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A list of UK asset managers have frozen withdrawals from real estate funds following massive redemptions by investors worrying over Brexit. We expect the impact on indirect listed real estate to be limited, although institutional selling pressure may affect the sector. In this climate, our focus on long-term winners capitalizing on long-term industry trends pays off.
Henderson, Columbia Threadneedle, Canada Life, M&G Investments and Aviva Investors followed Standard Life Investments in suspending trading in commercial real estate funds representing over GBP 15 billion. Aberdeen Fund Managers Ltd. cut the value of a property fund by 17% and suspended redemptions as well. According to the Investment Association, some GBP 24.5 billion is allocated to UK real estate funds.
Investors are increasingly worried that Brexit will propel the economy into recession. Pessimism among executives about the outlook almost doubled since the vote and June reports showed a fall in UK construction at the fastest pace since 2009. The pound plummeted to a 31-year low. Bank of England Governor Mark Carney signaled easier monetary policy and urged prudence on households.
Industry analysts have warned that London office values could fall by as much as 20% within three years of an actual UK departure from the EU. The big uncertainty for the UK (London) real estate market after Brexit is the demand for commercial real estate, both in terms of investor demand as well as occupiers’ demand. Especially the latter will be important as Brexit could cause many tenants to reconsider their London or UK presence. As long as this visibility remains unclear, it will be difficult to factor in any rental assumptions, vacancies or cap rates. Office supply will probably decrease as development pipelines will be adjusted.
Rental growth on the other hand has a strong correlation to GDP. Some analysts have therefore adjusted their rental growth forecasts by negative low single or even double digits. Fund flows might have a negative effect on valuations and, consequently, on cap rates as investors will pencil in higher return requirements given the unclear outlook.
It is important to note that the mutual funds mentioned manage direct real estate assets. Such funds are much less liquid than funds, such as Robeco Property Equities, that invest in indirect, listed real estate. Direct real estate funds have to sell UK real estate assets to generate enough liquidity to satisfy any further redemptions. An estimated total amount of up to GBP 40 billion is invested in such funds.
We expect listed UK Real Estate Investment Trusts (REITs), which are already trading at steep discounts to net asset value (NAV), to be impacted in two ways. Direct funds sometimes own listed REITs as a liquidity buffer, and can liquidate their positions to manage outflows. Liquidating direct real estate might also put pressure on cap rates, resulting in negative NAV adjustments. Still, overall we do not believe that direct funds will have a very significant impact on commercial real estate valuations in general.
Selling pressure of long-only institutional investors or (private) real estate investors in general will have a more profound impact on commercial real estate valuations. The exact impact is however difficult to assess right now. Much will depend on the actual tenant demand for office and retail space and the impact this will have on rental levels.
Positive factors that offset some of this negative impact are the decline in interest rates, sterling depreciation and the fact that any future speculative supply is on hold. For the listed sector and in particular our holdings we believe that balance sheets are strong, as REITs have actually de-geared their balance sheets. Real estate stocks outperformed global equities by around 500bp over June and year to date the sector outperforms equities by more than 800bps.
After the surprise outcome of the Brexit referendum equity markets initially corrected sharply but ended the month virtually flat. Real estate stocks also dropped but ended the month 4% higher. In particular US and Asia Pacific (ex-Japan) outperformed whereas the UK was a clear underperformer. Currencies had a significant impact on total performance, in particular the pound dropping more than 8%. As US Treasury yields dropped, this had a positive effect on fund flows to US REITs. We expect that the global search for yield combined with the implementation of the 11 GICS sector in September could support further sector inflows and valuations.
The past month clearly highlighted the risks of an active regional allocation strategy. Although the valuations of UK REITs were attractive with a 10% discount to NAV before the referendum, stocks are now trading at discounts of 20% to 30%. One of the fund’s key investment process principles is a regional neutral allocation. Political outcomes, betting on one region versus the other or having implicit currency bets is something out of our control. Instead we focus on long-term winners capitalizing on long term industry trends, while maintaining a regional neutral allocation.
In the UK office sector we still favor Great Portland and Land Securities. Both companies have de-levered their balance sheets, positioning themselves for a turn in a cycle that would ultimately come. Following Brexit, it has come. In June, the negative effect of our small overweight in the UK was offset by successful stock selection in this country. Robeco Property Equities returned 4.1% in June, outperforming the S&P Developed Property Index by 40bp.