Private lenders are justifiably concerned about the implications of “Brexit”—the British exit from the European Union—for the U.S. commercial real estate market, considering the wave of uncertainty that has washed across the UK and Europe. In the months prior to the June vote in the UK, the CRE industry appeared to be flattening out, suggesting it had reached the peak of its seminal business cycle.
Naturally the “view” from the top of any business cycle tends to be downward, but the question remains: Will Brexit be the catalyst that pushes the U.S. CRE into bearish territory? Or will it prove to be a boon as interest rates stay low and investor liquidity flows to the safety of our shores? The answer will be determined in time. As this all plays out, private lenders should carefully monitor what is happening across the UK and EU markets, as opportunities and new deals are sure to surface as a result, as well as a hefty new dose of risk.
Prior to this year—and the instability associated with Brexit—the UK had enjoyed steady growth in the commercial real estate market. Indeed, compared to its last peak in 2007, prior to the Great Recession, the UK’s Commercial Property Price Index has more than doubled. Assets across all manner of CRE investments were paying off and attracting more buyers.
However, during the spring of 2016, signs began to emerge that the party was almost over and the hangover was starting to set in. Over the three months prior to the Brexit vote, deal flow in the UK and EU slowed significantly, particularly in London. Of the pending deals, many had contingency clauses that allowed lenders or buyers to exit the contract in the event Brexit passed.
In advance of the vote, most polls suggested the “Remain” side would win by a couple of percentage points and the UK would stay in the EU economic structure. However, prudent lenders and buyers were nervous that Brexit might somehow happen, an anxiety compounded by the localized shocks of grisly terrorist attacks.
Starting in early July, before the vote, several leading commercial property funds barred withdrawals by investors who wanted to cash out as a hedge against a possible Brexit downturn. Given the vote to leave the EU, more funds are likely to adopt this approach over the course of this summer.
Brexit, Regret It.
On June 24, pure panic set in across the investment world. The official vote was announced: Britain would leave the EU. Prime Minister David Cameron, chief advocate of the “Remain” side, stepped down. The ruling Conservative Party was reshuffled and a new Prime Minister selected. Meanwhile, nobody had a clear view on how a breakup between the highly integrated UK and EU markets was supposed to proceed. Leaders on either side of the English Channel could not even agree on the start date for the untangling.
For investors and buyers, the news of the “Leave” vote and the calamitous political environment left in its wake caused CRE markets in the UK and EU to seize up virtually over night. Pundits declared it would lead to a severe downturn of all world markets. The public CRE companies trading in U.S. markets, as well as the London bourse, all took a big hit in share value. Global and domestic banks immediately adopted a much tighter approach to buyer debt ratios. Meanwhile, the British currency plunged, causing CRE funds in Britain to lose billions of value in a matter of days.
Banks across the UK and Europe were battered as a result of the vote and remain that way, with share prices tumbling and bond prices also under pressure. According to an article in the Financial Times, the cause is less a direct effect of Brexit and more a function of what the central banks of Europe are going to do about it: “The medicine: very low interest rates, with little difference between short- and long-term interest rates, make it hard for banks to profit from lending.” Italian banks, the article went on to note, were in trouble long before the “Leave” vote.
Now, all pre-existing problems for the banking and CRE sectors across the EU can be, for political and policy purposes, thrown into one common bucket called the Brexit effect. No matter what the original root cause of these problems was—like Italy’s overly aggressive track record in property lending—the EU now has to deal with the symptoms in a collective manner; with, as usual, larger economies like Germany bearing the brunt of the cost.
Brexit, Terrorism and the Very Bad Summer
While the UK is ground zero, real estate in the EU is under tremendous pressure and not simply because of Brexit. It was reported after the bloody July attack in Nice, France, that one of the main extremist aims was to destroy the economy of that country. Shocks that harm tourism, a vital economic sector for most European countries, have a cascading effect on investments in hotels, restaurants, airports and infrastructure. Similar acts of terror in Belgium, Turkey and other countries compounds the feeling ordinary Europeans have of being under siege. CRE service companies across the EU have lowered expectations, as deals have been canceled or downgraded.
