Imagine you are a top executive manager of a multi-billion global business headquartered in London. Although the privilege of running and administrating the enterprise from the world's leading financial center is everything but cheap, you are enjoying all the benefits associated with it. Ceaseless influx of capital and top-notch professionals are available on demand, a dozen of the world's most prominent universities are situated in a 60-mile perimeter, the regulations and taxes are bearable and the international trade is happening just around the corner. A sunny Friday, however, everything is turning upside down.
Following fierce debates, the unthinkable has happened - the general public voted to opt out of the European Union. With the country's trade relations jeopardized, currency at historical lows, enormous degree of economic uncertainty, and severely negative political repercussion across continental Europe, you start thinking about relocation. Staring at the map, the first coming to your mind is Paris - an established business hub that is already hosting part of your operations.
There are some considerations, however. The personal and corporate tax rates are higher, civil tension and radical violence are not isolated cases, right-wing extremists are gaining popularity. Maybe France is not your destination. You slide your sight to Germany. Frankfurt looks appealing - the home of ECB and country's financial capital. Here, the taxes are lower but the city itself is relatively small - less than 700k inhabitants. An indirect drawback is the absence of strong competition among the local universities. Although practically free, the higher education in Germany struggles to attract or even keep the world's brightest individuals. Last but not least, the language barrier might be a serious obstacle for both students and professionals. Looking back to the west, you finally spot the favorite.
Less than 300 miles away from London, the Irish capital is resurrecting from a devastating housing and banking crisis. A tax haven alike corporate rate of 12.5%, Eurozone membership and slightly lower cost of living have already stolen some business from London. As the Irish economy is flourishing while the United Kingdom is getting more and more expensive - TMT, financial, and pharmaceutical companies are migrating their operations to Ireland. Citigroup (NYSE:C), for example, already shifted their European retail banking headquarters to Dublin. In addition, the aftermath of the Brexit gave birth to rumours that Morgan Stanley is also transferring a substantial part of its staff to the bordering island (expectedly, quickly denied by the bank).
From a macroeconomic standpoint, Ireland is going from strength to strength. Last year, the economy grew by 7.8%, outstripping official and market forecasts and reaffirming Ireland as the fastest-growing EU economy. The impressive figure is not a spike but a trend. The European Commission research body predicts country's GDP will expand by 4.9% and 3.7% in 2016 and 2017, respectively.
The unemployment is currently hovering slightly below the EU averages and is expected to further improve over the near term. Improving employment coupled with recently-announced tax reductions, low commodity prices, and the first period of sustained wage growth since the recession began are having a positive impact on consumer spending.
Source: European Commission
Despite the inflated economic figures, we can hardly call this a bubble formation. Considering the residential property market as a good benchmark of the underlying economic health, the recent price appreciation does not appear to be credit driven, but rather a result of supply/demand gap, growth in real income and flow of international capital. The lending in Ireland is characterized by high net interest rate margins (compared to the rest of EU) due to a low degree of competition among the commercial banks. In addition, rigorous checks are performed to all loan applicants following last decade's severe crisis. These factors combined predispose sustainable and robust economic expansion.
Source: Latest European Commission report on Ireland
So far you might think Ireland appears too good to be true. And it probably is. The Irish 2016 general elections led to a highly fragmented parliament, with 60% of the seats split between the two leading parties. Following months of negotiation, a new government was formed (albeit a minority one). The political instability is expected to persist especially if the British anti-European sentiment starts spreading across the continent.
The most challenging issue the government is facing right now, however, is nothing but the Brexit itself. The United Kingdom is Ireland's largest trade partner accounting for 18% of the Irish exports and 30% of the imports. Although the short- and long-term consequences are still ambiguous, the potential worsening trade relations could seriously harm the Irish growth perspectives.
Historically, a 1% reduction in UK GDP has led to a 0.3% fall in the Irish GDP. A weakening sterling will put the Irish producers into an undesirable spot. Given that food is the major export to the UK and customer price sensitivity (following the price war among the British retailers), it is likely to see a replacement of the Irish goods on the British shelves by local equivalents. An extensive analysis of the impact a Brexit might have on Ireland is available here.
