August 23, 2018 / 1:10 PM / 2 months ago

'Safe as houses'? Brexit looms over UK real estate market

LONDON (Reuters) - Investors are ditching British real estate as Brexit uncertainty, rising interest rates and inflation erode house prices and office values in a market hurtling toward a potentially messy exit from the European Union.

FILE PHOTO: Terraced houses are seen in Primrose Hill, London, Britain September 24, 2017. REUTERS/Eddie Keogh/File Photo

Shorting real estate investment trust (REIT) stocks is gaining in popularity, as the government publishes plans to cope with any disruption if Britain and the EU can’t agree on the terms of its departure.

The list of the UK’s top 50 most shorted stocks is peppered with real estate names. They range from REITs Intu (INTUP.L) and NewRiver (NRRT.L) to housebuilders Crest Nicholson (CRST.L) and McCarthy & Stone (MCS.L) to the number one short, Travis Perkins (TPK.L), which sells building materials, Markit data shows.

Short interest data from FIS Astec Analytics shows REITs that concentrate on residential and office space have higher share-borrowing activity and costs - a measure of demand to borrow the shares in order to short them.

The short - net of borrowing costs - would have been lucrative. British REITs have underperformed their European counterparts by more than 20 percent since the referendum.

(Graphic: REIT stocks UK versus Europe Aug 23 - reut.rs/2OZft17)

OFFICE EXODUS

Office real estate is also under pressures from Brexit. London offices now demand a hefty premium over those in Dublin, Paris, Frankfurt or Amsterdam, but a drop in London’s relevance as a financial center is weighing on its market valuation.

Several banks are already moving part of their operations from London to cities like Dublin, Frankfurt, Paris, and Amsterdam after Brexit.

“People are clearly thinking that with Brexit there will be some movement to Dublin, and therefore why should London command a circa 50 percent premium on a per square foot basis,” said Henry Dixon, portfolio manager of the Undervalued Assets fund at Man GLG.

Fewer EU nationals working in the country will also lower demand for both residential and office space.

The second quarter saw the biggest drop in EU nationals working in Britain since records began. Net EU migration to Britain has fallen to its lowest since 2012.

Market pricing has already, to an extent, factored these pressures in.

“If London offices are being valued at 1500 pounds per square foot but [REITs are trading] at a 30 percent discount to net asset value,” Dixon said. “In many ways the market seems to be already valuing London as being akin to Dublin.”

Land Securities (LAND.L), which derives nearly half its capital value from offices in London’s City and West End, trades at a 30 percent discount to book value. But even that discount isn’t enough to attract investors.

(Graphic: Price-to-book value of UK REITs - tmsnrt.rs/2OZg7f3)

HOUSING IN A “HOSTILE” ECONOMY

House prices have also been feeling the strain. They rose annual 3.0 percent across the United Kingdom as a whole compared with 3.5 percent in May, the weakest increase since August 2013, ONS figures showed.

“There’s a received wisdom that there is safety in these things because of the old ‘invest in bricks and mortar’ adage, but we just couldn’t disagree with that more right now,” said James Dowey, chief investment officer and chief economist at Neptune Investment Management.

“The domestic economy has been hugely supportive of the UK housing market for many years, but over the past couple of years it’s suddenly become really quite hostile,” he said.

London - where prices were pumped up post-crisis by global capital inflows and demand for safe assets - has seen the biggest decline in its house prices. They fell by 0.7 percent, the biggest fall since September 2009, during the global financial crisis.

The average discount versus original price is widening, properties are taking longer to sell, and the supply of “for sale” properties is creeping up, UBS analysts found.

About 46 percent of London’s 68,000 partly built homes have yet to find a buyer, the most ever, according to property market research firm Molior London.

To an extent, the downturn was coming even before the Brexit vote - but uncertainty has accelerated it.

“We have been negative on London residential for eight years,” said Rogier Quirijns, portfolio manager and head of European research at Cohen & Steers, the largest REIT investor globally.

London’s housing market is past the peak of its cycle, while real estate in European cities still offers around three years of growth, he argued. Quirijns invests in Berlin residential real estate as well as Madrid and Paris.

Rising inflation - in part a consequence of the pound’s devaluation after the referendum - is putting more pressure on UK real estate.

House prices in the top-end prime residential market of London have come down by 20 percent from the peak in 2014, Man Group’s Dixon estimated. While most of that has been in nominal terms, but the rest will occur in real terms, as inflation erodes the real value of homes, he said.

The Bank of England’s rate rises, the first since the crisis, are also adding pressure to buyers, with mortgages becoming more expensive to pay off.

(Graphic: London rent prices fall - reut.rs/2OZfClb)

“IF THE BLOOD FLOWS IN THE STREETS”

Some investors see the potential for a big value play in real estate.

“If things really get bad, if rents drop, I could invest. If the blood flows in the streets, then I could go back in,” said Cohen & Steers’ Quirijns.

Man Group’s Dixon also said that for REITs, as for every stock he watches, the portfolio managers have a clear idea of a price at which the shares become “too cheap to ignore”.

The fact the stocks are widely shorted sets the foundation for a potentially strong rally if sentiment improves, as short sellers rapidly unwind their positions.

But in the meantime, investors can only wait and hope for more clarity as the formal exit draws nearer.

“We would have to see a good deal, a soft or relatively undisruptive Brexit, and then we would want to see some recovery in the economy [before investing],” said Neptune’s Dowey.

The catalyst for a recovery could come as early as October, when Britain and the EU might strike an exit deal.

But diplomats in Brussels on Tuesday said they expect leaders to have to hold an emergency summit in November instead, having missed the informal October deadline.

“I personally feel it’s going to go down to the eleventh hour,” Dowey said.

(This version of the story was refiled to fix a typo in the first paragraph.)

Reporting by Helen Reid, editing by Larry King

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