The outcome of the EU referendum and fears surrounding the strength of the global economy have generated uncertainty and placed upward pressure on yields as investors put investment decisions on hold. In the face of current investor uncertainty, some prime segments have been considered 'overpriced' relative to the peak levels achieved in 2007. Eight of the prime sectors tracked by the global real estate provider Savills have yields at or below their 2007 level. However, these yields remain highly attractive compared with other assets. The buoyancy of the UK’s commercial property market has boosted mortgage demand. As of April 2016, the highest prime yields were on retail warehouses (5.75%) and regional hotels (5.5%).

The diversification of the UK commercial property lending market has steadily deepened over the last six years in particular. Insurance companies now represent 15.1% of total debt, up from 12.7% last year. However, De Montfort University’s research suggests that, proportionally, UK banks are still the most active in the market - with RBS the biggest lender in 2015.

The aggregated value of outstanding loans secured against commercial property in the UK rose, for the first time since 2008, by 2% in 2015 to a total of £168.4 billion.

Figure 1: Aggregated Value of Outstanding Debt in Loan Books Secured on UK Commercial Property, 201115, (£ Billion)

Source: MBD analysis of De Montfort University’s UK Commercial Property Lending Market data

Loan originations increased sharply in 2014 and rose again in 2015 to the highest level seen since 2008. A quarter of new lending came from non-bank lenders, contrasting with the pre-crisis lending environment, where banks were heavily exposed to highly-valued real estate assets. This reflects the extent to which companies are looking outside the core banking sector for finance. Over the review period, the gross value of loan originations rose by 95% from £27.5 billion in 2011 to £53.7 billion in 2015.

Figure 2: Gross Value of Annual Loan Originations, 2011-15, (£ Billion)

Source: MBD analysis of De Montfort University’s UK Commercial Property Lending Market data

Uncertainty in the market until the UK’s exit from the EU is negotiated and completed may lead to lenders being less willing to lend and the cost of mortgage borrowing increasing. In the long term, if the cost of compliance with both UK and EU regulations increases, lenders may begin to increase cost provisions in finance documentation. Finance documentation should be reviewed by borrowers to understand lenders’ ability to adjust interest rates and collapse loans in adverse credit markets.

Interest rates on loan advances to the corporate sector declined between 2012 and 2015, with lower rates seeking to attract businesses and investors looking for commercial property funding. Rates rose over each of the first four recorded months of 2016, from 2.65% in January to 2.79% in April. Increased demand for commercial property during 2015 is believed to have created greater competition for lenders, prompting offers that have pushed rates even lower. However, demand for commercial property over 2016 and the foreseeable future has entered more uncertain territory as the UK public opted to leave the EU in the June referendum. As a result, a decrease in values and rents is likely to occur in the short term.

Figure 3: Average Interest Rate for UK MFI New Advances to PNFCs, at April in 2012-16, (% Not Seasonally Adjusted)

Source: MBD analysis of Bank of England data

The nonresidential property market accelerated through 2015, with a 4.5% increase in transactions. This followed a substantial fall during the 2008-09 recession, with transactions remaining low as the economy stagnated between 2010 and 2012. The most recent HMRC data showed that non-residential transactions have continued to rise, while higher stamp duty land tax rates were introduced from 17^th March 2016, bringing the sector more in line with its residential counterpart. According to the ONS, non-residential transactions continued to increase in the calendar year to May 2016, with improved economic conditions supporting commercial property investment.

Figure 4: Number of Non-Residential Property Transactions, 2011-15, (Number, Seasonally Adjusted)

Source: MBD analysis of HMRC data

During 2015, industrial and office property investments delivered the strongest return, while residential property provided the weakest return. However, residential property investments have still provided a stronger return than commercial property over the last decade, with offices delivering the strongest commercial property return. Property investment has delivered a similar return to equities and bonds over the past decade. Despite the market crash from 2007 to 2009, property’s annualised investment return over the past decade was 5.7%, compared with 5.6% for bonds and 4.7% for equities.

