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​The European Debt Crisis:  Uncertainty, caution and opportunity for U.S. investors

COOKE-Greg---UK_150x150.gif Greg Cooke, Chairman of BNP Paribas Real Estate UK, is certainly no stranger to the European economy. In his current role, Greg is responsible for international and U.K. development and the firm’s growth in India, China, South America and the Gulf region. Through Transwestern’s strategic alliance with BNP Paribas Real Estate, Greg offers a unique look into the European debt crisis and what it means for U.S. investors.​

In the movie “The Royal Tenenbaums,” a family of individually brilliant siblings is brought together by a crisis. But it is a dysfunctional family, plagued by disaster, dishonesty and an inability to resolve problems.

The European Union (EU) also considers itself a family (of nations), but like the Tenenbaums, the EU is also somewhat dysfunctional in the way family members interact. And with the Euro, the EU has its own crisis with which to deal. The Tenenbaum children’s early success ends up in difficulties, so it is good to ask how the EU ended up in a mess when it all started so well, and what it means for real estate investors.

Rules are made to be broken

The EU, born out of a desire to prevent wars, began in 1957 with six countries. Germany, France, Belgium, Luxembourg, Italy and the Netherlands are the original family members of the current 27. Many families, even dysfunctional ones, like to establish ground rules to live by. The EU is no different – it is a rules based organization.

The creation of the Euro currency lies with the signing of the Treaty on European Union (TEU), or Maastricht Treaty, in 1992. At this point, the rebellious teenagers of the family, the U.K., Sweden and Denmark, decided to opt out and keep their national currencies. The treaty’s two key rules are that government debt remains below 60 percent of GDP and budget deficits do not exceed 3 percent of GDP in a year.  The currency eventually went live in 1999 with cash circulated in 2002 to the 17 members.

Like many family rules, they are usually broken first by the parents – in this case, the EU founding members Germany and France. Both Germany and France broke the 3 percent deficit and Italy was allowed to join despite its government debt being over 60%. The troubled child of today, Spain, actually stuck to the rules right up to the outbreak of the subprime crisis in 2008. 

Problem children always cause a headache
The family problem child, Greece, apparently took no notice of the rules to begin with and undertook creative accounting to make its borrowing position look better than it was. Re-evaluation of the Greek financial situation occurred in December 2009 when the government announced it owed 300 billion Euros ($442bn), then the highest in its history at 113 percent of GDP (over 160 percent now), moving its budget deficit from 3.6 percent to over 13 percent in a day, four times the Maastricht limit.

A crisis was triggered. Why?  Economies and financial systems depend greatly on confidence. The Greek debt situation created uncertainty, specifically about debt repayment. Sovereign debt subsequently moved from risk free to high-risk for some countries and a new banking crisis emerged.

Today it shows in the wide discrepancy between bond yields across Europe. German 10-year Bunds are under 2 percent, France 2.5 percent, Spain and Italy at 6 percent and Greece at 27 percent, all under the same currency intended to harmonize economies. The U.K., outside the Euro, is benefiting from safe haven status. Bond yields of below 2 percent are at historic lows. Put simply, yields show the degree of trust that investors have in their money being repaid.

For Greece this has been a tragedy. Its contracting economy cannot cover existing interest repayments even without the problems of getting new debt. No one will lend to Greece, so it relies on bailouts by the European Union, European Central Bank and International Monetary Fund (IMF) – the troika.

Everyone has to go to family therapy
Europe’s response has been summit meetings leading to support funds and bailout packages.  Family therapy for the Euro has involved Germany and France pushing a fiscal agreement to oversee future government spending, signed in January 2012. Germany is playing the role of the strident parent, lecturing the errant children about the dangers of credit card spending – the price of its financial support.  Europe’s rebellious teenager, the U.K., opted out of the fiscal compact, too.

While these moves are helpful, Europe’s political leaders always seem to hint that measures are not comprehensive or quick enough.

The doubt is sufficient for financial markets to suppose that Europeans are not all for one and one for all; national, rational self-interest is the real motivation. Financial markets continue to pressure weaker European nations.

So what do Europe’s family problems mean for their U.S. cousins?
Direct economic effects are largely confined to the Eurozone. And even within Europe, the struggle of some Greeks seems very remote to people in Germany, France and the U.K.  Nevertheless, if there is one lesson from this crisis for U.S. investors, it is that being related matters, through linkages in the financial system especially.