Will Brexit Impact the US?
Prior to the Brexit vote, the U.S. CRE market was already showing signs of being at the peak of a lengthy business cycle, possibly at a bubble stage, with a potential market correction looming. Regulators took notice.
In 2015 the Fed, FDIC and others issued warnings about lending practices in CRE transactions. Banks had over $1.8 trillion in outstanding loans—billions more than the last peak before the Great Recession. This year regulators and lenders began to carefully monitor the risk in CRE loans versus equity and are now backing off some loans. According to one report, bankers are getting tougher regarding lending for more speculative projects, lowering allowable loan-to-value ratios. Expectations that the Fed would increase interest rates, albeit slowly, created more cause for worry. It’s a stew of uncertainty peppered by terrorism, an unpredictable presidential election cycle, a slowdown in China’s economic growth and now Brexit.
London newspapers as well as some American media outlets likened Brexit to a contagion that would infect all the world’s markets. But in fact, the U.S. has been pretty well inoculated. This inoculation results from two factors.
First, the Federal Reserve’s philosophy is to use low interest rates as a lever to support economic growth. When the economy is healthy, the Fed is supposed to ease up on this lever so rates gradually increase. Last December, after seven years of the most accommodating monetary policy in U.S. history, the Fed approved a quarter-point increase in its target funds rate. The range for its target funds rate went from 0 percent to 0.25 percent previously, to 0.25 percent to 0.5 percent where it is today. Prior to Brexit, there was widespread expectation of another 25 basis point increase to come by the fall of 2016. Now, however, the “Brexit Surprise” caused the Fed to reverse course and signal that the time is no longer right for an additional interest rate hike.
Secondly, massive amounts of investor liquidity from the UK and Europe are likely to flow to the relative safety of the U.S. market, given the unpredictable path ahead for the UK and EU in determining their economic engagement for the post-Brexit era. Investors and analysts reached this conclusion pretty quickly in the aftermath of the Brexit vote. The doom-and-gloom expectations for major indexes lasted no more than three weeks, and by mid-July, the Dow Jones Industrial Average jumped to several all-time records.
Be Bold, But Not Too Bold…
Because of today’s high risk in the CRE market across the UK and Europe, and the fact that the US market—while relatively more stable—still presents a good amount of unpredictability, private lenders need to be more vigilant about risk while keeping the door open to lucrative new opportunities. The risks are many: property and collateral values may fluctuate; funds and traditional lenders may pull money out of deals; and buyers may bail out of contracts. Yet other factors may create positive conditions here. For example, investors who ordinarily would have pursued deals on the other side of the Atlantic may flock to the relative safety of the U.S. as buyers find more attractive possibilities here. Traditional lenders getting the screws put to them by regulators may leave prospective buyers hungry for private lending, despite a yield spread that will probably widen over the next few quarters. While the total number of CRE deals may well shrink from the torrid pace of the last few years, the percentage of deals coming to private lenders may actually increase as a share of the market.
Furthermore, while regulatory and market conditions are different and require careful research, intrepid private lenders may also find opportunities in the UK and Europe in this post-Brexit environment. Even though there may be some great opportunities, without a doubt there will be fewer overall CRE opportunities on the other side of the Atlantic.
While it’s very early in the process that will see Britain start a new course on its own, investors should stay upbeat and diligent. There will be gems out there for private lenders looking for the right opportunities. The big drop in the British currency against the dollar could offer as many good deals as it discourages.
As the multinational and regional European banks back off during the transition, by ratcheting up collateral requirements and making financing, insurance and securitization of CRE deals more difficult in a bid to reduce their portfolio exposure, many buying and financing opportunities are likely to emerge for those private lenders paying attention.
Everyone should move with the understanding that Brexit is the first such divorce from the EU and could result in further financial crises. The EU countries are fluid and economies like Italy could be in danger at any moment. Private lenders will want to do more than their usual due diligence, but the potential victories on the other side of the Atlantic could be well worth the effort.
This article was originally published in Private Lender Magazine. Check out the full magazine along with other great articles.