The debt crisis in Europe has not stopped institutions from investing in real estate but it is affecting investment strategies. Lynn Strongin Dodds reports

While policy makers are battling to find a solution to the euro-zone crisis, real estate investors are reining in their ambitions and retreating to the safe havens of large liquid, transparent markets. There are several scenarios playing out, but the popular cliché of ‘location, location, location' has never been more apt.

One of the main problems stalking the market is uncertainty. Equity prices veer from euphoria to despair on any shred of news, although it is becoming apparent there will be no imminent solution.

"This wait-and-see game is not just hurting our industry but also asset classes across the spectrum," says Mike Keogh, senior investment and economic analyst of Henderson Global Investors. "Markets have reacted well to the anticipated proposals to halt the escalation of the sovereign debt crisis, but real estate needs sustained policy developments and clarity to kick-start any prolonged upturn in occupier and investor sentiment."

The recent events have firmly dashed any hopes for a sustained recovery; not only were property markets rebounding this year, investors were also gradually moving out of their comfort zones. "The markets bounced back and investors were beginning to look at some core quality assets that were not in the best locations," says Robert Stassen, head of EMEA capital markets research at Jones Lang LaSalle (JLL). "There had been a hope that there would be a slow and steady recovery, but the panic started to settle in when the US government could not agree over the lifting of the US debt ceiling and the Europeans did not seem to take the euro crisis seriously."

Giles Wilcox, head of cross-border investment at Savills, a global real estate service provider, adds: "The two halves of this year have been quite distinct. There were signs of improvement earlier in the year, and while people were discerning, they were beginning to look further afield at secondary and decentralised locations. However, that changed this summer, and investor sentiment has become more cautious."

Research from JLL shows global direct real estate investment volumes in the third quarter of 2011 totalled $99bn (€71.9bn), a 36% hike over the same period in 2010. In the first nine months of this year, investment activity jumped by 43% with total transaction volumes hitting the $297bn mark, compared with $208bn in the same period last year.

Despite heightened economic and sovereign debt concerns, European activity in Q3 2011 held steady and not only rose by 14% to $41bn from the previous quarter, but showed a 38% jump over Q3 2010. The UK, the largest market in Europe, improved markedly in the three months ending 30 September 2011, mainly due to deal completions delayed from the second quarter. The core markets of Germany, France, Scandinavia, Poland and Russia also all continued to attract strong investor interest due to their relatively healthy GDP.

Investors also showed interest in Asia Pacific, where Q3 transaction volumes came in at $20bn, an 8% hike on the previous quarter, and a 3% rise from Q3 2010. China's direct commercial property investments enjoyed a 13% increase to about $2.8bn compared with last year. Volumes in Japan stayed flat at around $4.7bn, in line with the same quarter in 2010.

Unlike the other markets, the Americas experienced sluggish growth, with third-quarter volumes dropping 22% compared with a robust second quarter when investments soared 60% to $38bn.

Not surprisingly, against the current backdrop, prospects for property in the fourth quarter do not look bright, with delays in closing deals and volatility in transaction volumes quarter on quarter. Bank finance will become even tighter and even those with cash or mezzanine will not want to stray much beyond the prime borders. Market conditions, though, will depend on how events unfold.

According to a report from economic forecasting consultancy Oxford Economics, a worst case scenario (20% probability) would involve disorderly defaults in Ireland, Portugal and Greece, which would plunge economies across Europe back into recession, including those outside the euro-zone, such as the UK. The resulting falls in employment would severely depress occupier demand for commercial real estate across Europe.

DTZ's Tony McGough, global head of forecasting and strategy, and Fergus Hicks, director in the global forecasting and strategy research team, believe that in such a situation, office rents in nearly all European markets would drop over the next five years, compared with modest rises in most markets under the base case (a 30% probability). This assumes that Greek debt would be restructured and that major economies would slip into recession.

McCough and Hicks note: "We think that office capital values would fall by around 20% over the next five years in most euro-zone markets, with larger falls in some - nearly 30% in Dublin and Oslo, for example. Markets outside the euro would hold up better, with falls of 10% and less in markets such as Stockholm, London West End and Moscow. Only in Prague and London City do we think that capital values could still show modest increases."

As for total returns, they expect a decline across the continent, although most markets are likely to remain positive. Moscow would boast the highest, at around 10%, albeit lower than the 15% under the base scenario. The City of London would follow at around 8% in both cases.

In the near term, McCough and Hicks believe the recession, combined with weak sentiment and increasing risk premiums will push yields higher across Europe. For example, the Paris central business district office yield could rise from a current 4.5% to around 6% in 2013 - the same level it reached after Lehman Brothers collapsed.

