REITs Slammed, £500M Deal Collapses, Rates Head For 6%: The Pound And UK Markets Are In Turmoil

Shares in REITs have been among the biggest fallers on the UK stock market as turmoil continued to grip UK financial markets on Monday, causing a £500M real estate investment deal to collapse. The sharp interest rate rises expected to be caused by the collapse in the value of the pound augurs a tough period for the real estate sector in the UK. 

LXi REIT said Monday it was pulling out of a deal to buy 18 supermarkets from Sainsbury’s for £500M at a yield of 5%.

Just last Thursday, it said that it had exchanged contracts on the deal, flagging that the inflation-linked leases would be beneficial in a period of high inflation.

In its announcement on Monday, LXi cited only “market volatility” as its reason for pulling out of the deal. But in a note on the transaction, analysts at Stifel gave insight into how the deal was scuppered, pointing to collapsing share prices, triggered by the volatility in the pound and expectations on UK inflation. 

LXi had said it would raise equity from shareholders in order to complete the deal. But following the announcement, the new UK government of Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng last Thursday unveiled a minibudget that included big tax cuts and a subsequent increase in UK government borrowing. On Sunday, Kwarteng followed this up with an interview on the BBC, saying that there was “more to come” in terms of tax cuts.

Financial markets reacted sharply. The pound dropped in value to $1.07 on Friday and fell as low as $1.035 on Monday morning, its lowest level since 1985. Analysts at Nomura put a 50% chance on the pound reaching parity with the dollar by November. 

Financial markets fear the tax cuts will push up inflation, already at 40-year highs. That would, in turn, hurt the economy, as consumers spend less amid rising prices.

Yields on five-year UK government bonds rose to 4.6% as investors sold them off, calculating the government will have to take on more debt to cover the cost of the tax cuts that have been announced. This adds to worries about the UK’s ability to repay some of its debt, a large proportion of which is linked to inflation. 

Concerns caused shares in all UK companies to fall, with real estate particularly hard hit; the EPRA UK REIT index fell 8% between Thursday and Monday.

LXi’s shares have fallen by 13% in the past week. As a result, LXi would have found it more difficult to raise equity to fund its Sainsbury’s deal at a level high enough to make it worthwhile to go ahead with the transaction. When the numbers didn’t add up, the deal was canned. 

Real estate shares were particularly hard-hit because the fall in the pound raised the prospect of a faster and higher rise in interest rates by the Bank of England.

Shares in Helical, Derwent London, Capco, Hammerson and Shaftesbury all fell 5% on Monday, while Landsec and GPE shares both fell 3%, and British Land shares fell 2%. Regional REIT fell hardest, with a drop of 8%.

“As such, we’re likely to see monetary policy committee members and Governor Bailey making lots of public statements over the next few days emphasising the MPC’s commitment to 2% inflation and that it intends to raise interest rates sharply over the rest of this year,” RSM UK economist Thomas Pugh said. 

The BoE raised interest rates by 50 basis points last week, and there was an expectation it could hold an emergency meeting as early as this week which would see rates rise by an additional 75-100 basis points. That expectation was the key factor in helping the pound recover to $1.08, former BoE policymaker Danny Blanchflower said on Twitter.

Moody’s predicted Monday interest rates would now peak at 4%, higher than its previous estimate of 3%. And the BoE said that in its upcoming stress test for the banking sector, it was telling banks to factor in a rise in interest rates to 6%. 

Rising interest rates are bad for real estate for two reasons. For investors that borrow money to buy assets, the cost of that debt is higher, raising the prospect income from properties might not be high enough to repay interest costs. For investors to make any money, the price at which they buy assets has to be lower, leading to valuation falls.

Real estate prices also drop at times of rising rates because investors can buy lower-risk assets like bonds and get the same return. If UK government bond are at 4.6%, it is less attractive to acquire an office building at a 4% yield, considering the cost and hassle that goes with it. That leads to less money going into the sector and falling values.  

“With U.S. and EU rates back to levels not seen in a decade at 3% and 2%, investors now have alternatives outside of real estate (and equity), in contrast to the TINA (there is no alternative) situation of recent years with negative rates,” Bank of America wrote in a note on European office real estate stocks in July.

One potential positive for real estate from a drop in the value of the pound against the dollar is that it makes buying UK assets more attractive to investors from the U.S. and Asia. 

However, buying assets because the pound is weak is only profitable if the value of the currency does not continue to fall, MSCI pointed out in a 2019 research paper.