Secondary property likely to suffer as result of current turmoil in government bond markets (EUR)

Beyond the political and economic fallout of the Greek debt crisis and turmoil in the government bond markets in Europe, real estate investors are pondering the implications for the property sector. A new report by CB Richard Ellis – which considers whether increases in government bond yields in a number of European countries will negatively impact property market recovery – suggests that it will be the measures taken to restore public finances have the most potential to impact the real estate sector in the short to medium term, but that these impacts are more remote than might be expected and are most likely to affect secondary property rather than prime.

If the recent strength in the real estate market has, to a significant extent, been driven by the yield differential between prime property and government bonds, then the recent increases in government bond yields in some European countries could arguably be expected to produce a negative impact on the property market recovery seen over the last year.

The historical relationship between the pricing of real estate and that of government bonds is a complex one because of the part-bond-part-equity nature of property and the fact that real estate is not a homogeneous asset class. Each property has different characteristics and these (in particular, the length of lease and financial strength of the tenant) will make each asset more, or less, linked to bonds in its performance. This is particularly important in today's market as a high proportion of the properties currently being traded, and for which there is greatest competition, are those with most bond-like characteristics – long leases to strong covenants.

The simplistic conclusion is that if these properties have bond-like characteristics, and the yield on government bonds increases, then the yield on these properties ought also to increase, driving down the price. However, the real answer depends on why yields on government bonds are rising. Interest rate rises are not driving recent bond yield increases, and they have not risen consistently across the Eurozone, but are confined to a selection of countries. The increased 'spread' between government bond yields in different Eurozone countries has been driven more by liquidity risk and the possibility of extreme events such as outright default or a country being forced out of the Euro.

Michael Haddock, Director, Research and Consulting, CB Richard Ellis, said: "Sovereign default or a country being forced out of the Euro would impact the market for bond-like properties, but not to the extent that might be expected. The risk of a tenant defaulting on a rental payment is independent of the credit risk at a country level. A property let on a long lease to a major international company will continue to generate rent almost regardless of what is happening to the sovereign debt of the country where it is located. And whereas normally in the case of sovereign default an international investor would also experience a huge loss from currency devaluation, any investor from the Eurozone itself would see no currency loss whatsoever."

If a country left the Eurozone, it is possible that contracts (such as leases) written in Euro would continue to be valid, as the Euro will continue to exist. Where properties are let to local occupiers, dependent on local revenue streams, the investor is less secure and as such, businesses may struggle to continue paying rents in Euro in the event of a substantial devaluation.

"Real estate investors have less to fear about sovereign debt market volatility than might first appear – and investors in prime property probably have the least to worry about. Despite speculation, the risk of sovereign default and/or a country leaving the Eurozone is still very small, so 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. Secondary property, which is more exposed to changes in the market, is therefore more likely to see an impa

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