Tougher Times for the British Real Estate Market
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Tougher Times for the British Real Estate Market

British voters said "Yes" to leaving the European Union (EU) – this could have far-reaching consequences not only for the UK economy, but also for the real estate market. London's office market, in particular, is likely to see lower demand for office space. But prices for residential property are also expected to come under pressure in the short to medium term.

Clouded Economic Prospects

British voters opted to leave the EU, surprising the markets despite poll results suggesting a slight edge for the "remain" camp prior to the referendum. A lengthy phase of political and economic uncertainty is likely to have an adverse impact on investments and jobs growth. The tangible uncertainty will probably have negative consequences for private consumption too. Credit Suisse's International Wealth Management team have accordingly lowered the forecasts for GDP growth in the UK from 1.9 to 1.5 percent for 2016 and from 2.0 to 0.2 percent for 2017. In light of the weaker economic outlook, they believe the Bank of England will probably lower the benchmark interest rate to zero in the coming months.

Lower Demand for New Office Space

The clouded economic outlook will likely have negative consequences for the British real estate market. In the commercial sector, London's office market could come under particular pressure. There, traditional office-based businesses in the private sector account for around 40 percent of all jobs. In addition, the city is host to many multinational companies and firms in the financial industry. The economic uncertainty may make companies think twice before investing or recruiting, which could in turn depress demand for office space.

Rent expectations for British office space

Rent expectations for British office space

Share of landlords who have positive expectations for rents, minus those with negative expectations (last data point: 31/03/2016)

Source: Royal Institution of Chartered Surveyors, Credit Suisse

Ongoing Uncertainty

Uncertainty was already a factor in the first quarter of 2016, in both tenant and investor markets. For landlords, expectations of future leasing potential for office and retail space have deteriorated sharply. Investors, too, have become increasingly cautious: transaction volumes for commercial properties were around 43 percent lower in the first quarter of the year than a year earlier. A number of transactions have been canceled or put on hold. The transaction volume of EUR 14.4 billion was the lowest observed since mid-2014. The negative trend seems likely to continue over the coming quarters.

Early Signs of Office Market Cooling

On top of that, the office market in London, in particular, is in a late stage of the real estate cycle. In London's West End, the vacancy rate for prime properties climbed by nearly 200 basis points to 6.4 percent in the first quarter of 2016. At the same time, annual growth in rents contracted from more than 10 percent to just 0.4 percent over the last 12 months. Further complicating the picture is the fact that more properties are being developed. The number of building starts for new offices in central London is now at a 20-year high. In less central areas of London as well as several secondary cities such as Birmingham and Edinburgh, such a cooling is not yet evident. A glance at the initial yields shows that real estate prices have not yet reacted to this change in the fundamental data. Over the last 12 months, initial yields for prime office space in London, as well as in the country's other major office markets, fell further, or at least remained static.

Vacancy rates for British office properties

Vacancy rates for British office properties

Prime office vacancy rates

Source: PMA, Credit Suisse

Rents and Capital Values May Correct Sharply

The combination of economic uncertainty and a mature business cycle will probably have a negative impact on growth in rents and capital values. Rental prices in the central areas of London may correct by 5 to 15 percent by the end of 2018, while the downside for their capital values is estimated at up to 30 percent. Initial yields may rise by up to 100 basis points by the end of 2018 (source: PMA). Less sharp corrections are forecast for retail floor space. On the supply side, a weaker outlook for rents should depress investor appetite for speculative development projects, resulting in a gradual correction in the relatively high expectations of new properties coming to the market, which would have a supportive effect.

Regional house prices in Great Britain

Regional house prices in Great Britain

House prices by region, indices: Q1 2005 = 100

Source: Nationwide Building Society, Credit Suisse

Prices Rose Sharply for Residential Real Estate

The implications for the residential real estate market are difficult to assess at this juncture. The housing market has been on a strong uptrend since the beginning of 2013, driven mainly by positive real wage growth, low financing costs thanks to an accommodative monetary policy, and supply-side constraints. At the national level, nominal house prices are 35 percent higher than their end-2008 values. London prices are 80 percent higher, on average. Price growth in the British capital has recently decelerated, but was still up 10 percent YoY in Q2 2016. London's prime segment, on the other hand, has been much less dynamic of late. Over the last two years, prices rose by a mere 2.4 percent. One reason for this was a series of regulatory measures. The reform of the stamp duty land tax in December 2014 raised transaction costs for the upper price segment. And an additional stamp duty of 3 percent of the purchase price is being levied on second homes and buy-to-let properties.

Trend in British mortgage market

Trend in British mortgage market

Number of approved mortgages in thousands; mortgage rate (right scale)

Source: Bank of England, Credit Suisse

Job Jitters vs Low Interest Rates

The decision to leave the EU affects the housing market through several channels. Economic uncertainty raises job and income uncertainty, which tends to depress demand for owner-occupied housing. On the other hand, the potential for further interest rate cuts by the Bank of England suggest that financing costs will remain at the current low level. On balance, conditions will probably be less certain and more volatile for the British housing market, and prices are likely to come under pressure in the short to medium term.