could be larger still if a Brexit were to catalyse a further break-up of the EU.
In terms of commercial property, we would see an exit having the biggest negative
impact on London offices: many continental European companies (especially investment banks) would likely retreat to the EU, increasing vacancy rates, while a slowdown in GDP would negatively impact rental growth. The London office sector is already trading at close to record low yields. Retail would probably be less affected, with the main impact from slower growth and higher inflation being consumer spending coming under pressure.
But against the potential negatives there could well be large offsetting positive benefits from both a weaker currency, making UK property more attractive to foreign investors, and lower bond yields, which would make property yields look even more attractive on a relative basis.
By way of example, when the UK left the European Exchange Rate Mechanism (ERM) in 1992, property returns were nearly 20 per cent and stocks had rallied nearly 50 per cent by the end of the following year. However, property returns are likely to be
very varied; low-yielding finance-related offices are likely to underperform, whereas industrial units catering to export-oriented manufacturers should fare much better.
In conclusion, we believe that the probability of Brexit is currently low, but on balance it would have a negative impact on the economy and commercial property. However, with a weaker currency and lower bond yields, pockets of value could well appear.