PGIM: UK could outperform if Brexit uncertainty fades

The UK’s real estate market could surprise on the upside and outperform if Brexit uncertainty fades, predicts PGIM Real Estate in its forecast of late cycle investment opportunities, while low vacancy office markets, logistics, residential and real estate debt strategies are also tipped as late cycle winners.

Among major European markets, the cycle of the UK is clearly at odds with other major core markets, says PGIM.

Greg Kane, Executive Director, Head of European Research at PGIM Real Estate, explains:

“Brexit continues to pose a significant policymaking challenge and remains a source of uncertainty. So far, it has not led to an economic recession or a sustained downturn in real estate markets, but performance has lagged Continental Europe since mid-2016. However, assuming an orderly exit from the European Union, the economic outlook remains fairly bright. This begs the questions: at what point does the ‘wait-and-see’ approach of investors shift? And what constitutes a clear buying signal?

“The supply side has responded, both in London and in other key cities such as Birmingham, Edinburgh and Manchester. Already, a yield gap has opened between major UK markets and their counterparts in France and Germany. Historical analysis suggests that once the spread reaches a peak, the UK normally goes on to significantly outperform other European markets – by as much as 5% to 10% per year in the case of office returns – over subsequent years.

“For now, investor caution persists due to the binary nature of the risk profile, that features the prospect of a severe correction in a no-deal Brexit scenario. Some combination of the worst Brexit options being ruled out by legislation and a yield correction of 50 to 100 basis points to more adequately compensate for lingering downside risks, would act as a relatively strong buy signal for UK assets.”

Elsewhere, PGIM says office assets in major German cities and Paris remain an attractive near-term proposition, despite historically low initial yields. This is because

strong leasing demand and limited grade A availability imply significant rental growth potential in CBD and non-CBD areas, PGIM forecasts.

Greg Kane, Executive Director, Head of European Research at PGIM Real Estate, explains:

“Pricing on stabilised core investments already factors in decent rental growth, but opportunities are attractive for value creation strategies, for example capturing reversion potential, taking on re-leasing risk and repositioning or developing space.

“Among commercial sectors, logistics continues to look attractive, offering returns that compare favorably to other commercial sectors. As online retail penetration increases towards US and UK levels in Continental Europe, the upside risks to rental growth become more pronounced.”

PGIM Real Estate also tipped residential and real estate debt strategies. Residential markets offer comparatively favourable returns and downside protection, while providing a source of portfolio diversification. PGIM states:

“One key concern for investors looking at the residential sector are the low yields, with high-quality residential assets in major markets now trading below 3%. However, prime yields have always been relatively low due to their stable income-generating profile. In addition, the spread to commercial property yields has narrowed substantially, which suggests that residential real estate still offers attractive relative value, especially given that low interest rates are set to persist for a while longer.”

Another sector famed for its downside protection characteristics is of course real estate debt. PGIM states:

“As the cycle grows in length, investors are increasingly concerned about the downside portion of the range and using debt can limit exposure to such adverse outcomes – albeit by limiting upside potential too.

“The UK has the most mature non-bank lending sector, which already accounts for one-third of the market. Continental European markets remain more heavily bank-dominated, although the impact of regulations means debt fund and insurers are now starting to gain a foothold in the market. With regulations set to remain tight, the opportunity set is likely to expand further as existing loan books mature and refinancing needs grow.”

james.wallace@realassetmedia.com