Making sense of Brexit - update III - JLL

Making sense of Brexit - update III 1 August 2016

Summary • Early evidence on the immediate economic effects of the Brexit vote suggest a stark divide between the impact on UK sentiment and much milder spill-overs to the rest of Europe.

• Direct commercial property investment has slowed since 2015, though in Q2 this was largely due to a pre-vote slowdown in UK activity, as the rest of Europe saw an increase.

• A similar pattern is emerging from occupiers, with a “business as usual” tone in activity across mainland Europe set against caution in UK transactions (albeit that most are still proceeding).

• Market evidence suggests a swift, but relatively-shallow re-pricing of UK commercial real estate in response to the vote, with continued resilience in continental Europe.

• There is little evidence yet that Brexit is re-shaping corporate location decisions – this will require greater clarity on the UK settlement as well as consideration of a range of other factors.

Politics, markets and economics

Composite Purchasing Managers Indices

New UK PM sets cautious tone for Brexit talks The political situation in the UK has become clearer with the appointment of a new Conservative Prime Minister, Teresa May, and the establishment of a Brexit cabinet. The May government contains many prominent Leavers, including Boris Johnson, unexpectedly appointed as Foreign Secretary, and David Davis as the new Brexit Minister. In mainland Europe, the line has remained that the UK needs to trigger Article 50 before negotiations begin. PM May has had high level meetings with French and German Premiers, sending the clear message that the new administration needs time to build the right settlement and formal talks will not start before next year. So far this approach seems to be accepted as the best way to achieve an orderly Brexit. The autumn will see further engagement by the new UK leadership with EU stakeholders, as a prelude to evoking Article 50 in early 2017. Single Market access looks feasible without EU membership, but it remains to be seen if this can be achieved without unfettered free movement of people. For the rest of Europe, the aim will be maintaining existing trade links, but being careful not to give concessions that could imply a better deal for the UK outside the EU. Markets lifted by reduced political uncertainty The immediate post-vote market reaction was severe. The political upheaval created by the unexpected result and David Cameron’s resignation was clearly reflected in sterling, which immediately lost almost 10% of its value. But since Teresa May’s accession, the pound has regained some ground, stabilising at around $1.32 and €1.20, albeit well below its pre-vote highs. Financial markets quickly absorbed the impact, with sharp falls in global equity prices initially and financial and property stocks particularly hard hit. Since then a US-led global rally has triggered a swift reversal. Other major exchanges shared in this, including the FTSE 100. The recovery has been weaker in the wider FTSE250, which is less dominated by multinationals, and in French and German markets, though even these indices are now close to their pre-vote highs.

The Bank of England sought to reassure markets on the morning after the EU vote and has repeated this message several times since. So far, these reassurances have not been backed by substantive measures and the lack of a rate cut in July surprised many. After more bearish UK sentiment surveys, an August cut now looks very likely and the Bank may also consider further stimulus. The ECB is likely to wait and see by contrast, unless the economic situation deteriorates sharply. It has already loosened policy this year and scope for further activism is limited with market rates negative in the Eurozone. There had been worries that a Brexit vote, which was followed by ratings downgrades for the UK, would have an adverse impact on market rates. But by end-July, UK 10-year rates had fallen to just 0.8%, their lowest ever. German Bund yields have also sunk to historic lows of –0.1%, while Eurozone swap rates are negative to 5 years. Concerns that Brexit could reopen the cracks within the Eurozone have not been realised, with spreads between core and southern fringe rates remaining modest. Economic concerns concentrated on the UK It will be several weeks before post-Brexit economic data begin to emerge. In the meantime, there will be a focus on early sentiment surveys, which provide valuable insight, but can be volatile at times of uncertainty. Concerns about the UK impacts were reinforced by steep falls in flash Purchasing Manager Indices (PMI) for July, which perhaps took business confidence to a 7-year low.

Eurozone PMIs were significantly more robust, slightly down, but above expectation and consistent with continued growth.

and corporate real estate investments have benefitted from a weaker pound.

Concerns about the impact of Brexit on the UK economy have also been reflected in downgrades to the outlook. Comparison of house views (IMF and OE) and independent surveys (Consensus and HMT) show average revisions of -0.2 and -1.3 percentage points in the next 2 years for UK growth (see table 1). There remains considerable uncertainty too, as reflected by an unusually wide spread of forecasts around the average.

