OREANDA-NEWS. The suspension of trading, or gating, of several UK property funds highlights the immediate risks to commercial real estate (CRE) from the European Union referendum result, Fitch Ratings says. Market activity and valuations are at risk of decline, but companies or structured finance transactions in commercial property have buffers to absorb these shocks and there is no further near-term impact to these ratings.

The funds have suspended trading this week following a wave of redemptions after the UK voted to leave the EU in last month's referendum. This highlights liquidity challenges for open-ended funds invested in long-term property investments.

More open-ended property funds may impose some form of gating if redemption behaviour persists and cash cushions dwindle, particularly if there is further deterioration in CRE sentiment. Funds run by Standard Life, Henderson and M&G already reduced the value of their buildings by 5% last week, and share prices of UK real-estate investment trusts have fallen sharply.

Gating helps mitigate the inherent risk in open-ended funds that invest in illiquid assets by preventing value-destroying fire-sales. But once introduced, gates can be challenging to reverse. Experience in the UK and in Germany during the global financial crisis shows that responses varied from fund to fund. The majority of German open-ended real-estate funds that gated were unable to reopen to redemptions and eventually entered a liquidation process that is still ongoing. A minority that avoided gating had captive distribution networks.

The vulnerability of UK CRE to a vote to leave the EU was widely anticipated by the market. The sector had experienced particularly strong inflows of overseas capital since 2009 and there was already a sharp fall in activity this year ahead of the referendum. The Bank of England's financial stability report published this week identifies the sector as a potential risk to financial stability following the referendum. It points out how a CRE market adjustment could be amplified by behaviour of investors in open-ended commercial property funds and leveraged investors.

As we have previously said, reduced foreign capital flows will cause a decline in prime CRE valuations down from stretched pricing towards more sustainable levels based on longer-term yields. London is likely to be particularly affected if investment demand reduces (given reliance on foreign capital) and if companies reduce or relocate their offices. UK retail property is also likely to come under more pressure, adding to the challenge posed by the shift to online shopping.

A modest fall in CRE prices would have no further near-term impact on ratings for a range of sectors involved in the CRE market. We rate commercial property companies based on their cash flows from long-term contracted rents rather than a short-term equity focus on capital values. Comfortable loan-to-value covenant thresholds, limited exposure to property development spending and well-laddered debt maturity profiles mean these companies are unlikely to face unscheduled cash calls.

In CMBS, the primary exposure is to long-leased collateral supporting significant amortisation, such as Broadgate (affirmed since the vote) and Canary Wharf, and Land Securities Capital Markets plc, which operates with low leverage. CMBS exposure to UK retail property is dominated by prime super-regional shopping centres, and values would have to fall significantly to trigger downgrades as yields are well below Fitch's base case. However, cash flows and rental fundamentals could deteriorate as tenant credit quality weakens.

UK banks' exposure to CRE is substantial, averaging about 55% of common equity Tier 1 at end-2015, according to the BoE. However, risk appetite and the terms extended, such as LTV, vary significantly from bank to bank. Total lending to the sector is materially lower than in 2009 and capital set aside against this risk is generally higher. Nonetheless, some banks, including some challengers and building societies have built up a more highly leveraged CRE loan book. Given the use of CRE as collateral for a high proportion of lending to SMEs, price falls are likely to result in reducing credit supply to the SME sector.