October 20, 2017 / 8:05 AM / a year ago

Fitch: Brexit, Rates are Key Risks for London Offices

(The following statement was released by the rating agency) LONDON, October 20 (Fitch) The core London office market has cooled since the UK's EU referendum but remains highly overvalued, Fitch Ratings says. Tight office supply has supported prices to some extent, while sterling's weakness has caused a recent boost in overseas demand for trophy assets, allowing City office yields to fall back slightly in 2017. But uncertainty associated with Brexit is likely to see the cyclical correction resume during 2018. Longer term, the potential for rising interest rates presents considerable downside risk. Office values began to fall just before the June 2016 EU referendum. The continued fall after the referendum meant that overvaluation in the City submarket, measured as the market value decline needed to bring values into line with Fitch's cyclically-neutral metric, dipped from almost 40% in spring 2016 to below 30% a year later, before bouncing back slightly in 2Q17. CHART: <iframe src="https://e.infogram.com/86fe4431-7c49-4e03-8c38-3fb34d402eb5?src=embed " title="London City Office MVD to Cyclically-Neutral Metric" width="550" height="618" scrolling="no" frameborder="0" allowfullscreen="allowfullscreen"> Property transaction volumes have risen this year on the back of the record-breaking overseas acquisitions of 20 Fenchurch Street (GBP1.3 billion) and The Leadenhall Building (GBP1.2 billion). Purchases are being funded by significant foreign equity, rather than debt, partly in response to the post-referendum fall in sterling. The so-called "wall of equity" has been one driver of reduced UK CRE lending volumes in 1H17, but we think weaker sentiment among domestic investors is another. One reason price falls haven't been steeper may be that property developers have taken a more cautious and flexible approach to new developments than in previous cycles. Development plans that are either uncommitted or funded on-balance sheet can decelerate, while low interest rates also give indebted developers flexibility over construction speeds. The responsiveness of new office supply to lower demand may cushion one likely Brexit impact, namely the loss of financial sector jobs as global occupiers reduce their UK presence. Bloomberg reported last month that up to 13,000 London banking jobs were slated to move to the EU after Brexit. A Reuters survey released on 18 September suggested around 10,000 finance jobs would leave the UK or be created overseas if the UK left the Single Market. The ultimate impact on UK financial sector employment is hard to assess while terms of the UK's EU departure are unknown. Oliver Wyman estimated that 31,000-35,000 jobs could be lost if the UK acquired third country status without regulatory equivalence or new access arrangements, with 40,000 more dependent on knock-on effects. Even if the number is at the high end and concentrated in central London, the immediate direct impact will be limited. Our initial estimates indicate that 70,000 central London office job losses (or around 3%-4% of office workers in the major central London submarkets by some estimates) would result in a modest reduction in aggregate rents, although the impact would be unevenly spread. Long-let offices (which dominate City and Canary Wharf office exposure for UK CMBS) would be much less affected than newly vacant offices having to offer large incentives. Some could convert into flexible workspaces to appeal to firms waiting to see the full impact of Brexit. In this initial phase the overall market shock should be contained, with value declines in the low or mid-single digits. Brexit creates longer term uncertainty over the UK's macro-economic performance. In a scenario where it significantly weakens, the spill-over into property would go well beyond office headcount losses. A recession causing a relatively even reduction in corporate earnings would broaden and deepen the fall in rental value, and could cause a reversal in capital flows and a freeze in bank lending. This could see 10%-20% rapidly written off market values across central London offices. A scenario that saw faster-than-expected interest rate rises and a rise in unemployment across service sectors would weaken London office values further. In previous downturns, values overcorrected, and in the medium term if weaker occupational demand led banks to conduct fire-sales, or if higher rates forced debt-backed construction plans to accelerate, then we could see over 40% cut from London office values, taking them below our cyclically-neutral metric for the first time since mid-2010. <a href="(here">Disruptive Technology: UK Shared Workspaces <a href="https://www.fitchratings.com/site/re/894667">UK CRE: Countercyclical Lending Boosts Loan Returns Contact: Euan Gatfield Managing Director, Structured Finance Fitch Ratings Ltd +44 20 3530 1157 30 North Colonnade London E14 5GN Daniel York Senior Director, Structured Finance +44 20 3530 1034 Mark Brown Senior Analyst, Fitch Wire +44 203 530 1588 Media Relations: Athos Larkou, London, Tel: +44 203 530 1549, Email: athos.larkou@fitchratings.com. The above article originally appeared as a post on the Fitch Wire credit market commentary page. 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