Before real estate markets across Europe begin to show signs of a significant recovery, there will have to be an improvement in the area's economic fundamentals. Nicole Lux and Richard Plummer report

The recession has affected all countries in Western and Central and Eastern Europe (CEE), but to varying degrees in terms of severity and duration. The reason has to do quite simply with different economic fundamentals and internal policies within EU countries.

The actions of governments to support their economies have varied from country to country. This is especially true for the badly affected banking sector, which has received support in varying degrees and ways.

Overall, we note that the governments of the UK, Germany, Benelux and Ireland have provided the most for their respective banking sectors. Spain, whose economy is largely based on its construction industry, has experienced a major downturn in equal measure. But now that the worst of the financial and economic crisis appears to be behind us, there are three major challenges ahead for European economies.

Large fiscal imbalances and accumulated debt; Sustainability of recovery, which will be crucial to restore demand-side fundamentals; As low interest rates cannot continue forever, a rise in interest rates will translate into a higher debt burden for governments.

Governments continue to deal with their loss-stricken banking sector, as well as high credit losses on personal loans and credit cards. They will by necessity focus on deleveraging their debt burden, which they can do through either increasing their revenues by increasing the tax and fiscal burden for consumers or by focusing on increasing revenue from exports.

Success in stimulating economic growth will depend on the ability of governments to limit household expenditure and increase revenues to service their debt interest payments.

Economic country ranking
In our efforts to identify attractive real estate markets in 2010, we have ranked markets by looking at their future economic outlook. Then we have combined this with an analysis of real estate market fundamentals by looking at yield differentials, and supply and demand indicators. We have scored the economic strength of 12 countries by looking at the following factors:

2010 GDP growth forecast as a measure of the country's ability to stimulate future growth; 2010 inflation forecasts and expected treasury yield shift as an indicator of economic stability; Debt-to-GDP ratio as an indicator of relative indebtedness of the country within the EU.

Each of these factors has been scored on a scale of 1-12 (with 12 being the strongest). The overall score for each country represents the simple average of the above indicators.

The market achieving the highest overall score is Sweden (10), which is mainly due to the strong GDP growth forecast, moderate inflation and its relatively contained debt-to-GDP ratio compared to its peers, such as the UK or Germany. The second highest score has been achieved by the Czech Republic (9). Although a relatively small economy, the Czech Republic has a very low debt-to-GDP ratio and its export-oriented industry has achieved a positive GDP growth forecast. Despite low levels of consumer spending, consumers nevertheless benefit from a relatively low fiscal burden. Germany (score 8.25) has been affected by the downturn on two fronts.

On the one hand, exports have declined sharply, but German banks' capital base has been hit badly and loan losses are still expected to rise due to insolvencies. However, the reopening of the Pfandbrief debt market is now providing banks with some low-cost refinancing options. The German government still provides a large amount of economic support, which in turn has underpinned consumer spending. In addition, tax cuts are being considered as a means to reduce consumers' fiscal burden further.

Although export-oriented economies such as Germany or Sweden have suffered steeper GDP declines (-10.5% and -9.3% since the last downturn in 1990), due to a widely diversified industry base, these countries also have the potential to recover more quickly than Ireland or Spain (score 4.75). The latter experienced a property-led bubble with highly overleveraged households and weak employment market protection.

What sets the UK apart from Spain and Ireland is that (together with the US) it can take advantage of flexible exchange rates, which greatly helps to reduce its current account deficit. At the same time, however, the weakness of sterling (and the dollar) will impose an adverse effect on the economic recovery of euro-zone countries with large trade surpluses.

The UK (6) only ranks eighth out of 12, largely because it has the highest level of public and private household indebtedness. Furthermore, efforts to rebuild savings are expected to constrain consumer demand for some time. The major challenge for the UK is debt affordability, reflected in the fact that it issued £225bn of gilts in 2009 with another £175bn still in the pipeline for 2010. In the short term the UK has access to low financing rates due to the fact that banks' demand for gilts remains high. It can also increase revenues through higher fiscal flexibility than France or Germany. However, the low score is the result of the higher inflation forecast for 2011-2012 and a high level of government indebtedness.

The three bottom performers are Spain (4.75), Hungary (3.75) and Italy (2.5). Their low scores are due to high government indebtedness in the case of Italy, and in the case of Spain and Hungary, high unemployment rates, which are limiting government tax revenues.