Europe records strong Q2 demand, while London slows The uncertainty of the UK referendum had limited impact on European leasing markets outside the UK. In Q2 2016, office leasing was down 3% on a year earlier, but this in part reflects comparison with an exceptionally strong 2015 figure. Indeed, the 2.9 million sq m office space transacted in Q2 was well ahead of the 10-year average. Total annual net absorption records a 3.8 million sq m change in occupied stock, up 75% on Q2 2015 and a clear sign of expansionary demand across key markets.

Impact of Brexit on GDP forecasts UK and Eurozone Current

UK

Eurozone

Difference from June 2016 view

2016

2017

2016

2017

OE

1.8

1.1

0.0

-1.2

IMF

1.7

1.3

-0.2

-0.9

HMT

1.5

0.5

-0.3

-1.6

Consensus Economics

1.6

0.7

-0.3

-1.4

Mean

1.7

0.9

-0.2

-1.3

OE

1.4

1.6

-0.1

-0.2

IMF

1.6

1.5

0.1

-0.2

Consensus Economics

1.5

1.3

0.0

-0.3

Mean

1.5

1.5

0.0

-0.2

While UK activity has been affected by the referendum, elsewhere in Europe, it remains “business as usual”, with leasing maintaining the vigour of recent quarters. Excluding the UK, European take-up grew by +4% on Q2 2015. Activity was up across the Eurozone: in German cities (take-up was +5% year-on-year led by Munich); France (Paris +16%); Benelux (Brussels +108%, Amsterdam +29% and Luxembourg +39%) and in Southern Europe (Madrid +76% and Milan +57%). Office take up (000s sq m, 4-quarter moving average)

The latest estimates for the Eurozone suggest that robust domestic demand and low interest rates will support the economy, with relatively modest adjustments post-Brexit. The mean estimate of the impact on GDP growth rates across the single currency area is -0.2 percentage points for next year. While growth rates remain slightly below trend in the region, the Eurozone currently appears resilient to the worst impacts of Brexit uncertainty. Occupier perspective Brexit drives portfolio re-assessment After an initial period of market volatility in the wake of the vote, corporate occupiers are increasingly focused on portfolio assessment and scenario planning. With many businesses articulating a preference for the UK to remain within the EU, teams are engaging with executive leaders to assess and review CRE strategy. Internal groups are actively assessing operational implications, risks and scenarios. Contingency planning had begun prior to the vote at some larger organisations. Yet the result came as a surprise to most and any planning will have been far from definitive. The inherent complexity of predicting the political outcomes of Brexit is leading many businesses towards caution. While speculation will continue until a settlement is outlined, evidence of changes to portfolio and location strategy remains limited for both the UK and continental Europe. Sterling’s depreciation has been one of the immediate impacts felt by international corporations. While currency volatility hits international companies selling products and services into the UK, selective M&A

By contrast, London office leasing volumes unsurprisingly suffered from the uncertainty leading up to the EU referendum, with Q2 office take-up down 56% on a year before and 28% below the 10-year average. London City recorded a more pronounced decline than the West End, a trend we expect to continue in the short term, given differences in occupier base. Inevitably, some requirements have been withdrawn since the vote, but active demand remains resilient and early figures for Q3 suggest that leasing is running ahead of expectations. European take-up volumes are set to remain robust in H2 2016. Our current full-year forecast of 11 million sq m would represent a decrease on last year’s levels, though after a stronger than expected H1 there is upside to this. While corporates will inevitably review options post-vote, we believe it will be some time before this has an impact on occupier demand. It is too early to detect shifts in office requirements in response to Brexit. There has been considerable speculation about which centres will benefit, with the Paris, Frankfurt, Dublin and Amsterdam most often highlighted as alternatives for London financials. Recently, Regus announced it is

