A few lessons from recent history

With Britain’s exit from the EU a year away, Michael Brodtman reflects on what effect the decision has had on valuation and what it would be wise to keep in mind over the coming months. The dust has long since settled on the turbulence seen in the markets in the immediate aftermath of the referendum to leave the EU. But now that we have arrived at the next major milestone – the formal exit date of March 2019 – it is perhaps an appropriate time to look back on the impact that the referendum result had on commercial property valuations, and to understand if there are any lessons that might apply to what is to come in 12-15 months’ time. Crunching the numbers Figure 1 in the chart below shows the quarterly variation in transaction volume, at the all property level, over the past three years. Whereas in 2015 volumes tended to increase throughout the year, in 2016 this was not the case. The second quarter and particularly the third saw a decline in transactions, which eventually recovered in the fourth quarter. Some submarkets saw an even more pronounced fall in transactions after the referendum, including the London office market (figure 2). Those transactions that did take place, did so on average at higher yields: ■ At the all property level, the net initial yield on transactions in Q3 2016 was 5.5%, up from 5.34% in Q2. Yields on transactions then fell back in Q4, to 5.43%. ■ The pattern was more pronounced in London offices, where yields on transactions rose from 4.5% in Q2 to 4.81% in Q3, before falling back to 4.53% in Q4. ■ For individual transactions where a vendor wanted to effect a very rapid sale, sellers were occasionally forced to accept much higher yields. This spooked parts of the investment and valuation communities, with the impact particularly felt on larger, more complex schemes and development sites. Smaller well-let assets were largely unaffected. Challenges and causality These blips in the investment market were reflected in the occupational market, with take-up of London offices also dropping off slightly in the months immediately after the referendum. For the valuation industry, the above represented a challenge: with transactional and to a lesser extent occupational markets cooling sharply, if not exactly freezing, it was clear that a significant degree of uncertainty existed, which had to be reflected in the valuation advice given to clients. With volumes down, yields up, and demand uncertain, there could not be the same level of confidence in an investor achieving a valuation in the months after the referendum as had been the case in the months leading up to the referendum. Thus, it was necessary in many instances to include “uncertainty clauses” in valuations, for a period of a few months, as advised by the RICS Red Book. However, it is vital to understand the direction of causality. Although, as shown in figure 3, the period when these clauses were most often applied coincided with a sudden decline in capital values and a slowing in the rate of rental value growth, the clauses were not the cause of the softening in valuations; rather the sudden softening in values was caused by a temporary weakness in investment demand, which also made necessary the short-term use of uncertainty clauses. The market was quick to re-discover its level. Figure 4 compares GDP and all property capital growth. The two are closely correlated, but capital growth in 2016 was arguably lower than “deserved” by the rate of GDP growth. The strong capital growth seen in 2017, which appears more than merited by underlying economic performance, can thus be seen as the market “making up” for what was lost, or rather not enjoyed, in the previous year. Points to bear in mind As we try to anticipate what may happen when the UK technically leaves the EU, lessons from recent history are a useful guide. I suggest keeping in mind three key points: ■ Market volatility around the exit date will be less than around the referendum. People know what is coming, whereas the result of the referendum was a surprise. There is little justification for uncertainty in transaction markets: the UK has already seen yields correct relative to European peers, making further sharp movement around March next year unlikely. In the occupier markets, March is unlikely to bring any significant change in the level of uncertainty clouding decision-making. CBRE’s suspicion is that uncertainty over the terms of trade with the EU will not end in March 2019; given the shortage of time to negotiate a trade deal, a “heads of terms” document looks more likely at that stage, with more detailed negotiations of the precise terms of the deal following that. Much of this uncertainty is widely expected and priced in. ■ As with capital growth over 2016 and 2017, any short-term noise in values will be quick to correct; over the medium term, investors will see little difference. ■ The UK property market is healthy; all sectors performed well in 2017, with headwinds in retail offset by the strength in industrials as tenant demand remained robust and supply generally tight. Although investors are aware that we are late in the cycle, fundamentals are sound – pricing relative to other assets is compelling – and the huge volume of overseas interest shows that the UK is still seen as an attractive and secure location for capital. These factors point to a resilient market that should be well-placed to cope with forthcoming economic and political developments. Michael Brodtman is head of valuation at CBRE Pic credit: Simon Chapman/LNP/REX/Shutterstock