The impact of fiscal austerity measures on real estate performance in Europe is considered by Sabina Kalyan, who argues that even those countries with the biggest problems could deliver long-term benefits

The global boom in debt-backed investment between 2002 and 2007 can, with the benefit of hindsight, be seen as a gigantic misallocation of capital. With global interest rates held down by central bankers desperate to stop the equity market crash of 2001 triggering a recession, money became cheap and bonds were low yielding. This made real estate highly attractive and the shift to securitised lending was almost perfectly timed to fuel the flow of capital into the asset class. Given that the stock of institutional grade assets is, to all intents and purposes, fixed in the short term, the rush of cheap money resulted in a boom in prices. And, unsurprisingly, when the global capital market tap ran dry in 2008, prices fell.

The fact that prices had become frothy and a correction was inevitable was not hard to predict. What took most of us by surprise was the sheer inter-dependence of the financial system. Over-leverage and poor underwriting in some parts of the US housing market were everyone's problem. So, the big story of 2008-09 was the government bailout, as the bad debts and portfolio risks of households and banks were transferred to the government balance sheet.

If the big story in 2008 and 2009 was the government bailout, then the big story of 2010-11 will be fiscal austerity. But it wasn't always meant to be that way: the original idea was that policymakers would run up public debt to shore up the banks and pay for fiscal hand-outs. This would boost domestic demand and get economic growth going again. They knew very well that it was no real substitute for the necessary deleveraging of household and bank balance sheets - but it would allow that deleveraging to take place against a background of a functioning and growing economy. Once economic growth had recovered, say in 2012 or 2013, the government would slowly take out that fiscal stimulus, pay down the debt and return to ‘normal'.

The ability to withdraw the stimulus at a leisurely pace relies heavily on the tolerance of the global bond market and ratings agencies during the period of fiscal laxity. That tolerance was already starting to waver in 2009, with the worst affected markets in Europe seeing their sovereign debt ratings downgraded, and Bill Gross, the largest bond market player in the world, announcing that UK gilts were "sitting on a bed of nitroglycerine". But when the Greek fiscal crisis hit the headlines, the game was well and truly up. There was no time for a leisurely withdrawal of the fiscal stimulus over, say, five years: the market wanted action.

And that's where we stand today - with bond market vigilantes dividing developed markets into The Good, The Bad and The Ugly. In the European context, The Good markets seem to be Germany, the Netherlands, the Nordics and Poland - newly emerging as the safe haven market of the CEE region and with credit default swap spreads on its debt lower than Spain and Greece. It's no surprise to see direct market investment volumes in Poland pick up sharply in the wake of the Greek crisis. Who wouldn't want exposure to an economy that didn't actually fall into recession, has low public debt levels, and a shortage of good-quality real estate (with the exception of the logistics market)? Sweden, Norway, Germany and the Netherlands also have relatively low levels of debt at the household and government level and economies that are oriented towards manufacturing exports that should benefit from the resilience of the Asian economies. The only proviso is that, in the case of Germany, even after the bank stress tests, one has to wonder about its exposure to other euro-zone members' sovereign debt. Nonetheless, the Good Markets could well see the Goldilocks recovery - growth strengthens, fiscal stimuli are gently reduced - and real estate returns are income-driven and solid.

The Bad are the countries with structural inefficiencies that will need to be tackled in the medium term - unsustainably expensive social security systems, ossified labour markets - but where the current pressures on public sector financing are not so extreme as to have captured the attention of the bond market vigilantes. In other words, fiscal policy has to be tightened up, but not so quickly and drastically as to trigger an economic or occupier-market double-dip. In this camp, I would place markets such as France and Italy. For sure, the economic recovery will be constrained by the relatively high levels of public debt, but no one seriously doubts the ability of the governments to service that debt.

Then we come to The Ugly. These are the markets that have already attracted the ire of ratings agencies and global bond markets: Spain, Ireland, Greece and the UK. We are all, by now, painfully aware of the unprecedented scale of the public sector spending cuts facing these economies, and the potential for public sector job cuts and pay freezes to so depress domestic demand that the countries either fall back into recession (the UK, Ireland) or remain in recession for another year (Spain, Greece). Evidently, one would not want to invest in some of the provincial cities in these markets that are heavily dependent on the public sector as a source of employment and thus tenant demand. But, perhaps controversially, one can make a case for these markets, and for the UK and Spain in particular, over the medium term. The UK is a good example of an economy that saw dramatic public sector rationalisation in the 1980s and 1990s, and after both periods the economy emerged leaner, resulting in a period of above-trend growth and wealth creation. Bond market vigilantes may be forcing the hand of policymakers in these markets, but insofar as real estate returns rely on above-trend economic and employment growth to deliver a sustained increase in demand and rental value growth, those investors who can look through the current pain could reap the benefits.

Sabina Kalyan is European Head of Research at CBRE Investors.