Connecting the dots, the core logic should be clear by now - Dublin is a leading candidate for stealing part of London's business in the Brexit aftermath. The city should attract substantial financial and labour capital in the event the European Union offers unfavourable trade deal to the UK (base-case scenario at the moment). In turn, additional pressure will be put on the real estate supply/demand imbalance in the Dublin market resulting in further price appreciation.
There are two broad classes to be considered when acting on the trend - investing in residential or commercial properties. The reasons I decided to stick to commercial, and office REITs in particular include:
- Positive trend in employability: Apart from the expected relocations, the domestic growth in the local job-creation is expected to persist in near future.
- The longer it takes to deliver commercial property building (~2.5 years): Similarly to the UK, the majority of the population is inhabiting semi-detached houses. The time required for construction of a single/multi-family house is significantly less than the commercial building. The factor combined with well-known office pipeline leads to highly predictable market conditions.
- The demanding needs of the office buildings require substantial upfront investment, equipment, and knowledge keeping newcomers away from the business.
- Based on the historical price appreciation, the supply/demand gap is more severe (residential properties grew by mid single-digit over the past few months while both office REITs achieved double-digit upward movement in fair value of their properties).
- By nature, the asset class is offering less cyclical and clearly defined future cash flow streams. The commercial rents usually have longer duration and stable amount due.
The market for office spaces
A complete and informative summary of the office occupational market and development pipeline was provided by Hibernia REIT as part of the company's latest preliminary results:
...Despite the lack of available stock, take-up in 2015 totaled 2.7m sq. ft., above the 20-year average of 1.8m sq. ft. per annum (source: CBRE). 2016 has also started strongly, with take-up in Q1 totaling 0.6m sq. ft., 37% higher than the same period last year (source: CBRE). Occupation has continued to be focused in central Dublin, with 69% of take-up in the Central Business District (CBD) in 2015 (source: CBRE).
The overall Dublin office vacancy rate is now 7.7% and 6.0% in the CBD. However, there are marked differences by area and quality of stock...
...As a result of strong tenant demand and low vacancy rates, prime central Dublin office rents at the end of Q1 2016 were €57.50 per sq. ft. up from €47.50 per sq. ft. a year ago (source: CBRE). Most agents are expecting further rental growth in 2016.
...Dublin continues to be an occupational market dominated by lettings of less than 50,000 sq. ft.: 72% of take-up in the past 5 years have been in this category (source: CBRE). Almost two-thirds of the lettings agreed in Q1 2016 were to Irish companies (source: CBRE) highlighting the increasing importance of domestic demand in the Irish economy and the broadening of the economic recovery.
On the pipeline side: A handful of office refurbishment projects were delivered in Dublin in late 2015. 2016 will see the first newly built office building delivered to the Dublin market in over 5 years. In total, 1.3m sq. ft. of new stock is expected to be delivered in 2016, 46% of which is already pre-let and against a backdrop of an average 10-year take-up of 1.9 m sq. ft. and a take-up of 2.4m and 2.7m sq. ft. in 2014 and 2015, respectively (source: CBRE).
...we expect 5.3m sq. ft. will be delivered between now and the end of 2018 and that 8.3m sq. ft. will be delivered between now and the end of 2019. Availability of development finance remains scarce (particularly if a pre-let is not in place) which has resulted in the owners of key development sites in the CBD awaiting pre-lets before commencing development.
Click to enlarge
Source: Hibernia REIT Preliminary Results Presentation
To put these figures into perspective - the area floor of JPMorgan's European headquarters in London is 1.05m sq. ft., while the Barclays Tower in New York has total area of 0.56m sq. ft. Considering the size of the businesses that are likely to departure from London and anemic commercial property pipeline, the major question is not whether the prices will go up but does Dublin have the capacity to absorb the inflow. If we believe the market is rational and capital is employed to the best use - the answer is yes. Simply, the less profitable businesses should be pushed away on the account of the incoming international companies. Moreover, the vacancy rates are still relatively high and the Brexit as a process will take 2 to 3 years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.