Many investors do not expect such a dire picture to emerge. Most think that the policymakers will find a solution, but it will be a long and painful road. "Overall, I do not believe that the euro will implode, although it will be difficult to get 17 countries to agree on a solution," says Eric Adler, CEO at Pramerica Europe. "However, every time there is an announcement that a resolution is near, it is a signal that European policymakers do want to avoid a break-up."

Roger Barris, chairman and a founding partner of Peakside Capital, notes: "People should have been surprised by the mistaken euphoria of the last 18 months. We are now in a new normal where we will see an extended period of deleveraging and slow growth, punctuated by periodic eruptions of the kind we are experiencing."

In this environment, the divergence between prime and secondary assets, which had been narrowing slightly, will intensify. "One of the major issues today is that lending conditions will become tighter and the cost of borrowing will rise," says Milan Khatri, global property strategist at Aberdeen Asset Management. "This will have an impact on property activity. Secondary assets are more vulnerable, but prime will not be immune and will not escape a slowdown. It will depend on the quality of assets and the risk attitude of investors."

The divide between northern and southern Europe is also predicted to grow wider. The gap can be seen in the recent crop of figures from CBRE which show that real estate investment volumes in Italy and Spain were down by over 40% in the first half of 2011, compared with the same period of 2010. Portugal was one of the worst hit, with transactions plunging by 80%. Activity in the larger markets of theUK and France also fell, while Germany enjoyed a 6% hike. Central & Eastern Europe (CEE) recorded a 49% rise in investment volume.

Peter Damesick, EMEA chief economist at CBRE, says: "The sovereign debt crisis, as well as the divergent national economic performance, is leading to an increased polarisation in European commercial real investment markets. Investors are already avoiding southern Europe and focusing on the larger, more liquid markets and those where there are better fundamentals and growth prospects. These include Germany, the Nordics and parts of CEE, such as Poland, Czech Republic and Moscow."

Keogh of Henderson Global Investors agrees, adding: "There had been some initial investor flirtation with Spain and Italy a few months ago, but that has waned. People are erring on the side of caution and are only focusing on income and prime assets in countries such as Sweden, Germany and parts of CEE, such as Poland."

Breaking it down to a more specific level, industry experts are bullish on the prime office markets of Paris, Frankfurt and London. London has shown an impressive degree of resilience in outperforming other UK property sectors and markets.

According to the most recent Investment Property Forum (IPF) consensus forecast, it is the only property sector expected to show capital growth in 2012. The supply-demand constraint has made the West End an attractive proposition, although the City, which is closely linked to the financial services market, could be affected by higher occupancy rates due to a slowing economy.

Although prime locations will be top of the agenda for investors, market participants believe there will be opportunities elsewhere. According to CBRE research, good secondary property in stronger markets with potential for asset management to add value will attract interest. But those at the bottom end of the property ladder will continue to suffer due to a lack of debt finance. As the report points out, pricing is untested in substantial parts of the secondary market in Europe, and it is likely that a significant proportion of low-quality assets will only find purchasers at prices offering potential for high-risk, equity-style returns.

Gunnar Herm, head of real estate research and strategy for Europe at UBS, also believes that investors will broaden their horizons. "One of the main themes I expect to see over the next five years is a move away from countries, towards regions and their economic structure. The reason for this is that the major cities in Europe, such as Paris, Frankfurt and London, are all dominated by financial services and do not provide any economic diversity."

He adds: "I think investors will start to look at opportunities in the smaller cities, such as Stuttgart and Cologne in Germany, Lyon and Toulouse in France, or Turin in Italy. They have not felt the same impact of the financial crisis as the larger cities because their profiles are much more diversified. They also have strong economic prospects, good supply of stock and reasonable pricing."

Investors also think there will be opportunities in retail, particularly in countries such as Germany and Sweden, which have not experienced the same drop in consumer spending. "The main advantage of shopping centres is they have multiple tenets," says Stassen. "Also, unlike 20 years ago, there are more specialist fund managers who actively manage and can add value to the properties. However, as with all assets, you need to have the local knowledge to make the right decisions."

The euro-zone crisis is reverberating across the world and many countries in the developed world, such as the US, are grappling with their own economic problems.
Asia and emerging markets might look like bright spots but they will not be a panacea. As Alan Patterson, head of European and Asian research and strategy at AXA Real Estate, puts it: "The dynamics are different and investors have to look carefully at the potential risks and returns of each sector. Typically, Asian markets may generate higher returns but they can also have a higher degree of volatility."