Are Europe's safe havens too expensive in a challenging economic environment? Craig Wright provides some answers

The sovereign debt crisis dogs investment markets in Europe. Government bond pricing currently reflects the risk of disaster, highlighting the gulf between safe havens and the rest. Wealth preservation and the protection of income are crucial to investors today, most of which are understandably obsessed with core product across all asset classes. Only the bravest of the brave will look at anything riskier. Inflows to the European Central Bank (ECB) reflect this risk-off attitude in Europe.

The ECB has cut its deposit rate to 0%, increasing the cost in real terms for depositors, while Denmark has introduced a 20 basis point fee on central bank deposits.

With around €5trn on deposit at the ECB, southern Europe is being starved of the capital it used to rely on from mature European economies; the cycle has been broken and the gulf in prosperity between northern and southern Europe is widening.

Economic performance in Europe now stands as polarised as it has done since the introduction of the euro currency at the start of 2002. Intuitively, the underlying real estate fundamentals reflect this disparity in economic performance and this is governing real estate forecasts. Southern Europe makes up around 35% of the euro area economy by share of GDP and as such should offer investors a significant amount of scope for investment.

However, according to IPD, the southern European estimated investable universe is just 15% of the total euro area market by capital value. So not only does southern Europe play host to the sovereign debt crisis, it also harbours some of the smallest, least mature and least transparent real estate investment markets in Europe - a major turn-off for risk-averse investors.

The sovereign debt crisis has been fundamental in dictating the economic conditions in the periphery. Cumbersome budget deficits are being addressed, to the detriment of economic growth and thus real estate fundamentals. Here lies the crux of the current problem for southern Europe. Without economic growth, debt-to-GDP ratios and budget deficits will continue to climb. In Q1 2012, Eurostat indicated that public debt-to-GDP ratios in the euro area had risen to 88.2% on average.

This trend is unlikely to switch, with primary budget deficits forecast by the IMF to remain negative until at least 2016 in most European countries, outside Sweden and Germany - the best performers. The 3% deficit target agreed in the fiscal compact, as highlighted in figure 1, is likely to be impossible to achieve for southern Europe in the short term. Spain has pushed its deficit target back by a year, while historically robust economies such as the Netherlands also look vulnerable to missing it in 2012.

Labour markets are at the core of the regional disparities in Europe, a feature unlikely to change soon. It has been well documented that Spanish unemployment has reached nearly 25% of the working age population, while youth unemployment has topped 50%. The total compares with the EU average of 11.2%. EU countries experiencing the biggest increases in unemployment have been Spain, Greece, Ireland and Portugal.

While numbers of welfare claimants continue to grow, and lower tax revenues provide a drag, the outlook for public finances continues to be stretched further. Employment is a key driver for all of the key real estate sectors, showing high correlations to rental growth, and the relative weakness in southern Europe is set to sustain the polarised outlook.

Investment flows are an influential factor for real estate pricing. Stronger flows generally help insulate values, while a lack of liquidity is typically detrimental. In response to the varied outlook for Europe, investors have retrenched to safe havens and core markets expected to produce stronger economic growth. Indeed, 76% of total investment in the EU (excluding UK) over the 12 months to Q1 2012 was focused in Poland, Germany, Sweden and France, reflecting the stronger macro outlook.

The PIIGS (Portugal, Ireland, Italy, Greece and Spain), all of which face shrinking economies this year and next, received just 7% of total investment. With a lack of demand for assets in southern Europe to persist and the banks keen to reduce their exposure to property, the gap in relative pricing of assets in the euro area is likely to remain elevated.

Alongside the weak macro picture, another crucial reason for the disparity in investment volumes is the availability of debt. Bank stress tests, changing legislation, an increase in bad loans, have led to a fall in appetite for real estate debt among banks. This trend poses a significant question for the refinancing of existing real estate debt. Banks make up around 75% of the lending market for European real estate, and with around €175bn per annum needing refinancing over the next 24 months, this will have a continued impact on pricing.

Some banks are still willing to lend to existing customers, but even the strongest banks are cautious of lending large amounts without spreading the risk among counterparties. In accordance with this stress, lending margins are higher, while maximum loan-to-value ratios are also shrinking. In response, an increasing number of debt funds are looking to help fill the funding gap, but these are unlikely to solve the problem.

Estimates suggest that new debt funds launched by insurers might add €30bn per annum to the pool of finance available, although this will be senior debt focused on prime assets, leaving secondary assets vulnerable. This is expected to further enhance the gap between prime and secondary, and indeed northern and southern European, markets.

Indeed, looking at future investment trends, most investors are likely to continue focusing on core strategies. According to the 2012 INREV Investor Intentions Survey, 69% of investors prefer ‘core' strategies, a slight increase on the 2011 survey reading.
Although some funds will undoubtedly look for opportunities in the likes of Madrid and Dublin, absolute levels of investment are expected to remain thin in these markets. In the meantime, the bulk of investors will concentrate on prime northern European markets where income and capital value stability are considered more robust.
Is economic diversity fully reflected in relative real
estate pricing?

Having acknowledged the wide range seen in economic performance and liquidity, questions over pricing naturally arise. Prime office yields in the key European markets currently show a wide range. A margin of around 275bps separates the lowest yielding markets of Paris and Munich (4.75%) from the highest yielding markets of Lisbon and Dublin (7.5%). This range is over double the level seen in early 2008, when markets became more evenly priced. This thin margin has gradually unwound over time as risk has been priced back into European markets.

However, it is hard to identify whether southern European assets are being priced appropriately. There were only seven commercial real estate investments in Portugal in 2011, which has left the market void of transactional evidence - crucial for a market to be rationally priced. Given the circular nature of the problem, it is likely to take a long time for normal market conditions to return.

