Real estate: Property fund gatings revive memories of 2008

Banks and investors are weighing up the impact of the UK’s vote to leave the EU on its commercial real estate market. The sector has been the focus for Brexit worries after all the large open-ended UK commercial real estate funds stopped liquidity or slashed redemption values in July. Open-ended funds own around 7% of UK commercial real estate assets, worth about £35 billion ($45.8 billion). 

Investors have also fled from commercial real estate investment trusts (Reits) and real estate companies. Shares in Land Securities – the UK’s largest listed commercial real estate company – fell 20% in the days after the vote, while London-focused Great Portland Estates fell even further. 

Richard Choi, head of real estate investment banking for EMEA at HSBC, says his bank has continued to move financings towards completion since the vote. Despite the noise around the gating of the funds and the dips in listed property companies’ value, he says it is too soon to tell the true state of the market – whether, for example, London office assets are facing a cyclical or a structural challenge. 

Listed real estate firms’ results in the autumn will bring some clearer signs on the impact to their businesses, says Choi. But he says it is likely that margins will go up in UK real estate debt financings, or at least remain the same in the event of a Bank of England rate cut. Higher loan-to-value financings will be hard, he says, while the commercial viability of developments will be under more scrutiny.

“We’re open for business and we have plenty of deals in the pipeline,” he says, “but clearly we need to be cautious given the market dynamics, as any other bank.”

“Gating the funds is a bit like capital controls:  they’re easy to impose  but very difficult to lift” Tomas Hirst, CreditSights

The gating of the funds was an early sign of what Brexit might mean for markets and the economy, says Tomas Hirst, London-based analyst at CreditSights: “If the net impact was neutral, it shouldn’t have an impact on the commercial real estate market… but investors aren’t reading it like that.”  Even before the vote, there were signs investors were tiring of UK real estate. Commercial real estate transactions dropped by a third in the first quarter of the year, with the slowdown particularly marked in London and among overseas investors, which both account for almost half the market after rapid rises since 2009. 

The message from the funds themselves is that there will be no fire sales, but as they must eventually amass enough liquidity to allow redemptions, thoughts have turned to private equity. 

Ian Rickwood, CEO of UK real estate private equity firm Henley Investments, points to figures from Inrev, an Amsterdam-based investor association. These show non-listed real estate funds in Europe raised a record €123.6 billion in 2015.

“The weight of equity still available for real estate is colossal, and that money will be deployed,” he says.

Any shift from the UK as a European financial centre will weigh on office demand, however, and office supply in London is on the up. Lower consumer confidence and costlier imports after the sterling’s steep fall will also hit retailers, which are already struggling with the shift to online shopping. In addition, according to a recent Bank of England report, every 10% fall in commercial real estate prices means a 1% decline in investment across the economy, as SMEs typically use real estate as collateral.

The gated funds generally have little or no debt, and analysts say the big difference with 2008 is the degree of leverage. The hope is the market can weather greater losses before covenants are triggered, forcing further sales. The majority of new loan requests had loan-to-value ratios below 65% in 2015, according to Laxfield Capital and cited by the Bank of England, although requests for higher leverage were increasing. 

UK banks’ exposures to commercial real estate averaged about 55% of common equity tier 1 at the end of 2015. RBS and Santander UK were the most exposed among the top six UK banks, according to CreditSights, while challenger banks and building societies generally have a higher leveraged commercial real estate book, according to Fitch. 

However, the other question – as individual savers wonder when they will ever be able to get their money back – is if and in what form open-ended real estate funds should exist at all, given how prone they are to panics when the first fund gates. The funds offer daily liquidity, despite holding assets that take months if not years to offload.

Standard Life’s UK Real Estate Fund was the first to pull up the drawbridge, followed the day after by the biggest fund (at £4.4 billion) run by M&G. In total six funds have suspended trading, while a further two (Aberdeen and L&G) offered liquidity but only at hefty discounts. Only a handful of much smaller funds continued to trade as normal.

The Financial Conduct Authority’ position, outlined in a statement in early July, is that funds need to think about allowing redemptions at new valuations, as some fund managers, such as Aberdeen and L&G, have done. 

“It seems we learn this every crisis and then unlearn it,” says Hirst. “Gating the funds is a bit like capital controls: they’re easy to impose but very difficult to lift.”