Is it time for investors to give Spain and Italy serious consideration? Caroline Molette and Carol Hodgson investigate

Higher yields and a belief that the euro-zone crisis has eased are drawing foreign investors back to the Spanish and Italian office markets, boosting national investment levels. So far this year, one large deal by Qatar Holdings in Milan has already pushed Italian investment volumes above their 2012 levels. In Spain, where the investment recovery has been slower, volumes in the second quarter were twice as high as volumes in the first quarter thanks to the high-profile deals by AXA Real Estate and Meyer Bergman, in Barcelona and Madrid, respectively.

Certainly, the majority of investors are still cautious – volumes remain far below long-term averages – as Spain and Italy are both trapped in a double-dip recession, struggling with fiscal austerity measures and a weak household sector. However, even if both are unlikely to reach positive growth until 2014, tentative signs now indicate that the bottom of the downturn is not too far away.

In Spain, the recession finally seemed to be slowing in the second quarter, with only a 0.1% decline in Spanish GDP, although the crisis has, so far, hit Spain harder than Italy. In July, the Rajoy administration reaped the rewards of its labour reforms, implemented to increase Spain’s competitiveness, as unemployment fell for the first time in two years (although at 26.3%, it remains unacceptably high), and the current account finally showed a surplus. Further restoring confidence in the Spanish financial sector, the SAREB has been successfully acting as the ‘bad bank’, in charge of taking over the banks’ riskiest real estate exposure. Thus, even if a lot remains to be done, it seems that the Spanish recovery is on track.

Conversely, reforms in Italy have been harder to implement as the country has struggled with political instability. As a result, the economy has not shown any effective signs of improvement yet, and the unemployment rate – even though it is just over half the Spanish rate – continues to grow, while the north-south divide in the country seems to be widening.
Moreover, little has been done yet to limit the Italian public debt ratio of 125% of GDP, one of the highest in Europe. And this situation could last until the end of the year, despite the fact that the government recently survived a vote of no confidence. The recent Berlusconi trial outcome could call into question the current coalition, casting serious doubts on Italy’s possibilities for short-term recovery.

Given this fragile, although quite optimistic, outlook in the short term, investors should first return to these markets in prime locations of the main cities, in particular Madrid, Barcelona, and Milan, where strong real estate fundamentals will compensate for poor economic situations. This is certainly going to be a difficult judgement call and definitely a case of getting the timing and the price right.

As we approach the bottom of the downturn, it appears that the Spanish real estate market has more upside potential than Italy’s in the mid-term. Indeed, the severity of the Spanish crisis made capital values and rents fall apart and they now stand at half their pre-crisis levels, leaving more room for improvement than in Italy, where values have seen far less compression. Moreover, in Milan, office development is picking up whilst demand remains subdued. In Spain, fundamentals, at least in Madrid and Barcelona, are starting to return to healthy levels. The country seems to have learnt from past mistakes, as uncontrolled office development led to an oversupply in the early years of the crisis. New completions will remain limited there in the coming years.

Despite encouraging signs from both the economy and the real estate market, investment in these countries still brings its share of risk, which is only worth undertaking if properties are priced correctly. However, currently quoted prime yields of 6–6.5% — significantly higher than the European average of 5.2% — do not seem to accurately reflect the additional risk. Indeed, a lack of transparency makes it difficult to grasp the actual real traded yields, especially coupled with the sluggishness of transactions of the past few years. Fortunately, renewed investing should help shed light on what prices really are. For instance, AXA Real Estate’s purchase of a portfolio of 13 good-quality buildings in Barcelona, in a sale-and-leaseback transaction with the Generalitat of Catalunya committed to a 20-year lease, traded at a 9.5% yield.

The pickup of Italian and Spanish real estate investment is therefore the result of a growing optimism by investors that the worst is past. Asset-specific deals have lured major investors back to the market, and others will follow. However, the weak occupier market has led to high vacancy levels, and only a gradual improvement is expected. The key drivers of demand remain companies that are trying to cut costs, consolidate, and improve efficiency. As a result, even if the bottom of the downturn is not too far ahead, values will keep declining until at least the end of 2014, although some signs increasingly indicate that the Spanish recovery could happen sooner.

Spain offers more attractive investment opportunities than Italy in the mid-term. Its main cities, Madrid and Barcelona, are the last two global markets where pricing remains well below peak. At the moment, prime assets are worth investigating; however, secondary markets still hold more risk. Because owners are often reluctant to sell their prime assets at such high yields, investors might consider buying the debt behind these assets as an alternative entry into the market.

Caroline Molette is European market analyst and Carol Hodgson is European research strategist at PPR