speeding up expansion plans for Frankfurt on the back of increased inquiries, though other evidence is limited. This is no surprise as these decisions will involve the assessment of wide range of factors including market conditions and access to talent, and will not evolve until a UK Brexit settlement is clear. Office completions increased to 1.1 million sq m in Q2 (up from 780,000 sq m in Q1). But European vacancy continued to decrease, dropping by 10bp to 8.5% in aggregate, and the lowest rate since 2009. The mediumterm supply pipeline remains solid by historical standards, while office vacancy is expected to decline further against a background of steady demand. Any Brexit settlement is at least 6 months away and location decisions will play out over a much longer horizon. At present, some markets will be better placed than others to absorb new demand on the basis of their existing capacity and their supply-demand balance going forward. The experience of the recent past is also that small shifts in demand can bring a swift tightening and rapidly change rental dynamics. Medium term occupier outlook Most European markets saw no impact on leasing from pre-referendum uncertainty and we expect activity to remain robust for the rest of 2016. While there has been greater hesitancy in the UK, JLL estimates suggest that the majority of transactions are still proceeding, with only a small fraction withdrawn. Any potential strategic relocation decisions are unlikely until there is greater certainty on the UK settlement and associated trading, legal and operating considerations. Given the complexity of these, we believe that current warnings about impacts in London may be exaggerated. The impact of Brexit will vary considerably between sectors. Much of the initial focus has been on financial services. Potential changes to ‘passporting’ rights of the companies to sell into Europe, or to trade in euro denominated instruments from London, will be influential in long-term location and portfolio strategy. But these decisions will not be finalised until there is greater clarity. Other sectors including life sciences, energy, and consumer goods, which experienced less attention, report limited impact in the short term. All sectors will, however, be watching for greater clarity on the operational implications and adjusting their strategies accordingly. Outside of offices, increasing employment, rising real incomes and low interest rates have supported consumer demand and driven retail sales in Europe. Retail sales are forecast to rise by 2.4% this year and at a rate of just over 2% a year on average thereafter. All countries bar Greece and Russia are expected to see growth, with CEE, the Baltics, Ireland and the UK strongest. International retailer demand remains concentrated in Europe’s top tier cities. We expect Brexit will reinforce resilience in prime and new retail pockets, as the “ripple effect” continues in larger cities. European logistics witnessed another quarter of above-average occupier activity in Q2, driven by the ongoing shift towards omni-channel distribution. Although Brexit has heightened downside in one of Europe’s

largest markets, an increase in take-up remains in prospect. There is an ongoing need for corporates to restructure their supply chain networks to remain competitive and this should support occupier demand for European logistics in future. Back with corporates, while the political environment remains fluid, the announcement of a planned reduction in UK corporation tax rates (from 20% to 15%) marks the beginning of a wider policy to attract and retain international business, one that has also been seen in other European capitals. Inward investment agencies in many European centres are already active in pitching to international companies. Companies are also reviewing market conditions with interest, expecting more occupier-favourable conditions in the UK as markets adjust, although it should be noted that availability is currently low by historic standards in most major centres. Flexibility was already becoming more critical for corporates. We expect lease terms will increasingly adjust to incorporate greater flexibility, allowing occupiers to respond to the evolving political and diplomatic situation. Investor perspective UK market swiftly re-prices post-Brexit The vote to leave the EU has quickly impacted real estate investment in the UK with valuations quickly adjusted, yields moving out for the first time since the global financial crisis and rental growth expectations tamed. It is clear, though that the adjustments made are built on a fundamentally different basis to the 2007-09 period. That is to say that the current issues are seen by the market as contained to the UK, with limited risk of financial contagion. Following years of scrutiny by European regulators and more risk-averse conduct by market participants, there is limited excessive leverage within real estate and after years of weak supply response to improving demand, occupier markets are tight. Therefore, whilst we expected some pressures in the UK, at this stage, barring some major demand shock, they appear contained. Most important, the yield shift required by investors to accommodate the extra uncertainty of Brexit, is not applicable to the European context. Due to the rapid pace of developments - and the shifting sands of UK politics – the best way to look at the impact of Brexit is indirectly through equity markets. The UK REIT market has been efficient at pricing an increase in political uncertainty which has also been keenly felt in currency markets. As sterling corrected, REITS saw discounts to their net asset value widen to almost 30% (on a market capitalisation weighted average) from 8% before the vote. This sell-off has been partially reversed, but implies a (significantly smaller) downward revision in capital values and a small yield expansion.

