There are some interesting differences and similarities between the behaviour of the French and Spanish listed real estate markets. Béatrice Guedj, Richard Barkham and Ruth Hollies explain what investors should draw from this

In Spain, at least until recently, the listed property sector has been more resilient than the stock market as a whole - the IBEX 35 index. Worsening financial conditions with the knock-on impact on property seems to have dramatically increased investors' risk-aversion towards listed property companies.

Although historically the long-term correlation between both markets was only moderate, it has risen substantially since August 2007 when the sub-prime crisis broke. The correlation is now up to 95% from a historical trend of 16%. The sell-off that started in the property sector has broadened and fed back into the property sector. The big fall in the Spanish EPRA (European Public Real Estate Association) index may also be explained by the high level of residential exposure the sector has alongside relatively high gearing.

The French market has behaved slightly differently: the correlation coefficient between the stock market index - the CAC 40 - and the French EPRA index has been stronger in the longer term and France has not seen the sudden jump in correlation seen in the case of Spain. As yet, France has not experienced the property-led general recession that Spain has.  

Interestingly, despite its residential exposure, the listed real estate market in Spain is usually a leading indicator of the unsecuritised commercial property market. In the long run there is a strong inverse relationship between the EPRA index and the yields of the office market in Madrid (ρ= -0.76), meaning that an increase in the index coincides with a fall in the direct real estate yield trend, and, inversely, a decrease coincides with an increase in yields in the office market.

The office market is usually taken as the benchmark given its long track record, its higher degree of maturity and its greater liquidity compared with the retail and industrial markets. Analysis shows that the inverse relationship between property yields and the EPRA index strengthened to -0.93 after 2000 and rose even higher after the onset of the sub-prime crisis.

The result supports the idea that in times of market stress the listed and unlisted sectors feed off each other more closely. As scrutiny on the property sector increases there is a closer link between the direct and indirect markets. Possibly, as transactions in the direct markets dry up, valuers look to the listed sector for information relevant to valuations. Given that securitised markets tend to overshoot, the downward, or upward, spiral has become self-reinforcing.

For France there is also a strong inverse relationship between the EPRA France index and the level of prime yield (in the office market in Paris) with a long run correlation of ρ= -0.82. Here, however, the relationship has not strengthened since 2000 as much as in the Spanish case. In France, the correlation between both variables increased to -0.91 after 2000, while in Spain it strengthened from -0.76 to -0.93. Similarly, the volatility of the French prime yield profile has been less influenced by the volatility of the French EPRA index.

One interpretation is that the real estate markets in France, direct and indirect, are slightly less efficient than in Spain. Certainly, the turnover of property investment assets in Spain has been much higher than in France. 

More advanced analysis supports the idea that, in Spain as well as in France, there is a linear relationship between the EPRA indices and prime yields, with a stronger negative elasticity coefficient in Spain than in France. The level of repricing seen in the direct investment side (especially in the office market), has been more or less in line with the overshooting seen in the listed property market in Spain. The Spanish EPRA has fallen by 90% compared with H1 2007, while yields have shifted outward by 175 basis points.

So, with direct and indirect markets having gone into something of a self-reinforcing tailspin, what do economics have to say about the outlook for yields? Econometric analysis undertaken at Grosvenor indicates a relatively strong link between yield movements and the volume of credit in the economy. The huge inward yield shift observed over the past few years was strongly related to cheap money, particularly for domestic investors, such as listed property companies, which have dominated the market over the past 10 years.

In France, the office market has had a more diversified investor profile over the past few years, with a higher share of foreign investors compared with Spain, but the market has still been heavily impacted by cheap finance.

Evidence uggests there is a strong negative relationship between the change in the credit volume in Spain and the prime yield profile in Madrid, which means that when credit volume increases, the level of the yield decreases. The correlation coefficient stands at -0.76 over the long run.

More interestingly, the volatility of yield shifts in the office sector has been largely explained by the volatility of the volume of credit, specifically over the past three years, moving from a long-run correlation of 0.51 to 0.89 over the past three years. Again, this means that the fast yield compression of the past few years, one of the largest shifts in the euro-zone, was driven by the volume of credit, which was used by domestic investors to buy assets.

In France, the correlation coefficient between the change in credit volume and the yield profile is slightly lower than in Spain, as the market had a more diversified investor profile with many foreign investors. So what is the outlook? It is clear that listed sectors in France and Spain, particularly the latter, need to repair their balance sheets. This requires substantial additional equity input.

However, investors are unlikely to wish to invest in real estate, direct or indirect, until some end to price declines becomes apparent. If the banks remain supportive of the listed property companies and refrain from forcing them to make fire sales then there is some prospect that rapidly loosening monetary policy will help to stabilise property prices by Q2 or Q3 2009.

This will allow the necessary equity to enter the market. At this point, there could be a bounce-back in the listed sector, bringing the much hoped for end to the price correction in the direct market.

Béatrice Guedj is head of continental European research at Grosvenor. Richard Barkham is global head of research at Grosvenor. Ruth Hollies is group senior research analyst at Grosvenor