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27th June 2016

Prices of UK and select Continental European REITs have been heavily impacted by the Brexit vote. On Friday 24 June, UK REITs fell by an average of circa 15% whilst real estate stocks on the Continent declined by over 4%.

As a consequence of the likelihood of a protracted separation, we expect UK property leasing activity to slow-down and real estate valuations to come under pressure at least until the actual business and economic impacts become clear. We do not foresee a rapid rebound in prices owing to the extraordinary situation where it is hard to identify clear winners from this shambles. Furthermore, we expect doubts over the sturdiness of the European Union will be heightened for some time. The departure of the Union’s third largest member, and one of its best performers, cannot be good in the short term at least.

Whilst we reserve the right to digest the complex information and change our opinion, we currently believe that prices are not yet sufficiently depressed to indicate deep value in light of this market changing event. We note that UK REITs have still managed to produce total annual returns of 8% compound over the past 5 years after taking into account Friday’s price reductions, ignoring currency movements. Furthermore, despite Continental Europe’s turmoil over the past 5 years, it has returned in excess of 11% p.a. in local currency terms.

From our investment portfolio perspective, on the eve of the vote, total combined exposure to UK and Continental Europe real estate was less than 20%. Furthermore, exposure to € and £ denominated investments was less than 15% of the portfolio.

We highlight that over the past 12 months we actively reduced exposure to UK REITs, from 12% to less than 7% on the eve of the Brexit vote.  The decision to reduce exposure was based principally on excessive price to valuation parameters. Whilst not the key driver, risks associated with the Brexit vote was a factor in our considerations albeit we did not place a greater than even chance on the outcome.

Over the past 12 months the biggest reduction in our UK holdings was targeted at the West End office exposed Derwent London (DLN) and Great Portland Estates (GPOR).

We note that our concerns of a possible Brexit were tempered by the strong financial position of the UK REITs in which we invest. REIT management has done an outstanding job of prudently managing risk and as a consequence we believe they face little medium term financial pressure. Indeed many UK REITs are positioned to exploit dislocation in the property market, which gives us reason to hold on to a number of our positions.

Our assuredness is based on key metrics such as Loan to Value (debt/assets) of circa 25%. Furthermore the companies have very little debt maturity in the short to medium term. Stocks in our portfolio, such as Land Securities Plc (LAND) and Great Portland Estates, have not only been deliberately deleveraging but also winding back development activity.

Our largest single UK holding is Assura Plc (AGR). Assura owns National Health Service (NHS) backed medical clinics with a 14 year average triple net lease term. Its loan to value is 30% (down from 48% a year ago) and it has no major debt maturities until 2021. The stock now affords a prospective dividend yield of almost 5% which may well look appealing for yield starved UK investors.

Our overall UK REIT exposure now is slightly above the benchmark weighting of circa 5%. On a gross “look through” basis (e.g. taking account of non UK REITs with UK investments, for example Westfield’s London shopping centre exposure) we have an exposure to underlying UK real estate of less than 9% of the portfolio.

On the Continent our total exposure to € denominated investments is less than 7% compared with the benchmark weighting to the region of circa 11%. The portfolio gross “look through” exposure is less than 9%. Our investments are weighted toward German residential investments (circa 4% of the portfolio) which are enjoying high levels of tenant demand and limited competition in the form of new construction supply.

We also note the fund has been holding higher levels of cash, generally above 4.5%, over the past quarter.

Let’s not forget that there are events taking place over the next 12 months which could significantly alter investor perceptions of other parts of the world, the US election high on the list. The UK appears to have made a misstep but we believe its institutions, if not its politicians, remain sound and the REITs in which we invest are in a strong financial position to withstand this uncertain environment and potentially thrive from the mistakes of others.

Resolution Capital Limited ABN: 50 108 584 167 AFSL No. 274491
Under the authorisations contained in its Australian Financial Services Licence, the Company is only able to provide general advice to its wholesale clients. Accordingly the information attached is for general information only. It does not have regard to a specific investment objective, financial situation or the particular needs of any person. You should seek advice regarding the appropriateness of an investment strategy discussed or recommended in the attached information and should understand that statements regarding future prospects may not be realised. You should also note that the returns from investments may fluctuate and that past performance is not necessarily a guide to future performance.