Outsiders are quick in finding the right box for the Italian economy and property market. Two decades of anaemic economic growth, the absence of meaningful structural reforms and notorious dysfunctional politics do not help Italy’s reputation as an investment destination. Additionally, the global recession has earned Italy a membership in the infamous ‘Club Med’, alongside the struggling economies of Greece, Portugal and Spain. Financial markets are nervous towards this group of southern European countries as they show a worrying combination of economic problems, most prominently unsustainable government debt and weak international competitiveness. With regard to the property market the critical view on Italy from outside is completed with reference to weak rental growth, below average building quality, high tax rates, inefficient bureaucracy and unsatisfactory market transparency. As all of this is indisputable, it is very easy to ignore Italy as a property investment destination. In its latest analysis, Henderson Global Investors examines why this may be a bad idea.

Missing a trick?
The ‘Club Med’ term not only displays inappropriate arrogance towards southern Europe, it also bands together economies that have little in common. Spain’s economy crashed after an extraordinary debt-fuelled construction and spending boom and thus its current issues have more in common with the US and the UK than with its geographical neighbours. Greece and Portugal are both very small, poorly diversified economies, which failed to find their own formula for growth as other peripheral European economies such as Ireland, Slovenia and Finland. Italy does not fit well into either group. First and foremost, Italy is far from being peripheral. Italy is the seventh biggest global economy (only marginally smaller than the UK) and has been part of the European Union since its foundation. It has a broad-based diversified economy with an export industry almost on par with France and well-ahead of that in the UK. The global recession exposed other positive characteristics such as the relative resilience of the Italian banking system and the stability of its public finances, despite the very high debt to GDP ratio of around 125 percent. Bond investors are less nervous about Italy because the public debt level has been almost stable for 10 years, is forecast to increase only moderately and, like Japan, is mainly in the hands of domestic investors. Additionally, the high government debt is counterbalanced by low debt levels in the private sector; in fact, Italian households have the lowest consumer and mortgage liabilities of all western Europe.

1. Household debt as a percentage of GDP (2009)
Economic strength in Italy is regionally divided, more than in any other country in Europe. Northern Italy reaches the same GDP per capita as the wealthier regions of Germany, France and the UK, whereas in the south, levels are comparable to southern Spain, and are barely ahead of Greece or Slovenia. Hence all country level economic figures are heavily diluted and can be misleading. It becomes obvious that a closer look at the Italian economy reveals a rather more differentiated picture often missed by international observers.
Inside and outside views on Italy can be widely divergent. Foreign players mainly tend to see risks, whereas locals praise the achievement of relative market stability. Clearly, there is a middle ground to be found somewhere.

The fears of international property investors mainly revolve around the perceived country risk heightened by uncertainty about the sovereign debt issue. The argument goes that Italy is looking ahead to a painful period of fiscal austerity and slow growth if not outright economic disaster. The occupier and investment markets should therefore have crashed as they did in the UK, eastern Europe and the US. Discovering that price adjustments came in the same moderate dosage as in the core markets of France and Germany has left investors anxiously waiting for another round of substantial corrections. As at mid-2010, however, distressed sellers are nowhere to be seen in Italy, yields for prime product are hardening and rents are close to bottoming out. Italian players are not surprised by the market’s apparent resilience and look ahead with cautious optimism to a return to the familiar pattern of slow growth.

Are locals right to be so confident?
There are a couple of idiosyncratic characteristics which have helped to keep Italian property on a stable path. The rental corrections for office, retail and industrials have been sharper than in most other European markets, which explains why yields for rack-rented assets are relatively low. Basically, investors feel confident that the market has returned to sustainable rental values. Distress weighs more heavily on foreign rather than national players. With Italy being a relatively untransparent market, international players without a local presence are at a greater risk of ending up with the poorer assets that the locals have rejected. Additionally, international and more opportunistic investors tended to leverage more aggressively, often with the capital of foreign banks that had limited knowledge about the market.

Overall in Italy the use of debt has remained conservative. Banking is still strongly based on relationships, in particular as the weak position of banks in foreclosures encourages conservative lending policies. According to analysis from DTZ, during the last decade in Italy commercial property loan to values increased only slightly, when at the same time other European markets saw gearing increase considerably. Accordingly the funding gap of debt to be replaced by equity is on a similar level to France and Germany and significantly smaller than in the UK or Spain. Italy was able to avoid some of the short term sentiment fuelled market exaggerations bedevilling other markets in Europe. According to IPD, Italy’s comparably moderate capital value increases in the boom years were reversed in the last two years whereas in a number of European countries the corrections to date look questionably benign, given the considerable boost obtained before.

2. Total change in capital value over stated period
With very few exceptions, Italian property investors have stayed on their home turf, fuelling a steady inflow of capital from pension funds and insurance companies, which have helped to keep the market liquid in difficult times. Ironically, efforts to convince Italian investors to go cross-border are said to be tarnished as European markets, after the volatility seen in the last years, are regarded as too risky in the eyes of Italian investors. In the end, investors who stick to the caricature of the Italian economy and property market are quite likely to miss a trick in the same way that Italian investors could miss out on opportunities by staying at home.