Is lingering uncertainty - rather than a Greek exit - the biggest danger posed by the euro-zone crisis? Christine Senior reports

The euro-zone crisis lumbers on, stumbling from one cliff edge to the next. Each time Europe's political masters agree on a safety barrier, but only at the eleventh hour and only to tackle the immediate problem. No once-and-for-all solution seems imminent, or even possible, since agreement from so many diverse political standpoints is required.

Will the status quo of ‘muddling through' continue, or is a major catastrophe - with an exit or exits from the euro-zone, or the need for a bailout for Spain or Italy - just around the corner? Nobody knows for sure, but the issue of what will happen to European real estate markets in any of these scenarios is exercising the minds of real estate experts from the continent and beyond.

The general consensus seems to be that the muddling through is likely to continue, although alongside that the likelihood of one catastrophic event seems to be increasing. Oxford Economics' recent analysis views the former as the most likely with a 45% probability, although the probability of the latter has increased markedly over the past few months.

Matthew Hall, global head of forecasting at DTZ, says: "People are not talking about a break-up of the euro in far-fetched terms. As the euro area lurches from crisis to crisis, the potential for a domino effect-type breakup grows."

During the past six months, the probability attached to DTZ's euro-zone break-up scenario - an exit by Greece, Italy, Spain, Portugal, Ireland and Cyprus - has grown from 5% to between 20% and 30%.

Greece's apparent slippage in keeping to the terms of the bailout, the recapitalisation of Spanish banks and the need for loans to support Spanish regional governments, and unsustainable bond yields for Spain and Italy, have all contributed to a greater sense of doom, and hence investors' focus on the risk associated with current market conditions.

If catastrophe is avoided, DTZ's base case scenario points to the continued uncertainty impacting negatively on European property. No economic recovery and limited job creation mean real estate markets are likely to stay flat. Over the next five years the outlook is not rosy.

Fergus Hicks, associate director in forecasting, describes DTZ's expectations: "Rental growth will bounce along around inflationary levels - pretty insignificant and unexciting. Property yields will remain flat in the near term, although we see modest upward pressure on them in the medium term resulting in a slow, gradual rise. So, as a result, total returns aren't great - in single digits, ending at 8% in 2016, which is quite unexciting."

Given that the muddling-through scenario is a continuation of the status quo, current trends in investment activity can be expected to prevail. That means investors' interest directed principally to London, the Nordic region and Germany. The focus on core or core-plus sectors, rather than secondary, also seems likely to remain strong.

"In core markets, your returns will be lower but your risk of losing money is mitigated," says Mike Bowden of Knight Frank's European investment team. "There is greater polarisation between core and secondary markets. In some instances, core has seen such inflows of money that yields have hardened. That is slowly starting to stabilise and in some instances move back out."

Spanish and Italian property markets are suffering from the uncertainty associated with the risk of a possible exit. Risks are high and foreign institutional investors are steering clear.

Peter Damesick, chief economist EMEA at CBRE, says: "Many mainstream institutional investors looking at Italy or Spain, where there is a substantial risk the currency could change, find it extremely difficult to properly evaluate the risk. You don't know what risk to put on that, so it becomes a risk you can't take. That's tending to reduce the amount of cross-border investment."

Muddling through or catastrophe?
Aviva Investors published research on how the European crisis might play out, with three possible scenarios: continuation of the muddling-through policy from political leaders; a "disaster area" with multiple exits from the euro-zone; or the "decisive and coordinated action" of a strong policy response from leaders.

Muddling through is what Aviva Investors regards as most likely. This could last for the next couple of years, but gradually the economy would improve, through a series of policy responses that would eventually prove effective.

Under this scenario, Chris Urwin, global research manager at Aviva Investors, expects rental declines this year in most markets, but a marked difference in the fortunes of the European core real estate markets and the periphery. "We expect countries like Italy and particularly Spain to see sharper rental declines this year," he says. "But in some of the core European markets, which happen to be where real estate markets are larger, like France and in particular Germany, we expect rents to be more resilient. The German labour market at the moment is very healthy - unemployment at just over 5%. But Spain's unemployment figure is almost 24%, and that is reflected in the occupier market."

What is strangling markets is the uncertainty of the current environment, which is driving corporates to defer any business decisions they can. Companies are not hiring or spending cash reserves, which in turn affects occupier markets.

For Hermann Aukamp, director of real estate investment at German pension fund Nordrheinische Ärzteversorgung (NAEV), this uncertainty is of more concern than if Greece did leave the euro.

"If Greece did leave the euro, the effect on European real estate would not be that great," he says. "The problem is more: will this happen or not? The uncertainty goes on and on, and people don't decide to do anything and sit on the fence when it comes to cross-border investments."

As for the catastrophe scenario, the effect on the European real estate market would depend on just how widespread the contagion. If only Greece left the euro, and the exit was stage-managed effectively, the knock-on effects could be contained, although Greece itself would be likely to suffer a severe recession.

But Greece's commercial real estate market attracts few foreign institutional investors, so the effects on investors outside Greece would be limited. But if contagion spread to Spain, Portugal and Italy, and more countries had to leave the euro, the painful consequences would be more widespread.

