Portugal, Spain and Italy offer opportunities but in light of their problems stock selection is more critical than ever. To group them with Greece is misleading. Lynn Strongin Dodds reports

It is not surprising that market participants in Portugal, Italy, Greece and Spain bristle when anyone mentions the PIGS acronym. These four countries would argue that they are different in terms of culture, language, monetary policy, economic recoveries not to mention property opportunities. Three of them might even complain that they are being tarred by the Greek debt crisis brush. As for real estate investors, caution remains the watchword, particularly in southern Europe where economic recovery for the most part is lagging behind their northern counterparts.

David Jackson, fund manager of the M&G European Property Fund, says: “At the moment we have down-weighted our exposure to southern Europe and are overweight to core northern Europe because it generally has stronger growth prospects, and more supply-constrained markets. The UK has bounced back more quickly than most people expected, followed by France, and that is now filtering into Germany. There are also opportunities in Poland and the Czech Republic, which are the strongest markets in the central European region, but these countries are not yet at the core end of the spectrum.”

Simon Mallinson, director of European research at Invesco, says: “Overall, investors have become much more selective and are adopting an asset-by-asset approach. While they are taking into account the national economies and local characteristics of each country, their main focus is on prime, well-located, quality properties that have strong tenants and good covenants.”

These sentiments are borne out in recent property research reports such as the Cushman & Wakefield EMEA property report. The research shows that in 2010 there will be an increasingly pronounced divide between economies in terms of growth and levels of risk. The traditional east-west divide has become less relevant as top-performing economies are being drawn from different regions of Europe. In the short term, France, Germany and Switzerland stand apart from the pack due to their potential for outperformance and below-average risk factors. Over the longer term - a two- to three-year period - the Czech Republic, Poland and Slovakia, alongside Nordic markets such as Sweden and Norway, could be star performers.

A more mixed picture emerges for southern Europe, traditionally a smaller property investment market. Noel Manns co-founder and principal at Europa Capital, a pan-European real estate investment management business, says: “About 80% of the real estate investment market is in the UK, Germany and France followed by the Netherlands and Sweden. There are opportunities in the southern European countries but you cannot lump them together. For institutional investors, Italy and Spain are the largest, most liquid and have clearer pricing, while Greece and Portugal are minnows.”

David Hutchings, head of research EMEA at Cushman & Wakefield, adds: “Southern Europe appears beset by problems, ranging from short-term economic stagnation to government debt and long-term structural rigidities. In reality, the position and outlook of each of the so-called PIGS varies. All certainly have debt issues but to different degrees and in different areas. What is more, consumer debt, as opposed to government debt, is less on average for southern Europe than it is for the West as a whole. Greece is clearly in some disarray and only time will tell how long it will take to climb back from the brink.”

The problems of Greece, which some have dubbed the Lehman Brothers of Europe, have been well documented. The country’s debt jumped to 115.1% of GDP in 2009 from 99.2% in 2008; estimates for this year put it at 123% and 135% in 2011. It was hoped that the promise of a bailout package would assure investors, however the country was forced to activate the €45bn loan package from the European Commission, European Central Bank and International Monetary Fund. The uncertainty has pushed Greece’s 10-year bond yields to record levels of more than 8% - the highest since Greece joined the euro-zone in 2001. Portugal suffered in sympathy, with its 10-year bond yields increasing five basis points to 4.65%.

Rising bond yields can have an impact on property because commercial lending can be influenced by the price of government bonds. Although this is a concern, a new report by CB Richard Ellis shows that secondary and not primary properties are most likely to feel the brunt. As Michael Haddock, director, research and consulting, at CBRE, notes: “Despite speculation, the risk of sovereign default and/or a country leaving the euro-zone is still very small. The most significant impact on property would come from the measures taken to restore national finances, which will depress rental values in the short to medium term. The value of secondary property, which is more exposed to changes in the market, is therefore likely to be more affected than prime. Lower rates of growth and high unemployment levels will have the biggest impact on real estate.

Haddock adds: “The risk of a tenant defaulting on a rental payment is independent of the credit risk at a country level. For example, a property let on a long lease to a major global company will continue to generate rent almost regardless of what is happening to the sovereign debt of the country where it is located.”

Other factors will also come into play. Michael Keogh, senior investment and economic analyst at Henderson Global Investors, notes that “decisions will be based on an investor’s time horizons, risk appetite and particular return requirements. The main criteria they need to review include the tenant’s strength, the currency risk, the liquidity of the market, the growth potential and the debt structure.”

For now, property investors are likely to avoid Greece, which has always been a difficult property market to crack due to the dominance of shipping magnates and other wealthy families. Wayne Vandenburg, chairman and chief executive of TVO Groupe, an international real estate investment and property services company, comments: “The real estate market in Greece is generally too small and closed for the international investor. The country is not big enough to be in the same league as, for example, Spain or Italy. The current financial situation is also not only rooted in the global economic recession but is a result of years of mismanagement and corruption. The country is in need of government leaders who have strong financial backgrounds that can take a stand and pull them out the current debt problems.”

