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The impact of Brexit

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A second UK application in 1967 met with the same response and it was not until 1973 that the UK finally joined at the third attempt. However, when Labour came to power in 1974 they fulfilled their manifesto promise to hold a referendum following a successful renegotiation of membership terms and in June 1975, 67% of the voting public elected to remain within the EEC. Nonetheless, even as members, the UK remained hesitant to fully commit to all of the European initiatives, most notably remaining outside the ERM, the forerunner of today’s EuroZone.

Given this history, perhaps we should not be so surprised that the June 2016 referendum on EU membership returned a majority (albeit narrow at 51.9%) in favour of Brexit. There had been persistent resentment at having to adhere to some of the EU’s regulations. The tipping point was arguably the loose immigration policy and its perceived impact on employment opportunities, pay rates and increased pressures on the welfare state and housing. This resentment was fanned by the growth of populist movements such as UKIP, a trend which was mirrored across a number of EU Member States.

Background

The current discord between the UK and the EU is another chapter in a long history of ups and downs between the two. Back in 1951, the UK declined an invitation to join the European Coal & Steel Community (ECSC), a forerunner of the EU. Then in 1961, the UK had a change of heart and applied to join the EEC, as the EU was then known. This was vetoed by the French and general de Gaulle’s infamous “non!”

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The economyThere was an immediate aftermath reaction – within 24 hours of the vote, sterling had plunged almost 10% to a three-decade low, share prices sank and gilt yields slid – however, the markets recovered fairly quickly and the FTSE 100 reached a record high in January this year and remains over 7,500. Meanwhile, employment is close to record levels and the economy, although slowing, is still expanding.

It is difficult to say how much the slowing in GDP growth is a result of Brexit, although anecdotally the uncertainty surrounding what will happen when the UK leaves the EU has caused some companies to postpone or amend investment decisions.

Sterling has been the most obvious casualty thus far and, at the time of writing, remains 5.5% below its immediate pre-referendum level against the US dollar and 12.7% down against the euro. This has been something of a double-edged sword: it has made UK exports more price competitive but it has also made imports more expensive. The net effect has been a widening of the UK trade deficit and a hike in inflation, the latter largely responsible for the Bank of England’s decision to raise Bank Rate last November for the first time in over a decade.

ImmigrationBrexit does appear to be having an impact on immigration. Net migration of European Union citizens into Britain almost halved in the 12 months to September 2017. Whilst immigration was the main reason many Britons voted to leave the EU, industry groups worry that Britain is becoming a less attractive destination for the workers they want – particularly in sectors such as engineering, construction and healthcare. Google search data suggest the number of people in other EU countries looking online for jobs in Britain recently hit a new low.

Real estate – commercialThe impact on the property market has been mixed. Commercial property investment did indeed rise last year, the majority of it coming from foreign investors (especially from the Far East) for whom the fall in sterling represented an effective discount. According to JLL, London ranked as the top city for global real estate investment in 2017 with total investment increasing by 35% compared to 2016. London is still regarded by many overseas investors as a safe long term investment option and there is no sign yet of any lessening of appetite for the market.

Brexit has generated considerable debate with regard to its impact on occupier demand in the London office market. Notably, banking & finance is considered by some to be at risk of suffering major net losses in terms of employment if a “favourable” deal is not achieved. Whilst this remains a possibility there is little hard evidence to suggest this is a certainty. Despite the best efforts of Frankfurt, Paris and, to a lesser extent, Dublin and Amsterdam, it has been reported that the likes of UBS (Union Bank of Switzerland) has scaled down its original estimate of 1,500 jobs leaving London to as low as 250, while a touted figure of 4,000 for JP Morgan has apparently become just hundreds.

It is worth noting that whilst the financial services sector is undoubtedly a very important component of London’s economy, in terms of the proportion of total employment within London the sector only ranks 7th with around 378,000 employees. The TMT sector not only employs more people in London than financial services but continues to expand, with Facebook the latest major player to open a new London office that will allow it to house 800 new jobs in 2018. Indeed, London is rapidly becoming Europe’s tech capital.

Brexit may be having an impact on occupier leasing requirements. The Citibase Business Confidence Index last November found that small and medium-sized enterprises (SMEs) are increasingly looking for shorter leases and terms of one to three years have become increasingly popular. Almost three quarters of Britain’s SMEs now want short-term flexible office contracts of less than three months.