Damesick says: "In the scenario of multiple exits and a euro break up it's doubtful whether any truly safe havens would exist. The UK and Nordics wouldn't be so directly in the firing line, but they would undoubtedly be caught by the backwash of overall recession. What is really concerning about that scenario is what it does to the whole European banking and financial system or indeed the global financial system. Certainly London would get caught in that maelstrom."

If there were a rerun of the 2008-09 financial crisis, all real estate sectors would suffer. Last time, certain markets, including London, suffered a collapse in prices but rebounded relatively quickly from the lows. This time round damage could be limited because most markets have still not regained the levels they were at before the crisis.

Damesick continues: "With quite depressed rental levels, and with capital values not at the same elevated levels as in 2007 when the crisis struck last time round, the potential downside in terms of how far values might be hit in a worst case scenario should in theory be less."

In the catastrophe scenario, Hall expects to see significant falls in rental values across Europe over the following couple of years, and falls of 20% in capital values in 2012-13, (compared with capital value rises of 2% for 2013 predicted in DTZ's base case).

But then over the medium term the situation might be expected to reverse, as after 2008. Hall remembers: "In 2008, yields shifted out, then in 2009-10 they moved back in. We would expect a similar profile, an explosive decompression in yields over the next couple of years creating significant downward movement in capital values, but then over the medium term, the subsequent recovery is anticipated to be just as sharp.

"Although capital value falls would be severe in the short term, the subsequent bounce-back in 2015 and 2016 would minimise the total loss."

Land of crisis or opportunity?
For investors who are willing to embrace risk, current conditions have thrown up some opportunities. But opportunity funds keen to acquire assets cheaply in southern Europe are for the moment being thwarted, as few good quality assets at discounted prices are coming to the market.

But an early victim of the euro crisis, Dublin, is showing some signs that prices have fallen to a point where there is scope for growth over the medium term. DTZ Research currently views pricing levels in Dublin offices as extremely attractive.

Knight Frank is finding renewed interest in the Irish market from institutional investors. Joachim Radecke of Knight Frank's European investment team is seeing specialist funds which invest pension money from Switzerland and Germany looking at property in Ireland, although little is up for sale.

"People seem to see Ireland near the low point already, and potentially bottoming out," says Radecke. "We are surprised our core specialist fund clients who buy in the safest markets are already interested in Ireland again."

Larry Antonatos, product manager, global equities, at Brookfield Investment Management, sees opportunities now in markets "where anxiety is higher".

"If you look at fundamentals, a good property market in Europe will continue to be a good property market," says Antonatos. "It will be very difficult in the short to medium term, but in the long term Paris, London, Madrid, Rome, Milan will continue to be important centres for commerce."

Looking at listed property in Europe, Antonatos regards distressed markets as a source of opportunity. "Of interest to us, investing in property stocks, are companies in distressed countries like Italy and Spain with very high quality portfolios where the stocks are trading at meaningful discounts to the value of the real estate," he says. "There are a number of exciting opportunities. To make that kind of investment we have to have confidence in the long-term prospects of these properties and the com-
panies that own the properties despite the country risk."

In troubled times, real estate does demonstrate attractive characteristics for investors compared with many other assets. Equity markets are turbulent and volatile, and bond markets offer high yields from risky Spanish and Italian sovereign debt and meagre returns from those considered safe havens like Germany or the United Kingdom.

"For me property is one of most attractive asset classes at the moment," says Bowden at Knight Frank. "Property is considered relatively risk-free if you have a nice long lease in a mature market. In core markets, [such as] Paris, Munich and London, few new grade-A buildings are being put up.

There is a good argument, as the economy stabilises and hopefully turns into growth, there will be expansion of demand, which should result in movement in rents. Not only are you preserving money in a core real estate block but hopefully you will be getting organic growth through the rents."

At German pension fund WPV, managing director Hans-Wilhelm Korfmacher is relatively relaxed about the effects of the euro-zone crisis on the fund's real estate portfolio, which has a pan-European exposure. In the current climate of uncertainty, other assets are the main focus of concern. "Real estate is one of the stronger parts of our investments as far as the euro-zone crisis is concerned," he says. "Real estate is a real asset. The problems I see are mainly in the bond market."

The crisis has not prompted any major rethink of WPV's real estate investment strategy away from the euro-zone. Investments outside Europe have been under consideration for some time, but not as a reaction to the crisis. Korfmacher says: "We have been thinking about - and already invest more money in - the US, and perhaps in Asia. It's a strategic view that we should invest not only in the euro-zone but also in other countries and other regions of the world. It's more for diversification reasons than for euro-zone crisis reasons."

Like WPV, NAEV has not adjusted its real estate portfolio in response to the crisis. It has limited exposure to the south European markets, with European property investments outside Germany mainly in the UK, France and the Nordics. "We also continue to invest in eastern markets," he says. "We concentrate on Poland - but only Warsaw - and the Czech Republic - but only Prague. We think there is a growth story there."