Nadja Savic de Jager, associate director of CBRE, which categorises these four countries as the ‘Olive Belt,’ says: “There is no doubt that Greece has the most problems of the four regions with the highest projected debt. The economy is expected to contract by 5% this year, which is much worse than the 2% drop last year. The government needs to introduce austerity measures and cut public spending rather than only freeze it and hike taxes. One of the main problems though is that the trade unions have shown a strong resistance and the government has given in on some measures. This has not been the case in Spain where the implementation of the austerity programme has been much smoother.”

In terms of the real estate sectors, Savic de Jager adds: “Prime office and shopping centre yields in Athens are at the same level as in Madrid at 6.25%, while prime industrial yields in Athens are even keener than in Madrid. As for prime rental value, Spanish prime office and shopping centre rents have declined significantly from the peak to the fourth quarter of 2009 (27% and 31%) respectively and are bottoming out, while this adjustment is still pending in Athens.”

The Greek scenario is not all doom and gloom though. Michael Tsirikos, chief operating officer for Dolphin Capital, an independent private equity firm, says: “Although there are strikes, they are not nearly as bad as in previous years. I think people have understood how critical the situation is and they realise that the economy needs to be restructured. At the moment, foreign investors are sceptical because they view commercial real estate prices as being relatively high while local people are cautious. I do not expect much activity in the next 18 months in the commercial real estate sector but I see opportunities in the tourist market. I think the government understands the need to attract international investments in the tourism real estate industry, which is the only sector with a real competitive advantage, and will improve the framework for the development of integrated resorts that are a mixture of hotels and residences to be used as holiday homes by foreigners.”

As for Spain, the road to recovery of the residential market is likely to be long and rocky but there is potential in the commercial market. Hutchings believes it “should be viewed opportunistically as it is clear that some owners will need to sell, potentially creating good long-term investment potential for those able to focus on quality assets which can best endure the tough times still ahead but can also be improved through active management. At present, modern retail and logistics serving the larger cities are preferred while offices may start to look well priced in the cycle later this year.”

Ismael Clemente, head of Spain at RREEF, also notes that “German funds have come back into the market and are the main players, although Spanish real estate companies and family offices are also active. Financing still remains a problem, especially on larger deals, although we have not seen any distressed sales. Unlike in the early 1990s, Spanish banks do not want to have fire sales of assets. They do not want to realise their losses and are willing to restructure their loans. What we have seen is the growing popularity of sale and leasebacks on single assets and portfolios. I expect this to continue as it is a logical way for companies and banks to reinforce their balance sheets.”

The most notable deals in Spain have been the €1.9bn sale and leaseback of banking giant Banco Santander’s headquarters in 2008, as well as rival BBVA’s €1.15bn deal for 900 of its bank branches and office buildings in 2009. The most recent transaction has been the sale and leaseback of the country’s fifth-largest bank, Banco Sabadell’s portfolio of 378 high street branches for €400m.

Leaseback deals have also gained traction in Italy. Last year UniCredit disposed of a portfolio of 180 high street bank branches for €530m. Overall, Hutchings believes that Italy is in a strong position because aggregate debt is high but not growing at the same rate as elsewhere in southern Europe, and the country also has a smaller current account deficit and lower mortgage and consumer debt levels. “From a property perspective an undersupply of quality property in the right location for modern businesses and a steadily reforming public and private sector will continue to make Italy an interesting long-term target. Combine this with better current yield and rental pricing, a dearth of financing for new development and the availability of more stock, opportunities and potential partners for new investors than most would normally expect to see in a decade, and you have a recipe for an inviting market. “

As for specific opportunities, Gianluca Muzzi, co-head of RREEF Italy, believes “that there is renewed interest in core properties in cities such as Milan and Rome, as well as Florence, Padua, Turin and Genoa, where prices are reasonable due to a supply/demand imbalance. In addition, prices did not increase to such excessive levels as in some European cities so there was not such a massive correction.”

Looking forward, Muzzi believes there could be selective opportunities in distressed debt as well as leisure assets such as hotels on the back of Milan Expo 2015. There could also be more activity due to the Italian government’s tax amnesty programme launched last September, which waived penalties on hidden assets with the payment of an upfront fee of 5% on the amounts declared. The pardon, which was to have ended in December, has been extended until April, with the fee now 7%. The government has said about €95bn was declared and asset managers are enjoying healthy inflows. As a result a chunk of this money is expected to be invested in real estate.

Last, but certainly not least, is Portugal, which did not experience the same kind of real estate boom as Spain. The best sector, says Markus Meijer, chief executive of Meyer Bergman, a European real estate investment and fund management firm, is retail. “Portugal is often overlooked because it is small but the retail sector benefits from strong consumer spending and tourism. The market has been resilient and is attractive because there are institutional-quality shopping centres and pricing is reasonable. “