Initially, to get an idea of pricing, comparing the real estate yield margin over government bond yields is a familiar measure to use. Yet, with so much volatility in the bond markets and with substantial outside intervention from the likes of the ECB, the bond yield may be a less robust measure to use. At the time of writing, prime real estate yields over government bonds show margins of 250-450bps in Sweden, Belgium, Germany, Netherlands, Finland and the Czech Republic, as shown in figure 3.

These levels are as strong as they have been since the mid-1990s, making real estate appear very favourable from an income perspective. Across a basket of 13 key European markets, the arithmetic average margin is around 200bps, while the weighted average is closer to 275bps. This represents a solid foundation for the basis of investment in the real estate asset class in core Europe in particular.

The outlook for core European bond yields is for a modest rise, given the outlook for inflation and expectations of a general economic recovery in the medium to long term. However, bond yields would need to rise 150-200bps to have a real impact on the positive real estate yield margin.

Current yields vs historic yields
Historic real estate yields are of limited value in assessing current pricing. European investment markets have been through several different phases since the start of the euro area, characterised by periods of high interest rates, levels of inflation and stronger or weaker economic growth. Also, during the last 10 years some European markets have matured substantially, such as Poland and some of the southern European markets and Europe looks very different now as an entity.

Intuitively, investors do not need quite as much reward for investing in the maturing markets as they did in the early 2000s. However, psychologically, investors may shy away from markets yielding close to their historic lows, given the cyclical nature of investment markets. Most prime office yields lie within a range of 50bps above or below their 10-year average. Exceptions include Dublin and Madrid, which are much higher yielding now, while Prague, Warsaw and Stockholm are substantially lower yielding than their historic average.

The perceived safe havens of Paris, Munich and Stockholm have been targeted by a large proportion of the investment activity over the last 12-18 months and yields in these markets are close to historic lows. While this might suggest these markets are overpriced, the rental growth outlook forms part of the yield, and with development levels at 30-year lows, the potential for longer-term rental growth is still there, if not currently evident.

Also, the greater focus of investment and higher availability of debt in these markets should help to sustain capital values. So, on reflection, investors should be more comfortable with lower yielding assets with greater growth potential at a time of higher risk aversion. Moving down the risk curve is a natural reaction and one reflected in the bond markets.

Property vs risk-adjusted government bond yields
Given the difficulties with using historic yields to identify where yields should be today, it is perhaps more useful to compare the current prime yield on an investment to the current risk-free rate-adjusted for risk in each market. This introduces the risk premium element to the equation and makes the assessment of pricing a more real estate-specific one. The risk-adjusted yield can be estimated by adding the current risk-free rate (10-year government bond yield), plus a risk premium for that market, minus the five-year rental growth forecast.

When compared with the risk-adjusted measure, current pricing looks particularly favourable in core markets and very weak in peripheral markets. The risk-free rate is the dominant factor in producing these results. The high bond yields in peripheral Europe suggest real estate yields should be much higher to account for the greater macroeconomic risk in these markets. The core markets look far more favourable as a result of the low risk-free rate, but also due to the stronger rental growth forecasts, which essentially reduces the risk adjusted required rate of return.

Property vs risk-adjusted corporate bonds
Having acknowledged that, in the current macro environment, the biggest deciding factor in influencing relative pricing is the risk-free rate, it can be argued that it is more appropriate to compare current prime office yields to an alternative risk-free measure. Government bond yields reflect unusual market influences, such as ECB bond market intervention and forms of quantitative easing that we have not seen since the launch of the euro.
So it seems wise to substitute in a different risk-free rate. Corporations are underpinning the income in real estate portfolios and private sector fixed-income assets offer a comparative investment opportunity for institutional investors too. If we substitute in the euro area average AAA benchmark corporate bond yields for the risk-free rate in core European markets and the BBB bond yield in the southern European markets, we get a slightly different picture in terms of relative pricing. Figure 4 shows the relative attractiveness of the markets on this basis.

Markets looking most favourable using the corporate bond as the risk-free rate include the likes of Paris, Munich, Stockholm and Warsaw. Notably, Madrid and Dublin also improve in relative attractiveness, reflecting lower yielding corporate bonds. Conversely, weak market fundamentals in Budapest, Rome, Madrid and Lisbon continue to make these markets less attractive.

Amsterdam also starts to look more expensive by this measure, given the increased risk of weaker fundamentals. The weakening condition of public finances, its exposure to liquidating German open-ended funds, combined with a total vacancy rate of over 20% across much of the Randstad area, certainly detracts from the Dutch office market.

How is the outlook for pricing likely to change?
It is clear that real estate yields in core markets look expensive relative to levels seen during stronger periods in the economic cycle. However, in relation to other income-producing asset classes, core northern European real estate markets remain attractively priced. Given that core markets harbour the vast majority of investable real estate in Europe, this is very positive for the asset class. At present, the bond markets are significantly influenced by liquidity measures implemented by the ECB, which is maintaining the attractive relative pricing of real estate.

While the bond markets continue to price in the risk of disaster, the relative attraction of real estate is not likely to diminish. Even if the ECB can successfully convince investors that peripheral government finances have been stabilised, the low growth, low interest rate and low inflation outlook means real estate should maintain its healthy margin over bonds.

Furthermore, the pricing differential between the best and worst markets in the real estate sector is expected to remain elevated, in accordance with the polarised economic outlook. On this basis, southern Europe is expected to remain subdued, at least until we see an improvement in government finances. Opportunities to invest in prime assets at large discounts may well arise in southern Europe, although these transactions will remain the exception and not the norm, as most institutional investors and the bulk of capital will continue to focus on income security and defensive strategies for now.

Craig Wright is real estate investment analyst at Standard Life Investments