The economic division that has emerged between northern and southern Europe is filtering through to property markets. Pirkko Juntunen explores what this polarisation means for investors
As economic woes drag southern Europe to a financial cliff edge, the northern countries are pulling towards a recovery, creating a division within Europe, which some argue threatens the entire union. This divergence is now becoming particularly apparent in the property markets.
According to research from CB Richard Ellis Group, uncertainty over the sovereign debt crises slowed European property investment activity to €25bn in the second quarter of 2011. The data also shows that turnover in European property during the period was 12% below the Q1 2011 total (€28.4bn) and 3% lower than the same period last year (€25.7bn).
The decline was a result of reduction in activity in the UK market, where turnover fell by almost 40% versus Q1 - from €11.4bn to €6.8bn. In addition, Italy and Iberia also slowed significantly, reflecting growing concerns over government deficits and the impact of austerity measures on economic growth.
At the opposite end, activity in the more robust economies, such as the Nordics, continued to grow with Finland leading the way. Pricing for core assets across Europe continued to tighten and the CBRE EU-15 All Property Yield Index fell a further six basis points in Q2 to 5.48%.
The divide is beginning to be reflected in property valuation movements and according to data from CBRE, 2010 saw valuations in Germany and central and eastern Europe stabilise and increase in France and the Nordics. CBRE data shows that against this, in the ‘PIIGS' region (Portugal, Ireland, Italy, Greece, Spain) valuations remained under downward pressure throughout 2010 and are, on average, around 25% lower than their 2007 peak levels.
Germany remains the growth engine of Europe, with unemployment the lowest since reunification in 1991 combined with the availability of credit almost reaching pre-crises levels.
France is in a less strong position, but it is traditionally a consumerist economy and spending on the high street continues with Paris being the driving force domestically, yet also increasingly attracting wealth from growth economies such as China.
The Nordic region has sound fundamentals and was not as hard hit by the downturn. Its links to growth economies such as China, India and Brazil through exports, as well as growth in technology industries with high added value, was also a benefit, making the region a safer bet than many other countries, particularly at the southern end of the continent.
On the other side of the spectrum, unemployment numbers in Spain are over 21%, consumer spending is weak and house prices in decline, while taxes are increasing, leaving banks no other option but to tighten lending. Italy's is not in an equally bad situation but its debt position has been recognised by the market leading to rising bond yields.
The situation in Greece is by anyone's measure severe with an overly generous social welfare system, a rigid labour market and low tax base making it one of the continent's most regulated and least entrepreneurial economies. These underlying problems and reasons for the high debt levels need addressing before investors will touch Greek assets, which the country desperately needs to sell to get its books in order.
Steve Cochrane, managing director of economic research for Moody's Analytics, says the structure of the peripheral economies has to change in order to attract investors. He argues that the first necessity is to increase competitiveness by lowering labour costs. "Central and eastern Europe are the examples for the PIIGS to follow. These countries attract foreign investments by being linked to the economies in the core, such as Germany and the Nordics, which has been the key to their recovery" he says.
Not such a clear-cut division
Simon Durkin, head of research in Europe at Deutsche Bank Asset Management's real estate investment division RREEF, says the north-south divide is nothing new but has been exacerbated by the downturn and sovereign debt issues. "You could argue that the UK is closer to the problems of the peripheral countries, if you only look at numbers," he says. "But London is the driver for growth because of its position as a truly global city with financial and business services benefiting the city during the recovery."
According to RREEF, the European economic outlook falls into three broad categories rather than a simple north-south divide. First, markets where both governments and households are over-indebted, which include Ireland, Portugal, Italy, Spain and Hungary, have the weakest prospects in the near term. Second, markets are subject to fiscal constraints as governments reduce large deficits through austerity measures, including France, UK and the Netherlands.
These markets have better prospects in the near term, and have emerged from recession. Third, economies with limited debt, such as Scandinavia, Germany, Poland and Czech Republic, are already in an economic expansion and have strong near term prospects.
Durkin argues that the divergence between regions within countries will be even more pronounced than the north-south European divide, especially when countries such as the UK and France start to feel the pinch of their austerity packages. "Once the public spending cuts have kicked in, regional cities with less diversified employment bases will be hit the hardest," he says. "Markets are cyclical but this time around it will take longer to revert back to long-term relativities."
Tim Francis, director for continental European strategy and research at Invista Real Estate Investment Management, says: "The economies of Germany and Scandinavia are further ahead in their recovery, as they have benefited more from the rebound in global trade and their debt levels are lower than in the south. This has translated into a better outlook for their economies and more opportunities in their property markets."
Invista's research shows that GDP growth in the south is forecast to be very subdued over the next five years, significantly underperforming northern Europe, particularly Germany and Scandinavia, as the PIIGS countries struggle to reform their lagging economies.
Francis also points out that the cost-base had been driven down in countries such as Germany, increasing their competitiveness compared to the PIIGS, which are also less dependent on trade and had benefited less from resurgent demand growth from emerging economies such as China and India.
