European real estate: navigating the sovereign debt crisis

Warren Lewis
3rd July 2012

Chris Urwin, Aviva Investors’ Global Research Manager – Real Estate: comments

The sovereign debt crisis has had wide-reaching impacts on European real estate markets. Since the start of the year, real estate transaction activity has fallen as the sovereign debt crisis has intensified.  Due to the high levels of uncertainty generated, it has resulted in weak real estate fundamentals and investor reluctance to take on exposure to income risks.

Looking ahead, we envisage three possible scenarios for European real estate, each with very different potential outcomes and opportunities:

-Muddling through

Europe’s policy makers continue to “muddle through” the debt crisis. If this were to happen, sub-trend returns from pan-European real estate would be expected over the next five years. There would be significant near-term differences between resilient core markets (especially Germany) and the underperforming periphery (especially Spain). Defensive assets with secure income streams would remain highly prized while secondary assets and debt-dependent strategies would be likely to underperform.

-Disaster area

If it proved politically impossible to develop an aggressive and credible policy response to the situation there could be multiple exits from the euro zone, causing major economic and investment market disruption.  If this were to happen, it would be extremely negative for European real estate markets. Capital value declines could occur across most European markets and non-euro zone European markets would be likely to outperform. Meanwhile, prime, income secure assets would be more defensive, especially those in low leverage markets. Secondary assets across the continent would be likely to significantly underperform. A development such as this would highlight the case for global diversification, including exposure to Asia Pacific and the US.

-Decisive and coordinated action

Policy makers could prevent a euro zone break-up by rapidly deploying an extremely strong policy response, therefore greatly reducing the uncertainty that has pervaded the Eurozone.  Under such a scenario, investment markets would respond positively, with European REITs likely to benefit from a significant bounce in the wider European equity market.  European direct real estate would also perform stronger than we currently expect. Fundamentals would improve, supporting an occupier market recovery that extends to secondary sectors.

Core European markets would continue to be favoured but there would be greater opportunities for value-add strategies and perhaps even selective development. Prime assets without income growth potential could underperform as investors would no longer be willing to pay a premium for defensive qualities as risk aversion eases.

Careful and responsive portfolio positioning is currently required to negotiate this highly uncertain environment. Given the balance of risks, prime assets with strong income-producing qualities – especially in Germany and the Nordics – continue to be favoured. Although significant value can be hard to find in core markets, many investors will continue to value the defensive qualities offered by lower-risk real estate.
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