Drivers of real estate performance
What has driven the decline? In our assessment of real estate market fundamentals, we initially looked at yields as a performance indicator. The key driver feature of the 2008 downturn (in particular the decline in capital values and total returns in the real estate market), was the dramatic upward yield adjustment across all markets and sectors ranging from 100bps to 350bps.

The increase in yields was the result of the liquidity crisis, with investors responding by demanding an increase in their risk premium for non-liquid assets, as well as the uncertainty surrounding asset valuations. This was subsequently followed by sharp declines in rental growth, the result of the overall economic downturn, which led to substantial job losses in some sectors, consumer spending declines and business insolvencies.

We have identified five markets in which capital values have undergone the greatest correction and where yields continued to move outwards until the end of 2009. According to data sources from PMA and CBRE, all five markets are retail markets, starting with Polish retail warehouses with a yield of 8.50% (+150bps), followed by high street shops in Madrid 5.50% (+140bps) and high street shops in Budapest 6.90% (+140bps).

Following in fourth and fifth places are Hungarian retail warehouses and high street shops in Warsaw. Retail leases often contain a turnover element, which links them much more closely to retailer performance. In addition, retailers in CEE countries have often signed euro-denominated leases, although they receive their income in local currencies.

While all these markets can be considered to be relatively cheap, high street shops in Warsaw provide the highest spread over Polish treasury rates, and the Polish economy has in fact avoided a recession altogether. However, we need to keep in mind that the higher yields in these markets also reflect their higher degree of sovereign risk.

Although still showing a reasonable spread over treasuries the five markets in which yields have risen the least in the past 12 months are retail warehouse markets of Sweden, Italy and the UK, as well as high street shops (-30bps) and offices (-50bps) in London

In fact, all five markets have already started to display signs of yield contraction, despite continuing rental declines or rents stabilising at lower levels. Notwithstanding those encouraging signs, they require close attention since the respective economies have by no means fully recovered.

Drivers of occupational markets
Occupational markets, and especially rental growth, are directly affected by the supply of new space and net absorption. Markets which are in equilibrium tend to exhibit the best rental growth and stable vacancy rates over the long run.

PMA has forecast that the largest reductions in new office supply over the next three years will occur in Budapest (-24.5%), followed by Prague (-19.5%) and Dublin (-18%). This is very positive news since all three markets had a strong supply pipeline during the last three years and high vacancy rates. In addition net absorption is forecast to be positive over the same time horizon. However, we need to note that the adverse economic effects of high levels of household indebtedness, unemployment and debt (in the case of the Irish government) will keep growth prospects for the Irish and Hungarian economies subdued for longer.

Moreover, while net absorption appears to be strong for CEE countries, the data actually only refers to new office space and does not take into account old secondary space being vacated in favour of new premises. The London market shows hardly any supply of new space. Projects have been suspended or delayed. Net absorption for the London office market is expected to be the strongest compared with other mature European office markets.

The increased demand is mainly the result of companies signing new leases in order to move to cheaper office space and trying to take advantage of other incentives such as longer rent-free periods. However, with companies still being held in their old lease contracts availability of space remains limited.

The opposite is happening in the German office market. Limited future demand has been forecast for the next three years for office space in Berlin or Frankfurt, despite a large number of leases expected to expire in 2010. The German real estate sector has suffered on all fronts as a result of general economic changes that have affected the banking and corporate sector in addition to various mergers (Dresdner & Commerz), relocations, office closures and insolvencies. These factors will keep vacancy rates high until end 2011. In particular, we note that in Frankfurt the current vacancy stands around 20%. Higher rates are only achieved in Budapest (24.7%), Dublin (24.4%) and Amsterdam (22.5%).

Future prospects for real estate markets
Overall, we can conclude that retail markets have responded more quickly than office markets with an upward movement of yields in response to the economic slowdown. As soon as economic fundamentals improve, they can also be expected to recover more quickly. Office markets, which have historically been the more volatile sector, have shown lower levels of yield correction. Especially in Germany, where companies have been able to hold on to their workforce, the office market has shown less movement. But with the continued restructuring of companies and the possibly delayed effect of companies reducing workforce, office markets will take longer to recover.

When individual markets will start to recover is open to speculation and will depend on policymakers taking the right decisions. The UK especially has differentiated itself much from its European peers economically and politically, and 2010 will bring more clarity over the likelihood of a double-dip
scenario in 2011.

Dr Nicole Lux is deputy head of research at Rockspring
Richard Plummer is chairman at Rockspring