Poland, Russia and the Czech Republic attracted the lion's share of local and cross-border capital in 2011, says Jos Tromp

In 2011, overall property investment volumes in central and eastern Europe (CEE) amounted to more than €11bn, twice that of 2010 and the third-strongest level ever achieved. Following the continuous domination of Polish and Russian transactions in recent years, investment activity also picked up considerably in the Czech Republic during 2011. However, deal volumes in markets beyond the three mentioned, remain low.

Despite some strong local interest in markets such as the Czech Republic and Russia, most of the deal volume in CEE remains the result of cross-border investment. This was being driven by two factors. The first was that investors well known to the region become more active. The second was an influx of opportunistic investors seeking to benefit from the healthy performance in Poland and the Czech Republic, particularly in segments of the market where they believed income and capital value growth would be apparent over the coming years. These value-add or opportunistic investors mainly originate from the UK and the US.

In 2011, deals closed by UK investors significantly increased compared with 2010. Even more remarkable, was the increase of US investor allocations into CEE. With a total of over €2.5bn in 2011, US investors reached the highest level of activity ever recorded in CEE, far above levels achieved in 2006, the strongest year thus far for US investors.

Current interest in prime real estate is based on several indicators. The fear of a period of high inflation is pushing money into the real estate sector. Residential real estate, traditionally, has offered the best prospects as an inflation hedge. However, depending on the form of the lease contract, commercial property can also be of interest on this front. Alternative investment categories currently have less interesting prospects. Gold especially, but also other commodities, are currently at record high levels; a risky investment for the time being. Returns from government bond yields - examples are UK, German and US government bonds - are trading at record lows and would not even cover inflation in most cases. Significantly higher yielding bonds are available in other parts of Europe; however, the risk-return profiles are in a completely different category now and not comparable to prime real estate. Hard currency investments such as the Swiss Franc have become less interesting due to the strong value increases and ceilings put in place to limit value increases and safeguard the competitiveness of these countries.

One of the most important reasons why the demand for high quality property in the CEE has increased so strongly is the fact that prices have reduced considerably since the peak of the market in 2007-08. While the changes to capital values (price per sqm commercial property) differ strongly from market to market as well as by quality segment, as an indication, most western European prime capital values declined by on average 20-30% from peak to trough during the last cycle. Some markets, particularly the large German cities, saw less significant declines, while economies that suffered a more considerable impact on economic growth (Ireland, parts of CEE) experienced even more considerable impacts on values. Now prime yields and prime rents are currently at more sustainable levels in relative pricing terms to other assets classes. As highlighted in figure 1, the yield gap for central Europe - the difference between the German government yield and the prime central European yield - is at its highest level since 2003-04. This indicates that today's market situation offers interesting pricing levels for real estate investors.

Based on the assumption of continued economic uncertainty across Europe, it is likely that commercial property will remain an interesting asset class for a broad range of investors. However, unlike previous downturns, two tiers have emerged in the markets, both with different fundamentals and risk-return profiles. Economic growth in Europe - and possibly globally - is expected to remain limited in a potentially high inflationary environment, which is likely to adversely affect property occupancy levels. Increased occupier requirements in relation to their properties have resulted in a shift from older real estate into newly built and or refurbished space, partly driven by the possibility to get good deals on the back of increased vacancy in most markets. Vacancy therefore is on the rise in older buildings of a lower standard and in poorer locations.

Sustainable aspects have also become more important, which may relate to a building being well connected to public transport and/or offering lower energy consumption. From an investor's point of view, it is essential to understand these drivers in order to make an investment that will offer the returns needed over the total lifespan of the investment. A solid exit needs to be ‘guaranteed' as a result.

Based on uncertainty in the markets, it seems to be a good time to consider real estate investments. Due to increased interest, however, it is essential to select appropriate investment opportunities that will deliver the expected returns. A selective approach is required in line with individual investors' needs which should aim to ‘guarantee' that the mistakes made during the previous cycle will be avoided.

Based on the intentions investors and developers are having for 2012, a continued search for high quality real estate is under way. Limited availability of suitable product and longer time needed to close deals has resulted in relatively low numbers for property investment in CEE during the first quarter of 2012. The expectation, however, for 2012 is that investment volumes are to increase significantly but will remain focused mainly on Poland, Czech Republic and Russia.

Jos Tromp is head of CEE research and consulting at CBRE