Financial markets loathe uncertainty. Over the past few weeks we’ve had quite a lot of that, with potentially more to come. If you’re an investor in Australian or Asian commercial property, or an advisor with clients that are, here’s APN’s view on how the big issues of the moment are likely to impact you.
1. How might Brexit affect local commercial property markets?
The UK is already suffering. Sterling is at a 31-year low and a number of property funds, including M&G Investments, Standard Life and Aviva, have been frozen, preventing their investors from making withdrawals. This is a sign of the level of panic among UK investors, not of problems with the funds themselves. Standard Life said it was facing “extraordinary market circumstances”.
In Australia, the impact has been limited. On the day the vote result was announced, the ASX 200 Index fell 3.17% while the AREIT sector fell just 1.95%, confirming its ‘safe haven’ status. Unsurprisingly, AREITs with direct UK exposure, including Westfield Corp, Goodman Group and Lend Lease, were sold off heavily on the day. Although APN’s position in these stocks is either underweight or nil, meaning the impact was negligible, even these stocks have since recovered. All up, Brexit is a big deal in Europe but not such much here. In fact, it may be a benefit to local investors (see below).
2. What about a hung parliament?
In our view this isn’t a great concern, either. Although the consumer sentiment index fell 1% to 102.17% last month1, in May retail sales rose 0.2% month on month2. That was below expectations but only just. Annual sales growth is still running at 3.4%. There might be some short term instability with consumers holding back on major purchasers but we’re not expecting any long term impacts. Also, bear in mind that we’ve lived under a hung parliament before, and survived.
3. Won’t Brexit impact the global economy?
The UK is Europe’s second largest economy and the fifth biggest in the world. The vote may trigger referendums in other EU nations, leading to a potential break up of the world’s largest trading bloc. Moreover, the terms of the withdrawal are still to be negotiated. Almost half of the UK’s trade is with the EU3, which is why the UK would like to retain the benefits of EU membership without actually being a member. The EU, though, is unlikely to let that happen as it may encourage further withdrawals. This is a struggle yet to play out.
The financial and commercial property sector is the mechanism through which this instability is likely to pass. To quote the chief economist at UK stockbroker Panmure Gordon, “Commercial real estate looked very vulnerable as we entered the referendum with most finance directors thinking the stuff was overpriced before Brexit. Add that to the fact that material changes to immigration and market access will affect prime office space occupants and a financial sector most correlated to GDP slowdown, then this looks like a perfect storm.”
The Bank of England is certainly worried, claiming that there could be a wider fallout from declines in commercial property valuations. The Guardian reports that 75% of small business loans, which constitute part of a bank’s capital buffer, are secured against property. Should valuations fall, this has a material impact on the banking sector and the wider economy.
The Bank of England has relaxed banking sector rules to allow up to £150bn in new loans to businesses and households, saying risks were “beginning to crystalise” and that the current outlook for UK financial stability was “challenging”. From the psychological to the political, Europeans have many reasons to worry about Brexit. But it remains a remote threat to Australian investors. More significant are the policy responses and their local impact.
4. How will the policy response affect Australian investors?
Since the Global Financial Crisis, investors have come to expect every threat to be met with lower interest rates and quantitative easing. We’re not expecting Brexit to be any different. The argument that interest rates were going to be lower for longer was already powerful. Brexit makes it more so. Whatever the case before, rates are now set to be even lower for even longer.
That’s a good thing for higher income generating investments like AREITs because it makes the comparatively higher yields more attractive. On Tuesday, Australian 10-year bonds traded at 1.95%. As of 4 July, the APN REIT Fund sported a running yield of 5.57%4 and the Asian Fund 5.99%5. The appeal is obvious, especially when one considers that Australian commercial property is quite remote from European troubles and, in a practical sense, likely to be unaffected by it.
With greater earnings visibility, historically low government bond yields and the spike in equity market volatility indicators, the safe-haven status of AREITs is set to continue. As we said in 7 big questions for AREIT investors before Brexit, “the recent surge in AREIT share prices seems to have a foundation and we believe the fundamentals remain attractive”. The reality of Brexit strengthens that argument.
5. What happens if Australia loses its AAA credit rating?
The fear is that if a downgrade occurs bond yields would have to rise, taking property yields with them. The implication is that property prices would have to fall to bring that about. The theory is contradicted by recent evidence. Most recently, Japan and the US have incurred credit rating downgrades on their sovereign debt without incurring an increase in 10-year bond yields. In fact, the opposite has occurred – yields have fallen. If the country is viewed as a safe haven, which Australia is, that’s a more likely outcome.
6. What about APN’s Asian Fund?
We believe the argument here is even more powerful. The growth and resilience of Asia is one of the globe’s few bright spots. Indeed, after the Brexit vote the Yen rose rapidly, reaffirming its safe haven status. With the commercial real estate sector in the UK and Europe highly challenged and global interest rates at historical lows, the reliable and relatively high yields on offer in Tokyo, Singapore and Hong Kong – the focus of APN’s Asian Fund – is likely to increase. The likelihood is that capital looking for a home in commercial real estate will shy away from the uncertainty in Europe and turn to key Asian markets. That’s good for APN’s Asian Fund.
7. So Brexit uncertainty may be good for listed real estate?
As counter-intuitive as it may sound, yes. Brexit is largely irrelevant for Australian and Asian listed property investors. If there is an impact and central banks respond to the uncertainty with more stimulus and lower interest rates, then it may result in the outperformance of commercial property in Asia and Australia, which are perceived as safe.
Commercial property that generates high, sustainable cash income yields from long leases is largely unaffected by the ‘uncertainty’ posed by Brexit and a hung Australian parliament (if that’s what we end up with). This highlights why we like commercial real estate – real physical assets offer investors an attractive cash rental income stream, especially when compared with bonds. It may be boring, but in times like these, it’s also beautiful.