CoStar/PPR: How traumatic would a eurozone break-up be for Europe’s property markets?
By Sotiris Tsolacos Tom Francis - Friday, January 27, 2012 12:45
Costar’s independent real estate forecasting business Property and Portfolio Research (PPR) has released updated forecasts of how Europe’s real estate markets would fare in the face of a break-up of the Eurozone.
PPR has updated forecasts in response to its house view that one of the worst-case scenarios, that of a partial eurozone break-up, is more likely now than at any time since the turmoil started. In response crossborder investors are demanding ongoing assessments of the potential impact on their portfolios.
PPR in fact attaches a 10% probability to a partial dissolution in which Greece, Portugal, Italy, Spain and Ireland all exit the monetary union.
Within this Greece would leave first and the other countries would follow as contagion spreads, resulting in high bond yields and making the task of debt servicing unsustainable.
Politicians, with the consent of electorates, would proceed with the required reforms and adjustments outside the eurozone to make them less painful.
In this event PPR has identified major economic, political and policy response conditions that lead to the breakup of the 17-state monetary union. The key stakeholders (Germany and France) would remain committed to the survival of the euro. However, the eurozone would have no defences to avert the crisis when Greece leaves. The European Financial Stability Facility would be deprived of further funding to bail out countries as significant amounts would be required. The ECB will not become a lender of last resort, a QE response to the crisis is ruled out and finally the Eurobond is not seen as an effective solution in a region that is highly fragmented economically.
Sotiris Tsolacos, PPR’s Director of European Research and Visiting Professor in the School of Real Estate and Planning at Reading University, says that while PPR assigns just a 10% probability such dramatic events, many international investors currently see a greater chance of this happening.
Investors falling into this camp, says Professor Tsolacos, should consider adjusting their European portfolios and exposure to three broad regions: the new smaller eurozone (led by Germany and France), the ex-eurozone region (dominated by Spain and Italy) and the non-EU/non-eurozone group of countries (which includes the UK, Sweden, Denmark and Switzerland).
The ex-eurozone countries will experience a major recession lasting for around four to five years. The new eurozone will fall into a recession but a milder one that will end within two years. GDP growth attribution analysis carried out by PPR to assess the importance of the interlinkages among the three regions finds that output growth in the ex-eurozone economic group carries a weight of about 39% on the GDP of the new eurozone bloc, and of approximately 29% towards the GDP of the non-EU/non-eurozone group.
On the contrary the latter group is more linked to the fortunes of the US economy (33% weight) than the former (22% weight). The recession will bring employment losses and office-related economic activity will decline.
PPR sees office-using employment contracting by 5% over two years in the new eurozone region and by more than 16% over a four year period in the ex-eurozone group of countries. In contrast the group of countries outside the EU or the eurozone will experience moderate losses of 3% in addition to the losses already seen in the recent downturn.
Senior real estate analyst Tom Francis argues that the office markets would “inevitably” be adversely affected. Given the downturn in economic output and expected employment losses, occupier markets everywhere would suffer.
The exiting countries, where on average prime rents have already fallen for four consecutive years and by a total of 25%, would be worst-hit. Under the break-up scenario PPR would expect to see rents falling by a further 20%, compared to a decline of just 3% under the base case.
The remaining eurozone members would see still-significant rental declines of around 12%, although relatively speaking rents would be coming from a much higher level.
Within the new eurozone, Germany would be the most resilient, but financial centres such as Frankfurt and Paris La Defense would be harder hit. Occupier markets outside of the eurozone would be less affected, with rents sinking by 5% this year. Links with the European banking and finance sector would hurt the London City and Docklands markets, although the UK capital’s diverse occupier base would at least partly offset contagion from the eurozone.
Francis goes on to say that property yields would also come under significant pressure.
In the exiting countries, yields on long-term government bonds would hit 9% and remain around 100 basis points above the base case scenario over the five-year forecast period. PPR believes that bond yields would also move upwards initially in the remaining member states as uncertainty surrounding the eurozone would dent investors’ confidence.
With rising risk premia and a likely dearth of real estate lending, prime office yields would hit 8.5% in the ex-eurozone by 2013, an increase of 150 basis points over PPR’s base case. This would mean that prime capital values, which have already fallen by more than one third, would lose a further 30% under the break-up scenario.
In the new eurozone region, prime yields would increase on average to 6%, 75 basis points above the base case, but as confidence returns they would fall back relatively quickly. Nevertheless, capital values would still fall by around 20% over the next three years.
The flight to quality that would see lower government bond yields in the UK and other non-eurozone countries would lessen the pressure on property yields. However, a renewed credit crunch and the additional risk attached to European real estate in general would push office yields slightly higher. Even so, previous rental growth would generally be sufficient to keep net operating incomes from falling, and capital values would remain flat for three years.
Professor Tsolacos says although the strategy in such a scenario is obvious, the resistance level of specific locations differs and therefore active portfolio management is required to favour locations and assets that can hold out better. After a couple of years of preserving income in the portfolio Tsolacos suggests that the strategy should also be informed by how fast the market adjusts. In an orderly break up, the ex-eurozone countries may see the predicted adjustments in yields and prices happening fast and investors should position themselves to spot opportunities as early as two years after the break up.
PPR also highlights the assumption of orderly break up in this “Armageddon scenario”. Professor Tsolacos argues that electorates are becoming more educated about the eurozone and even within the group of exiting countries they recognise that a golden opportunity was missed to make significant structural changes that should have aimed to liberalise labour markets, make distribution channels more competitive, reduce public sector size, contain unit labour costs and tackle unsustainable pension schemes to mention some main ones.
Such changes will need to be pursued now outside the euro in order for the new eurozone to regain global confidence. A disorderly break up can lead to major frictions within Europe characterised by social unrest, increased nationalism and ultimate protectionism. The above scenario forecast will then become the best-case scenario.
PPR forecasts European markets and updates the scenarios quarterly.
stsolacos@costar.co.uk and tfrancis@costar.co.uk