The communist legacy in the CEE is passing into history, but the degree to which real estate markets have made the transition to maturity from an investment perspective varies, says Jeremy Birkett-Jones

The potential for the central and eastern Europe region to outperform the rest of Europe in economic growth is fundamentally underpinned by solid national balance sheets, competitive labour costs and relatively young and well-educated populations. The challenge of converting this strong GDP growth into real estate performance is more difficult, the past three years having been a stark reminder to investors - in all markets - of the concept of risk-adjusted returns in real estate.

The pricing of this country risk is also distorted by investment pressure on stabilised assets in mature western European markets. With long-let Polish retail assets commanding a yield gap of between 250-300bps above comparable transactions in the UK the rationale for the pricing of either or both of these asset types might be questioned. Despite this, parts of what was historically opportunity fund territory are now drawing substantial investment from a wider group of investors, such as German open-ended funds at the other end of the risk spectrum.

Central to this diverse investment landscape are the risk factors for which institutional investors have sought country risk premiums, dominated by considerations of title, liquidity, the planning and real estate regulatory environment and the depth of occupational markets. These concerns remain in any market but are being resolved as markets mature.

Volatility in asset value is driven by volatility in the income element of the equation, a function of the relative depth and sophistication of occupier demand, and the degree of stability, or sustainability of the capitalisation component that is the depth and diversity of investor demand across the cycle. Against these parameters the real estate markets of central and eastern Europe vary greatly.

Structural limitations
Concerns stem from the relatively limited number of domestic investors in the space that is occupied in mature markets by local pension, endowment and life insurance groups. Viewed from this perspective, the challenge for former Soviet-bloc economies is more structural and will not be fully resolved for many years.

The domestic investor base is growing; the dominant buyer of institutional stock in the Czech Republic recently has been a domestic fund. Debt-reliant local private buyers continue to find it difficult to secure financing at loan-to-value ratios that will enable them to make larger acquisitions. But debt markets are freeing up and, in time, local and international banks will start lending in the more mature markets of the region, such as Poland and the Czech Republic.

Experience suggests that in these more mature markets of central Europe the rate of domestic participation is far higher, although a large part of this is domestic developers exiting projects at completion to international funds seeking exposure in stabilised assets. Total transaction volumes have now recovered strongly, broadly in parallel with the markets of western Europe.

The central European markets that have joined the EU are now destinations of choice, underpinned by their geographic proximity and historical connections. As in other European markets, regardless of domestic demand, investors have tended to set the tone of pricing for stabilised and de-risked investments of greater volume. The appetite for the investment opportunities in Poland among more risk-averse international investors remains robust.

Further east investors are limited to those seeking opportunistic returns with less of a concern for risk-adjusted performance. This risk expectation is underpinned by the performance experience of investors in markets such as Romania and Bulgaria in the last cycle, which now dictates an enhanced country risk premium.

The scale of modern real estate stock, reflecting underlying occupational demand similarly differentiates these markets. While Warsaw is no stranger to abandoned tower cranes, the supply-demand dynamic in all occupational markets in Poland is now balanced and offers modern stock that is comparable with western European markets.
Modern retail formats, for example, are now penetrating Polish towns with a population of 50,000 and above, as they did in western European markets in the last cycle, and are led by food and home-improvement operators. Tesco has identified penetration of the Polish market as a strategic priority and is rolling out a substantial programme of new stores.

In other major Polish cities, such as Poznan and Wroclaw, second- and third-generation shopping centres, increasingly comparable to those in western Europe, have now usurped earlier, less compelling offerings. These centres attract international retailers, with as H&M, New Yorker and TJ Maxx (trading in Europe as TK Maxx) seeking to secure market share.

Inherent in the modernisation of the commercial real estate stock of all these markets are the substantial pressures placed on the planning system and much more fluid movement between use classes. While sub-optimal, the formal planning and regulatory environment should therefore be less of a concern to investors, especially in economies that are ultimately answerable to the ECJ. The great threat lies in investing in under-developed markets where occupational demand is still shallow.

A region that was lumped together as ‘central and eastern Europe' is moving beyond this simple designation and away from a risk profile that historically limited investors to opportunity funds. The markets of Poland and the Czech Republic are rapidly approaching the levels of western Europe. However, markets from Bulgaria to the Urals remain the preserve of the opportunity fund manager where high absolute returns continue to be required to justify the uncertainties inherent in what can justifiably be called emerging markets.

Jeremy Birkett-Jones is fund manager for Hunter Property Fund Management based in Prague