In addition, as investors are battling with uncertainty, risk aversion has been in the forefront and many are heading towards what is perceived as the safe haven of northern Europe, Francis adds.
Stefan Wundrak, European director of property research at Henderson Global Investors, says GDP growth in Sweden has been phenomenal, with a yearly average of 3-4% in 2010 and 2011, resulting in rental growth and increasing retail sales. However, the market is getting expensive with interest rates also on the up. "Yields in the prime property sector are close to the peak and these assets are also becoming almost impossible to find," Wundrak says.
"In this segment, with prices and interest rates close together, we increasingly see equity-only deals. For secondary assets, yields are difficult to define and, whereas interest rate rises are not a major problem here, product availability is an issue."
The issue of access to direct property for international investors is also an issue in Norway and Denmark, and Wundrak points out that not all of the Nordics offer the same prospects: Denmark, for instance, lags as a result of bankrupt banks, overvalued housing stock and heavier household debt. Fundamentals in Finland are not as strong as in Norway and Sweden, but having the euro offers advantages to international investors, Wundrak says.
David Jackson, co-fund manager of M&G European property fund, concurs, saying his focus is now on France, Germany and the Nordics, where fundamentals are better and outlook over the next five years is positive. He, like Wundrak, believes that the dynamics within the Nordic region varies from country to country, with Norway, for example, benefitting from the high oil prices.
However, Jackson argues that Sweden and Finland have the best outlook and are the most transparent markets for international investors. "Both are liquid and accessible which is important for investors who are concerned about exit strategies," he says.
"The Nordic countries will be the stars of over the next five years because of their transparency and their links to the global growth economies through exports," says Durkin. "Sweden is not weighed down by the euro-zone issues and the economy has been managed prudently so continues to offer opportunities for investors."
Like many of its competitors, Henderson is rebalancing real estate portfolios away from the south and investing in the north, but Wundrak says it is not as clear cut as that. "You still find opportunities in the south; you just have to be pickier and focus on prime assets in specific regions within a country and where fundamentals are robust," he says. "Investors have to be careful and choose the right thing and pay attention to liquidity. This means there are more opportunities in the north in the current climate."
Francis, like most of his peers, believes the divergence will grow before it narrows with values rising in the north and falling in the south. "Nevertheless, the reverse could happen if a sovereign default in the south triggers large losses for banks in the north, interest rates start rising across the euro-zone, which would place pressure on prime property yields, and if southern European economies become more competitive. But on balance this is probably a long way off," he says.
According to RREEF research, late recovery markets such as Spain may offer opportunities to acquire core product at relatively attractive yield levels because of the uncertainties over the medium term but risks in the near term require close monitoring. "The implication of these trends for real estate investors is the uncertainty regarding which sectors of the economy will drive the recovery and thus, which real estate sector is best poised to benefit and reward investors," Durkin says. "Relative to GDP, public debt in Spain is not on the same scale as Greece or Portugal and the Spanish prospects are equally reflected in the relative low spread of government bonds over the German Bund compared with that of Greece, Portugal and Ireland."
Jackson concurs, adding that super-prime office market in Spain may offer good opportunities but because of the small scale - that is, two or three streets in Madrid - it is not representative of the country.
Disadvantage for Europe as a whole?
Despite the divergence and economic woes in Europe, according to DTZ's annual ‘Money Into Property' report, Europe retains the largest proportion of the current mix of the real estate invested stock across the globe, with a 37% share, compared to 31% in Asia Pacific and 32% in the United States.
RREEF research also shows that, although Asia Pacific is set to outperform and Europe is likely to lag, a global portfolio would still benefit from significant investing in all three regions for diversification. "Returns will likely average 8-11% globally from 2011 to 2015, although returns will vary substantially," Durkin says.
"Investors want lower leverage and risk," Jackson adds. "Pension fund appetite to diversify beyond their domestic markets slowed during the crisis but is picking up again, and there is appetite for Europe. Funds are diversifying globally as well but sticking to core, stable markets such as Australia, Hong Kong and Singapore and specific metropolitan areas in North America."
Durkin says Europe continues to be attractive compared to Asia because it offers transparency and liquidity, and risk is easier to understand and calculate. Compared to the US, Europe offers more opportunities because of the different nature of the various economies within the continent, as opposed to a one single economy in the US.
"Investment in new, less transparent areas can result in outsized returns; however, it may be difficult to successfully secure core investments," Durkin says. "While the number of institutional quality properties is expanding quickly in these markets, available investments are still rarer than in more transparent and liquid markets. Additionally, stricter government controls in emerging markets can result in higher transaction costs, lower investment control and the need to establish a joint venture with a local investor."
Investors are no doubt in for a bumpy ride. Deciding whether to go for the relative safety of more established markets with lower growth or riskier shores further afield with higher growth potential will be key. But everyone seems to agree that the risks in southern Europe are too high.
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