BREXIT - A Tale of Two Economies

Mangalesri ChandrasekaranOctober 25, 2016

 

At a time when looming tax law changes are making UK buy-to-let investors jittery, Brexit has certainly added anxiety to the situation. Forecasting where the UK property market is heading is definitely now a much more complex exercise. It would nevertheless be noteworthy to know that Brexit happened at a time where the UK economy is at one of its most prosperous moment since the 2008 crisis.

The unemployment rate is at a record low of sub 5%, funds under management are at an all time high and the housing market (ex-prime luxury) is in an excellent state when you consider the supply and demand conditions. If Brexit was inevitable, this would be the best time for it.

With the unexpected vote to leave the EU, the UK has put itself on a very tricky and uncertain path. What the future of the UK, and indeed the European Union, will look like when negotiations are over is anyone’s guess.

The back and forth posturing and pronouncements going on is akin to two boxers squaring up before a fight. Negotiation will be tough, and we suspect at the end there will be no victories, nor losses. Just a lot of horse-trading and compromises.

In fact, the few days following Brexit showed exactly how undecided the market was about the whole situation – first with a sudden drop in the FTSE followed by suspension of several commercial funds only to be followed by both bouncing back in the following weeks.

In fact, the only victim at this moment seems to be the GBP which fell to a record low. While some might see that as a negative, we tend to think that this will propel the services and export industries to a new height. Think tourism and education.

What surprised everyone was the realisation that the UK economy is in much better shape and was able to withstand the onslaught, even if that was somewhat more docile than expected at this stage. Employment, in particular, the benchmark of a healthy economy, has not taken a hit since the vote, holding up the rental market to support the property market.

 

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One might argue that since Article 50 has not yet been triggered (needed to commence the exit) we have not yet felt the full brunt of the event. That is true. However, the decision is clearly irreversible and we suspect the market would have priced in some risk by now.

Let’s spend some time taking it all in and attempt to make some forecasts for the property market and how investors should consider this market.

 

Market Fundamentals

 

There is a serious disparity between supply and demand that runs deep within the London housing market today. A recent report by RICS (Royal Institute of Chartered Surveyors) suggested that rising costs could mean that by 2025, 1.8m more households will be looking to rent rather than buy.

There is a growing number of well-off professionals who are renting, providing plenty of stability, growth and upside for the buy-to-let market.

London’s many universities provide a seemingly endless supply of renters. With increasing sophistication, the quality of housing that millennials require (and, more importantly, their parents) and are willing to pay for is now on a level once reserved only for young professionals.

While Brexit might pose a risk for the workforce especially in the finance industry, we are of the opinion that the current strength of the economy and the weakening of GBP will drive other sectors to pick up the slack.

We suspect the mass exodus of the EU workforce as UK resumes control of its borders is overstated and the government will try to minimise this. A combination of cheap GBP and the UK winning 2 of the top 5 universities in the world (Oxford and Cambridge) will likely encourage an influx of international students (including those from Europe) providing a comfortable cushion for the economy.

On the supply end, there might be a potential slow down as developers might not be keen to build for an uncertain market. That would likely translate into fewer projects coming onto the market reducing future rental supply.

That said, since the referendum, we have yet to see a slowdown in development and more than 60,000 build-to-rent units are now in the pipeline (British Property Federation). Whether that confidence will waver as Brexit becomes more of a reality in the coming months remains to be seen.

 

Government Policies

 

The government has consistently promised to build more homes given that the UK is woefully under-supplied, both in London and in development zones in the north of the country such as Birmingham, as well as locations within the South East commuter belt.

The House of Lords Select Committee on Economic Affairs has suggested that the UK needs 300,000 homes a year to have a moderating effect on affordability. The current construction pipe-line is nowhere near that figure.

Developments, especially affordable homes, are being encouraged and are supported by the rental market. Knight Frank estimates that the build-to-rent sector (purpose-built rental accommodation) will be worth £50 billion by 2020.

 

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Currency Movements

 

While we are not expecting a significant economic impact from Brexit on the UK, the impact on GBP will be quite a different story.

Earlier this year, we told our investors that GBP will be facing quite some headwind but not because of any weakness in the UK economy, but rather the weakness in the EU.

Brexit will impact the EU more than the UK for the simple reason that the EU is currently plagued with challenges on all front including a weakening economy. Germany itself is on the brink of a recession brought on both only by its inherent economic weakness, but compounded by weakness in the Europe banking sector.

Angela Merkel is seemingly losing her grip on Germany and with that the country might transit to again, a more socialistic government next year. One which might no longer be too keen to put the priorities of Europe above Germany.

As we like to tell our clients; while the UK faces administrative risks, Europe faces an existential risk.

The potential challenges all across Europe will likely have a contagious effect on the UK since the region makes up almost half of its trade. This will have a detrimental effect on the GBP. While the economic affluence of the country will tempt an interest rate rise, a weak European economy might just hold that at bay. That is why we have a short-term negative outlook on GBP.

 

Conclusion

 

The story of the UK, post-referendum, remains largely unchanged but its future is uncharted. Current take-up remains strong as the GBP weakens. Supply of good-quality stock is limited and the development pipeline is progressing steadily.

We do not envisage an oversupply situation and therefore vacancy rates will likely remain low, with rents maintaining an upward trajectory. Prices have dropped slightly (by 0.9% across the UK, and 5.6% in London), showing that sellers are cutting deals to bypass the uncertainty in the wider economy, and buyers are taking advantage.

Weaker GBP will likely lead to stronger buying interest from international buyers on the top end, and government initiatives will support demand on the bottom more affordable end.

If we pair this outlook with the fall of the pound, it does seem that the market has never looked better for foreign investors to participate in the London market.

 

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Jenna joined RunningStream in July 2016, bringing with her extensive experience and knowledge of the UK market. She previously worked with several asset management firms managing over £1 billion worth of office, retail and residential developments across UK and Europe. In addition, she graduated from The College of Law Moorage with electives in commercial and property law including finance.

This article is contributed by RunningStream International (Singapore).

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