Figure 5: IPD UK Annual Property Index, December 2014 and 2015, (December 1980 = 100)

Click here to zoom

Source: MBD analysis of IPD data

UK commercial property yields generally edged down between April 2013 and April 2016, reflecting stronger investor demand across most sectors. However, Savills reported a slight upward trend in yields in Q1 2016 amid increased investor uncertainty due to the upcoming EU referendum and the strength of the global economy. Following the Brexit vote, yields may be pushed further upwards as associated risks and uncertainties dampen investor confidence, at least until a plan for the UK’s future relationship with the EU is in place. There are also reports that some markets are overpriced, which is tempering confidence.

Many alternative lenders focused on residential or residentialled schemes in London and the south east, until the first signs of economic recovery following the recession. However, most now lend across the UK, with many targeting purely commercial schemes in major cities and regions. Over the last two years, the major success story has been in P2P lending associated with property, whether to developers for financing new developments, or for bridging finance. P2P property lending accounts for nearly half of the sector’s recent growth, and looks set to become an even more dominant subset next year. According to AltFi data, P2P lenders have now lent more than £3 billion to businesses, and is becoming an increasingly crowded space as new entrants await regulatory sign off from the FCA.

The commercial mortgage market has expanded and diversified considerably over the last few years, with more lenders offering commercial mortgages and funding, increasing the flexibility of productsWith more lenders entering the commercial mortgage market products are becoming more flexible. A variety of lenders have refreshed their product offering, bringing new deals and revised product criteria to suit the commercial mortgage market.

The wider commercial banking industry is increasingly opening up to new entrants, with regulators keen to inject further competition. The growth of challenger banks since 2010 has impacted the SME market in particular, with new additions to the industry, such as Shawbrook, Aldermore and Triodos, all increasing their presence. However, these firms are still dwarfed by the size of the major banking groups, such as Lloyds.

The sector could benefit further from the regulatory changes that have taken place in the wider mortgage market. From 21st March 2016, Mortgage Credit Directive (MCD) rules were implemented, and lenders now take sole responsibility for assessing the affordability of borrowers. The application process for mortgages has likely increased as lenders conduct strict affordability checks to remain compliant. Despite the UK’s decision to leave the EU, this directive is expected to stay in place until final exit negotiations have taken place and been approved.

Underlying indicators before the outcome of the EU referendum suggested that the commercial mortgage market would continue to grow. Despite initial positive net lending, rising commercial property transactions, and continuing low interest rates in 2016, demand for finance secured against property could stall. Key market performance drivers include continued economic growth, which could weaken due to current UK market uncertainties, and low interest rates, which are expected to fall to 0.25% by summer 2016. Between 2016 and 2020, the gross value of loan originations is estimated to increase by £8 billion, equivalent to a 14% rise, from £57 billion to £65 billion.

Figure 6: Forecast Gross Value of Annual Loan Originations, 2016-20, (£ Billion)

Source: MBD forecasts

The value of outstanding loans in the market is anticipated to rise in the short term as lenders and borrowers react to changing market conditions following the outcome of the EU referendum. Borrowers may find it harder to increase repayments, while lenders are likely to attempt to reduce exposure to commercial property and run down loan books due to uncertain returns. However, a pick up in repayments is expected once the UK has successfully negotiated its exit from the EU, from 2018, as the market outlook becomes clearer.

Overall, the value of outstanding debt in loan books secured on UK commercial property is estimated to fall by £4 billion from £174 billion in 2016 to a review low of £170 billion in 2020 - as the UK market adapts to the post-Brexit environment.

Figure 7: Forecast Value of Outstanding Debt in Loan Books Secured on UK Commercial Property, 2016-20, (£ Billion)

Source: MBD forecasts

While commercial property is certainly not without risks, current supply pressures are likely to continue to make both commercial, semicommercial and residential developments a worthwhile investment opportunity. However, the potential risks arising from ‘Brexit’ include unusually high currency volatility, higher gilt yields, ‘capital flight’, and weaker economic growth. All of these could drain liquidity and harm the investment performance of UK commercial property, dampening the mortgage market’s development, in the short term at least.