Investment Matters

UK Property Crisis

Perhaps the most specific fallout from Brexit, so far anyway, aside from their change in Prime Minister, has been in the UK property sector.  I thought there would be merit in expanding on W&D's piece last week on this sector.

What has happened?

An uncomfortable truth has emerged.  Eight large property funds in the UK (greater than A$25 billion of investments) have frozen redemptions (or in some instances allowing redemptions at substantial discounts).  That is, investors are not able to 'get their money out'.  Well, not immediately.

The problem is founded on concerns about property valuations, for instance some forecasters are predicting a 20% fall in London office prices as a consequence of lower rental demand post Brexit. 

It has also come about because of the mismatch between the ability of investors to request cash, and the illiquidity of the property assets being invested in. 

These UK funds are open-ended unlisted funds, with redemption requests normally paid in a few days, whereas an asset will likely take many months (or longer) to sell.  Hence, when many investors request a return of funds simultaneously, really the only way to regain stability is to freeze the fund.

Spiral?

The selling of properties to meet redemption requests (see more below), in conjunction with lower demand for leases and less willingness to pay, creates a downwards spiral - feeding into more redemption requests etc.  As we saw during the GFC, where UK property prices fell 45%, these situations can be a red flag for things to come.

Property valuations are relative, as well as being impacted by rental demand. Therefore, the UK property crisis will impact not just properties owned by funds, but all property valuations. 

Since the Brexit vote, we have seen the listed sector pre-empting formal write downs in property valuations, as shown in the following graph of the UK's FTSE Listed Property Index*.  

In summary, there has been a 17% fall since the Brexit vote on 23-Jun-16.

Brexit and UK property 

Forward risk 

The risks from here are threefold

Firstly, a fall in commercial property values.  As the funds need to sell assets to raise cash to meet redemption requests (assuming they cannot borrow), the sale of property assets will push prices down.

Every property fund knows that many other funds need to sell properties.  So, the first-mover advantage has already begun, with one large fund (Henderson Global Investors) offloading prime assets to provide cash to meet redemption requests.

Secondly, contagion into other sectors, notably the UK banking sector, as property loans go sour, lending covenants are breached, etc.  

This has already been anticipated by the Bank of England, which has aggressively eased liquidity requirements.  And there is one significant factor that moderates the risk: generally banks are in a better capital position than leading into the GFC (not necessarily the case in other jurisdictions). 

Thirdly, systemic problems in other property markets may become apparent, as global investors withdraw cash and funds' flows are impacted.  

An example in relation to the latter is the US commercial property market, with Morgan Stanley recently expressing concern about commercial valuations and unsustainable lending (potentially worse than the GFC in the commercial sector).

Implications & conclusions

We don't see any direct immediate impact on Australia's property sector.  

First Samuel's property allocation invests in listed funds only, mitigating the risk of investments being frozen.

Developments in the UK are, though, a reminder that things can change, and quickly - especially when the underlying fundamentals are not sustainable or sound.

We note that Australian commercial property valuations are stretched, with many REITs trading at a premium to those valuations.   Therefore, we retain our conservative position regarding clients' property investments. 

*FTSE = Financial Times Stock Exchange.