Whether the euro-zone will avoid breaking up is still to be seen. But more importantly, Sotiris Tsolacos finds significant ramifications for real estate investors under every scenario

Since the Greek crisis erupted, various scenarios about the future of the euro-zone have been discussed in numerous commentaries and several research papers. They range from the worst-case scenario of a euro implosion, with the reintroduction of national currencies, to the most optimistic, in which the euro-zone sustains its current structure but with costly bailouts and further integration.

According to the worst case, the euro-zone's fatal flaws mean it is doomed to fail without a fiscal and political union. Another group's milder view predicts a breakup of the euro-zone, with the most indebted and less competitive economies exiting. But there are also advocates of the euro-zone survival-and-muddling-through scenario: the euro-zone stays alive even if Greece, a special case, secedes, or it defaults but remains in the euro-zone. The rest of the euro-zone is ring-fenced from contagion, and the currency bloc's financial system restores healthy balance sheets.

But even in this scenario - given a probability of 90% in most published analyses - the euro-zone has to implement major reforms. By doing so, the post-crisis euro-zone will offer a compelling environment for real estate investment, mitigating macroeconomic and systematic risks through policy responses to the current crisis and new instruments to safeguard the region from similar shocks in the future.

• The future euro-zone will emerge as an area of strict fiscal discipline. Budget deficits and overall debts will of course be reduced, but there will be a strengthening of budget surveillance. Peer pressure will also be enhanced; member states will evaluate budgetary and economic policies in the group through initiatives such as the ‘European Semester' and the ‘Euro-Plus-Pact';
• Mechanisms will be created to avert unforeseen fiscal and banking crises. In the beginning, euro-zone authorities underestimated the current crisis, and they had no instruments to tackle it. They started from scratch, and further progress is expected. Facilities such as the European Financial Stability Facility and the European Stability Mechanism will help to lessen similar future risks. Another defence, the eurobond solution, will be adopted when budgetary convergence is achieved;
• The euro-zone will expand, but lessons have been learnt. The new member states will have robust public finances and more competitive economies than did entrants 10 years ago.

Although not the direct consequence of this crisis, the region will offer a different mix of macroeconomic policies. For example, the uncertainty about the impact of quantitative easing and similar policies on inflation and asset prices is more pronounced in the US and the UK than in the euro-zone. With its commitment to price stability, the euro-zone monetary policy differs from policies in other countries.

As a smaller public sector leads to less crowding out of the private sector, long-term growth in the euro-zone could lift off. Italy is a prime example, since most of its budget now services a large public debt at the expense of public fixed-capital investment. Labour-market reforms instigated by this crisis will further support long-term growth in the euro-zone.

Finally, the euro-zone will remain a reserve currency area. About 25% of international transactions are in euros, and usage is growing. The euro-zone can provide another hedge against global shocks. It makes perfect sense to have holdings in both dollars and euros, the two most important reserve currencies.

In this new environment, the euro-zone might not be the land of the highest real estate returns, but rather of the highest risk-adjusted returns.

Despite the return of macroeconomic stability in tomorrow's euro-zone, the recent crisis will leave markets and investors with scars. We should not, therefore, expect a return to the absence of spreads in euro-zone bond yields prior to 2008. Markets will not go back to sleep again; country risk premia will be applied. The current spreads will converge once more, but not fully and certainly not so for the bailed-out countries, especially Greece, for many years. It is likely that euro-zone core will be redefined. Risk premia are likely to discriminate against main-core, semi-core, elevated-risk, and bailed-out countries.

But would these spreads be reflected in real estate yields in the respective geographies? The prime real estate market seems to have shrugged off the current crisis (obviously adopting the 90% scenario) in most of Western Europe. The re-priced budgetary and economic vulnerabilities across countries, while an upside risk for current real estate yield spreads, are also not bad news. These assessments comfort real estate investors, who need a bond market that is alert and constantly assessing sovereign risk.

The removal of the sovereign debt risk and more clarity about country risks will catalyse the appetite for commercial real estate and spur capital movements to non-prime and peripheral markets. European exposure will still offer valuable portfolio diversification, as the European markets will retain their heterogeneity.

In a more stable macroeconomic environment, real estate risk will reflect more idiosyncratic elements, such as sector-specific risk, local economic dynamism, market fundamentals, and of course the market/sector sensitivity to wider macroeconomic factors, GDP growth, inflation, and interest rates. For example, the impact of changes in national GDP growth on office rents is more pronounced in Paris CBD than in Frankfurt.

But many doubt the 90% muddling-through scenario. What will the impact be in the 10% scenario in which reforms do not go far enough, the euro-zone does not recover and it eventually breaks up? In such a scenario, the new euro-zone (excluding Spain, Italy, Greece, Ireland, and Portugal, according to some commentaries) will still suffer turbulence. Our scenarios suggest that such a break-up will hurt the new and smaller euro-zone. For example, if Spain and Italy are to face a GDP contraction of, say, -2% under such a scenario, the probability of a recession in the euro-zone is 80%.

Yields will be pushed up by up to 80 basis points at the prime end to reflect the economic downturn and falls in rent growth and net operating incomes (NOIs). It can, of course, be argued that the new euro-zone will be a safe haven, free of the problems of the southern periphery and perhaps Ireland. However, this scenario is messy and would have an impact on risk premia for several years due to the cracks in the monetary union and the uncertain aftershock consequences. It may not look very promising as a solution to today's crisis.

Sotiris Tscolacos is director of European research at PPR