REIT prices (June 23=100)

Limited evidence of contagion to European markets Looking outside of the UK, European listed real estate has been resilient. Whereas the UK REIT index is trading over 10% below pre-vote levels, European REITS are broadly in line or above their pre-vote positions. This positive dynamic for European real estate belies some negative spill-overs from Brexit in terms of a slightly more modest GDP outlook and negative sentiment, but does show the sector’s underlying strength. European real estate exposure appears able to retain its position as a sweet spot for global capital. This is encouraging sign when there had been a movement out of European equities in recent weeks into higher yielding (higher-risk) emerging-market sovereign debt. Capital flows split by Country (€mn, 4-quarter moving average)

As share prices reflected the market uncertainty, a number of UK retail funds had to meet growing pressure from redemptions. The mismatch between the liquidity of these funds and the underlying assets forced a number to suspend outflows to avoid a forced disposal of assets or applied aggressive discounts to their valuations to discourage redemptions. Although this attracted some negative press, suggestive of a repeat of the pressures of the global financial crisis, where there have been sales to meet redemptions, pricing appears not to have been aggressively reduced. In terms of the disposal of UK assets to meet redemptions, they have not been excessive and generally the assets have been of high quality and in prime locations, for instance Aberdeen Asset Management sold 355-361 Oxford Street to Norges Bank REM for £124m. The message from these disposals is that despite recent dislocations, long-term capital remains attracted to UK prime assets, particularly at a discount to pre-Brexit pricing. Furthermore, there appear to be plenty of buyers with strong cash positions, unlike during the global financial crisis. As we move beyond the vote, markets have become more settled. There remains uncertainty over the nature and timing of the UK’s exit from Europe, but the shock of the vote and the uncertainty of domestic politics have eased. The consensus is that sterling probably has further to fall against the US dollar, but, with improved visibility, it is easier to price the extent of that dislocation. As risk aversion has receded, REIT stocks have recovered ground lost immediately post-vote and property funds are starting to see inflows again. Both Aberdeen and L&G have also trimmed discounts on withdrawals over the past week or so. It is too early to precisely quantify impacts on the UK direct Commercial property investment market. Most UK deals in negotiation prior to Brexit are progressing with only a small portion withdrawn, and the impact on pricing has been mixed. Some segments are seeing discounts relative to pre-referendum levels, but others have yet to see any. The picture is likely to be nuanced and vary by sector and region, in particular, product offering long-dated income will out-perform shorter income in the current environment.

Within direct markets, the lag in transactional activity means it will be some time for the full impact of Brexit is felt. But it appears that demand for commercial real estate was strong across Europe at the time of the vote. Overall volumes for the region (excluding the UK) were up 15% in Q2, despite a dip in German volumes relative to Q2 2015, though this may be more an issue of scarce supply than demand. Looking ahead to the end of the year, we anticipate that demand for European assets will remain robust, with the adjustment in UK pricing unlikely to be replicated on the Continent.

Contacts If you need more information, please get in touch with one of the following contacts: James Brown Head of Research - EMEA +44 (0)20 3147 1155 [email protected]

Jessica Jahns Head of Hotels & Hospitality, Research - Pan-EMEA (Hotels) +44 (0)20 7399 5821 [email protected]

Jon Neale Head of Research – UK +44 (0)20 7087 5508 [email protected]

Jon Sleeman Director, Research - EMEA (Industrial) +44 (0)20 7087 5515 [email protected]

Tom Carroll Head of Corporate Research - EMEA +44 (0)20 3147 1207 [email protected]

For macro and Brexit related questions, please contact:

Robert Stassen Head of Capital Markets Research - EMEA +44 (0)20 3147 1117 [email protected] Ben Burston Director, Research - UK (Offices) +44 (0)20 7399 5289 [email protected] Adam Challis Head of Residential Research - EMEA (Residential) +44 (0)20 7399 5324 [email protected]

Andrew Burrell Head of Economics & Forecasting - EMEA +44 (0)20 3147 1180 [email protected] Tom Mundy Director, Research - EMEA +44 (0)20 7087 5028 [email protected] For media enquiries, please contact: Lorena Sanchez Marketing Communications Manager - EMEA +44 (0)20 7087 5126 [email protected]

Alex Colpaert Head of Offices Research - EMEA (Offices) +316 5067 1152 [email protected]

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