Brexit has almost certainly had some impact on this with companies unwilling to make long term commitments within an environment of high uncertainty – some 42% of London SMEs interviewed expected a negative impact on revenue when Brexit finally takes place. The survey also reported that 23% (rising to 30% in London) of respondent business owners said Brexit was

Current situationAlmost two years on from the Brexit vote and we have yet to see any significant economic impact, despite pre-referendum warnings from the “remain” camp that the economy would plunge into a deep recession.

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already having a negative effect on revenue, a figure which rose by 2% in the first three quarters of 2017.

However, there has been a trend towards shorter leases for some time with the long-time standard 25 year institutional lease now almost non-existent. An emerging trend, not just in London but in major cities across the UK, is the growth in demand for flexible space. In 2017, flexible space accounted for around one fifth of all office take-up in central London, with WeWork being the largest taker of space in the capital over the past five years.

There is likely to be increasing demand for co-working space from larger businesses, as more corporate occupiers change their working culture and look to take on shorter leases. Demand for flexible workspaces is likely to be driven further by new lease accounting standards (IFRS 16) which require occupiers to capitalise rental liabilities on their balance sheets as leases under 12 months can be excluded.

Real estate – residentialBrexit impact on the residential property market has been equally mixed. In the owner occupier sector, a number of purchase decisions have been put on hold with Brexit concerns given as the reason, although it is difficult to say definitively whether this was the sole or even real reason. We have seen some evidence of EU nationals – specifically French – who have relocated back to France, although it is not clear how much of this was to do with Brexit and how much was due to President Macron’s decision to slash French wealth tax, which had originally driven many French households to the UK. That said, there does appear to be genuine concern among EU residents about their post-Brexit residency status, although the government is designing a system to give EU citizens who are already living in the UK ‘settled status.’

Buyer demand has certainly weakened in the prime locations in London, however this was apparent even before the referendum and was more to do with pricing than anything else. Indeed, prime London values began to fall in the summer of 2014 and in many locations remain under downwards pressure, although the rate of decline has slowed and in some locations there has been a modest return to growth in Q1 this year.

Buyer interest in prime London has risen over the past 6-9 months as asking prices have come down to a more acceptable level but transaction numbers remain low by historic standards. Some would say this is due to Brexit concerns although it is just as likely that buyers are waiting to call the bottom of the

market before committing. Moreover, high stamp duty rates and a phased reduction of tax relief on finance costs for buy-to-let landlords continue to hinder transactions.

Away from the prime locations, both within and outside London, transaction numbers have also fallen although this is mainly due to affordability issues and, at times, record low volumes of available properties. In spite of numerous predictions of a price crash, prices continue to rise nationally according to the Land Registry, albeit the rate of annual growth has slowed considerably. However, across Greater London, latest Land Registry data reveals that prices fell by 1% in the year to February for the first time since September 2009. Whether this is a temporary blip or the beginning of a more sustained downward trend remains to be seen.

The impact on the investment sector has been similar to that experienced in the commercial market. Some investors have postponed or shelved purchase decisions – although it is likely that the changes in the property tax regime and high prices have had as much or more to do with this than Brexit.

On the other hand, both foreign and UK large investors (e.g institutions, funds and property investment companies) have been increasingly attracted to the UK’s private rented sector which has grown rapidly over the past decade and is projected to expand further in the future. The private rented sector in London has risen from 14% of households in 1991 to 30% in 2016/17. Foreign investors have additionally benefited from the relative weakness of sterling.

PoliticsThe Brexit vote triggered a major political reaction with the resignation of Prime Minister David Cameron who had campaigned unsuccessfully for a “Remain” vote. His successor quickly called a snap general election which did not go according to plan and resulted in the Conservatives losing their majority. This has been, and will continue to be, a major obstacle in the Brexit negotiations as the government faces having to compromise with the “home team” on issues before it even arrives at the negotiating table with Brussels. This is in addition to having to manage the existing divisions within the Conservative party between the “remainers”, the “hard Brexiteers” and the “moderate Brexiteers”.

“Buyer interest in prime London has risen over the past 6-9 months as asking prices come down...”

“...both foreign and UK large investors have been increasingly attracted to the UK’s private rented sector which has grown rapidly over the past decade...”

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The deal was approved by EU-27 leaders at the European Council summit on March 22-23 but will only become legally binding once the withdrawal agreement is signed. However, the question of the Irish border remains unresolved and may yet be a deal breaker.

