The economic prospects for Europe remain divergent, but it is now clear that fears over Greek solvency were overly alarmist. However, fiscal weakness in Greece, Ireland and Portugal in particular will continue to cast a cloud over the future of the Eurozone in its current form. Despite the original intentions of the single currency, Europe remains a heterogeneous region and this diversity will provide opportunities for investors. However, there will be few easy wins given the subdued economic backdrop. The primary challenge will be investing in a low-growth environment without taking on unwanted or unmanageable risks.
Throughout the region governments have had to put into place austerity programmes to deal with the mounting public debt burden. However, the three largest economies of France, Germany and the UK, which account for 50% of the European Union's GDP growth, are all expected to show solid growth while the weaker (and mainly Southern European) countries will continue to struggle. However, there remain challenges for all economies.
The UK plans to cut government spending sharply and this will have to be well managed so as not to reverse the economic recovery, although it should benefit from the Olympics in 2012. France is enacting painful reforms, including increasing the retirement age, while Germany's austerity package is less drastic, as the country went into the downturn with reasonably healthy finances. We also expect Scandinavia (most notably Sweden) to perform better due to its innovative, adaptable and well diversified economy. Overall, growth is likely to slow in 2011 as government stimuli are withdrawn and fiscal balance sheets are brought down from their stretched levels. In this environment, in a global context Europe's real estate markets remain an attractive investment opportunity because they can still deliver solid returns with only modest GDP growth.
We see the best opportunities in Germany, France and the UK. As well as being the region's largest, these countries are also the most mature, transparent and liquid real estate markets, creating a good and reliable environment to operate in. Given the still uncertain economic outlook, occupier markets will remain weak for some time and income interruption and falling rental levels remain key risks. However, the supply/demand balance will become more landlord friendly in 2011 in the CBD office markets of London and Paris, as occupiers become aware of pending supply shortages through the thinness of the construction pipeline.
Another feature underpinning the attractiveness of European real estate is the significant volume of outstanding mortgage debt to workout. At the end of 2009 over €900 billion of commercial real estate debt was outstanding in the UK, Germany and France. Moreover, €482 billion of commercial real estate debt is up for refinance over the next two years.
This not only offers an opportunity to secure distressed assets from banks, but also offers the chance to provide new mezzanine finance as the supply of such debt is much reduced. Banks in Europe lent significant sums secured against retail property, often in highly leveraged structures.
In the UK market, for example, the British Council of Shopping Centres has estimated that 19% of the national shopping centre stock is held on loans that are at risk of defaulting. Retail assets in Europe often have a degree of monopoly power because there are governmental limitations on the supply of new competition, and so are especially attractive. The banks are being cautious in disposing of their non-performing loans so investors need to be flexible in how they exploit the opportunity through providing both mezzanine finance and asset management cooperation/workouts.
Another very attractive investment opportunity in European real estate today is the creation of core real estate. We expect the current high demand for core real estate to continue, driven by low interest rates as well as investor risk aversion. Around 80% of Western European real estate stock consists of older properties, not meeting the demand for modern and sustainable space from tenants in good locations.
We would generally recommend an overweight to good-quality retail for long-term growth and stable income. Offices and logistics in France should also offer opportunities, although offices are less attractive in Germany for core investors given the weight of domestic money. In the UK, portfolios should be typically underweight regions outside the South East (particularly offices).
Alistair Seaton is a regional director, and Andrea Pavelka is a national director, both within LaSalle's European Research & Strategy team