Real estate investors prefer markets where they understand the fundamentals and consider these factors: legal structure, transparency, liquidity and risks.  This normally means staying local or specializing in certain markets. Very few investors feel comfortable buying an asset they have not visited; “kicking the tires” is almost part of due diligence. 

The underlying supply constraints in European cities can be attractive, so European investors wanting to stay local can find plenty of value. But the Euro crisis’ impact on risk profiles may make the U.S. look more attractive.  Similarly, U.S. investors with New York, Washington, D.C. and San Francisco (in the top five global cities for real estate) to choose from have little desire to take on exposure from currency risk, so they can stay at home.

Private equity funds are looking at opportunistic investments in the U.S. and Europe as bank deleveraging continues.  Investment strategies may be looking for a balance of riskier European assets and safer U.S. assets. Currency risk can be hedged against at a price. The strong U.S. dollar is making U.S. assets look pricey, but this position could unwind quickly as underlying fundamentals do not support a strong dollar; the dollar’s position is driven by Eurozone uncertainty. Those already invested in the U.S. may be looking to repatriate before the U.S. dollar weakens, but will only do so if they have another safe haven to place their money.

The Euro crisis will continue to have an impact on credit availability, and not just in the Eurozone. The April U.S. senior loan officer opinion survey on bank lending practices reported tightening standards on loans to European banks and non-financial firms with substantial business in Europe. This means that credit will be harder to come by and more expensive, too.
 
The IMF suggested that the Euro crisis will lead to a sharp drop in risk appetite, falls in asset and commodity prices and lower global demand. In effect, the IMF said the more terrible it gets in Europe, the worse it will be in the U.S., with rising yields and risk premium.  The spillover from the Euro area to the U.S. is relatively strong as the U.S. is a prominent financial center and safe haven.  The recent flight of capital to the U.S. has been positive on U.S. government bond yields, offset by higher volatility.  The IMF thinks there will be negatives on bank funding costs, corporate bonds and equities. Occupational requirements from international businesses are likely to be lower.

Uncertainty in the Eurozone will make holding assets there less attractive. The weak Euro makes assets price attractive, but the risk perception is heightened.  Eurozone investors will look outward, initially to non-Euro EU countries like Sweden and the U.K. because they are seen as safe havens.

The final outlook for U.S. real estate will depend on how the real U.S. economy fares and how the money and credit markets behave.  It has been estimated that a Eurozone meltdown would lower growth by 1.5 percent relative to what it would have been without the crisis. The close relationship between the real economy and real estate returns means that U.S. investors need to keep a watchful eye on Europe.

Will family happiness be restored?
To answer that, we end up back with the EU’s problem child, Greece. In “The Royal Tenenbaums,” family problems are partly resolved by the lead character, Royal, dying of a heart attack. No politician in the European Union publicly espouses Greece do something similar by leaving the Eurozone. With its national election concluded, Greece decided to stay in the family but it faces a generational challenge to rebuild its economy. Staying in the Euro requires Greece to keep wage growth subdued to stay competitive with Germany; many think it may take Greece up to 50 years to regain the standard of living it had before 2008.

It is this type of strain over jobs and living standards that present the greatest difficulty for EU leaders today. The solution to the Eurozone crisis is increasingly seen as creating a complete monetary union with a common debt issuance and banking union. Whether Europe’s individualistic family members agree to their lives being so closely parented remains to be seen.

 

Transwestern and BNP Paribas Real Estate
Transwestern offers real estate services throughout Europe, the Middle East, Africa, Asia and India through our strategic alliance with BNP Paribas Real Estate. Transwestern is BNP Paribas Real Estate's exclusive service provider for outward bound occupier business throughout the U.S. In Europe, the Middle East, Asia, Africa and India, BNP Paribas Real Estate exclusively serves Transwestern's occupier clients.

Both firms seamlessly deliver a consistently high-level of service to clients across borders, managed by a single point of contact. Combined offerings, global reach and close-knit teams enable both companies to serve clients effectively. To understand how our strategic alliance can help you navigate these challenging economic times and locate unique investment opportunities, contact transwestern@transwestern.net.

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