This agreement nonetheless provides some clarity as to the outlook for UK business for nearly three years and should support business investment as it should mean the UK initially continues to operate as though it were still inside the EU, until December 2020. The sting in the tail is that Michel Barnier, EU’s chief Brexit negotiator, has repeated that “nothing is agreed until everything is agreed”. The transition phase is one part of the package of negotiations that the UK and other European Parliaments will be asked to ratify at the end of this year. Barnier’s comments remind us that the negotiations are a “take-it-all” or “leave-it-all package”. As such, rejection of this deal by any of the Parliaments could still see the UK abruptly leaving the EU in 2019 with no deal.

The House of Commons Brexit Committee has published the UK government’s assessment of the economic impact of Brexit. The analysis suggests that there will be an adverse effect on the economy both nationally and in every region, and that the degree of impact will depend on the outcome achieved in the negotiations.

The impact on the economy is arguably the most important consideration. A PwC (PricewaterhouseCoopers) report commissioned by the CBI suggests a decision to leave the EU could mean that total UK GDP in 2030 would be around 1.2%-3.5% lower than if we remain in the EU. However, this could change depending on the trade agreements the UK could negotiate outside the EU, so the validity of these figures is somewhat questionable.

Trade and investment will be major factors in determining how successful the UK is when it exits the EU. The UK is by far the biggest recipient of foreign investment in the EU. However, almost half of the FDI stock in the UK originates from the EU, the future of which is now uncertain. The position of London as Europe’s biggest international financial centre is unlikely to change overnight. However, the loss of EU market access via passporting would have a significant impact on the UK financial services sector and the associated tax revenues. Banks and financial services companies could decide to exit London en masse after all which would have negative implications for the office market, especially in London, and to some extent on prime London residential demand, both in the sales and rental sectors.

A vote to leave means the return of the UK’s contributions to the EU budget. From 2010 to 2015, the UK’s average annual gross contribution to the EU amounted to around £16.8 billion. However the UK also receives a rebate and funding from various EU initiatives. This means that the UK’s average annual net contribution to the EU budget over these same years is estimated to be around £8.8 billion, or around 0.5% of GDP. Although in the near term budgetary contributions to the EU must still be made, and funding flows into the UK will continue, there will no longer be a requirement to make these contributions beyond the expected two year negotiation period (unless these become part of a deal similar to the Norwegian or Swiss models). The UK will also cease to receive funding from the EU, therefore “swings and roundabouts” outcome is possible.

Brexit will mean an end to EU regulation – but it could also mean that UK businesses have to adapt to a different set of UK regulations which could be just as costly, notably with regard to immigration. Currently, EU citizens are able to live and work in the UK without restrictions. Revised government migration policy could result in increased labour costs for companies with a high proportion of foreign workers, notably the building industry which could result in increased costs for property developers.

Politically, there is a risk that Brexit could result in a break-up of the UK. The SNP (Scottish National Party) is already keen to apply for separate membership of the EU for Scotland following Brexit while the Irish border situation remains unresolved.

OutlookThe Brexit negotiations have yielded some progress with the announcement that the UK and the EU have reached broad agreement on a transition deal which will last until December 2020.

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However, once free of any EU shackles, there may be opportunities for the UK to make itself more attractive for investment, for example via tax and regulatory incentives.

Market specific factors are likely to continue to have most impact on the residential and commercial property sectors, although no property market operates in isolation from the wider economy. There is a consensus view that the UK will experience “turbulence” for a period after Brexit but that the economy should settle down to steady growth thereafter with prudent management from the government and no global economic or financial shockwaves.

Due to its international make-up, London is likely to experience any Brexit fallout more sharply than the rest of the country. However, there is no sign to date that foreign property investors will suddenly desert either London or the UK post-Brexit. Indeed, there is every reason to believe that the flow of overseas money will continue to increase, especially into the burgeoning build-to-rent sector which is expanding not just in London but in most of the major regional centres across the country.

In the meantime, until the UK actually leaves the EU, it is uncertainty itself which is likely to have the greatest impact on the economy. This will potentially include commercial and residential property markets, if corporate and household investment decisions are delayed or shelved.

Conclusion

The bottom line is that nobody knows what will happen after the UK leaves the EU. There is clearly downside risk to both the property market and the wider economy.

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The contents of this report are intended for the purpose of general information and should not be relied upon as the basis for decision taking on the part of the reader. Although every effort has been made to ensure the accuracy of the information contained within this report at the time of writing, no liability is accepted by Chesterton Global for any loss or damage resulting from its use. Reproduction of this report in whole or in part is not permitted without the prior written approval of Chesterton Global. May 2018.

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Nicholas BarnesHead of Research

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